Harford Business Ledger: June 2005

This month's Harford Business Ledger features family businesses. A family business is ripe with the potential for significant legal complications. In addition to the issues and challenges faced in the operation, management, dissolution and inheritance of any business, when the owners are family members, problems can increase exponentially.

It is bad enough to have a falling out with a partner you will never see again, but when the falling out impacts the invitation list at Thanksgiving it strikes much closer to home and heart! From a legal standpoint, the goal of any family business should be to eliminate as much opportunity for dissension as possible. The first step in dissension elimination harkens back to my article of two issues ago ? "get it in writing." Any business involving two or more people, especially a family business, should have a comprehensive set of agreements clearly specifying ownership, management, operation and what happens in the event of dissolution, death or disability. If everyone understands the rules from the outset you have a much better chance of quelling dissension and unhappiness. If matters cannot be resolved, rules regulating the orderly dissolution of the business may allow the preservation of the family relationship even if the business relationship fails.

A buy-sell agreement should be entered into which provides exactly what happens if someone resigns, retires, becomes disabled, is fired or dies. Generally, this agreement would provide that the remaining owners have the right and/or the obligation to purchase the ownership interest of the departing owner. It is usually best that this provision be mandatory so that the remaining owner does not end up with a partner he or she doesn't want.

These issues are best illustrated by example. Our hypothetical family includes a mother, father and two married daughters. One of the sons-in-law, we'll call him SIL, is in business with Dad. All other family members are employed elsewhere. Dad and SIL should have all of the agreements in place as previously discussed. SIL and Dad should have a written agreement allocating responsibilities between them setting forth salaries and other issues essential to the operation of the business. A buy/sell agreement should prohibit SIL from selling his ownership interest in the business to anyone (including, but not limited to, Osama Bin Laden), without first offering the interest to Dad. And vice-versa!

The agreement should also provide what happens in the event of the death of Dad or SIL. If Dad dies first, SIL does not want to have Mom as his new partner, but Dad wants to make sure that Mom receives the value of his interest in the business for her financial protection. Therefore the agreement should provide a formula (perhaps funded by insurance) for SIL to pay Mom to purchase Dad's interest in the business. In the end, SIL ends up with the whole business and Mom is protected. A formula ensures that there will be no family squabbles about the value of the business, because Dad and SIL agreed upon the formula before Dad died.

Another variation of this same issue is presented where there is no agreement between Dad and SIL, and where, although Dad wants to leave his interest in the business to SIL and/or SIL's wife, Dad also wants to treat his other daughter fairly. This can be accomplished in a variety of ways depending upon the value of the business. If the business is equal in value to other assets, SIL and his wife could be left the business, and Dad's other daughter could receive a bequest of the balance of the assets. Alternatively, Dad could take out an insurance policy with the other daughter ("TOD") as the beneficiary in order to equalize the value between his children. If the business is by far the most valuable asset of the estate, Dad could give SIL the option to purchase Dad's ownership interest in installments payable with interest over time to TOD. If the option was not exercised then Dad's interest in the business could go to TOD.

There are a myriad of ways to structure solutions to these problems. It is absolutely essential that the issues be identified and agreed upon, in writing, in advance to avoid dispute and dissension. Dealing with issues such as payment on death early in the process allows the use of additional tools such as insurance to solve problems. If you wait until Dad is not insurable, you have removed insurance as one of the solutions. Failure to do so simply limits your options, increases your costs and, most importantly, in the case of family businesses, increases the probability of devastating consequences to the business and family relationships.