Share Ownership in a Family Business
In this, the sixth of our series of articles on family businesses, Andrew Drake looks at share ownership. Many family businesses are carried on through private limited companies and the family needs to think about establishing some rules as to which family members should be allowed to own shares.
Who should be allowed to own shares?
Ownership of shares in the early stages of a family business can be a relatively simple matter. All of the shares will typically be held by the founder and his immediate family, all or most of whom will often be working in the business.
However, once the business moves into the second generation and beyond, ownership can soon become fractured and a number of questions arise:
- Should ownership by in-laws be allowed? If the answer is yes, what happens if the marriage fails?
- Should non-family executives be allowed to own shares? If yes, what happens when the employment ends?
- Should ownership be confined to family members? If yes, what is meant by a family member? Does this, for example, include adopted, illegitimate or step children?
Families will have different views on the above questions and there is invariably no right or wrong answer. However, each family should really be addressing these questions and establishing a clear ownership policy. This policy can then be reflected in the share transfer provisions in the Articles of Association or in any Shareholders’ Agreement. In the case of larger companies the main principles might additionally be set out in a Family Charter.
Sometimes the answer to these ownership questions may be to have two classes of shares.
Different classes of shares
In its early stages a family business will tend to have a relatively straightforward share structure with one class of ordinary shares owned by the relatively few family shareholders.
Different classes of shares can, however, be particularly useful as the number of shareholders increases and the business becomes more complex. Here are some examples:
Distinguishing between family branches: More mature family businesses may have a shareholder base which consists of a number of different branches of the family. In these circumstances the shares could be classified into, for example, “A”, “B” and “C” shares, corresponding with the three branches of the family.
The three classes would have the same rights in terms of matters such as the right to receive dividends, the right to participate in a return of capital and the right to vote. However, the classification can be useful in terms of matters such as:
- The right to appoint a director: the Articles of Association or a Shareholders’ Agreement might provide that the holders of each class of shares have the right to appoint one or more directors.
- The pre-emption procedure on any transfer of shares: the Articles or a Shareholders’ Agreement might provide that if a holder of one class of shares wishes to sell, those shares must first be offered to the other shareholders of the same class before they are offered to the shareholders of the other two classes.
The differing income expectations of shareholders: Family shareholders who are not employed in the business may be more reliant on dividends than those who are. Equally there may be a feeling that those who are not employed in the business should not have voting shares (or perhaps should only have shares with restricted voting rights).
To deal with this, the share capital might be divided into:
- ordinary shares having the normal rights as to dividends, voting and capital and
- preference shares which have a preferential right to a fixed dividend and rights on any return of capital but no voting rights (or restricted voting rights).
The ordinary shares could be owned by those employed in the business and the preference shares by those who are not.
Passing down wealth but not control: The founder of a family business may be happy to pass down his or her wealth, for example in the form of entitlement to dividends, to the next generation but at the same time may be concerned that the next generation is not yet old or mature enough to assume control of the business.
One solution to this is for the share capital to be divided into:
- preference shares carrying a preferential right to a dividend but no votes and no rights to capital and
- ordinary shares carrying a non-preferential right to a dividend but full voting rights and rights to capital.
The founder could then retain a majority of the ordinary shares but pass down all or most of the preference shares. Additionally the founder could consider putting the ordinary shares which are retained into trust.
Non-family executive directors: One obvious way of incentivising non-family executives is to allow them to have shares, so that they are encouraged to maximise the value of those shares. However, the family may be reluctant to allow this as it may feel that voting power should be retained strictly within the family. In these circumstances the solution may be to provide the executives with non-voting ordinary shares which in all other respects have the same rights as the other ordinary shares.
Distinguishing between employees and non-employees: A family might decide that share ownership should be open to all family members, whether employed in the business or not, but that voting control should be in the hands of those who work in the business. In this case the share capital could be divided into:
- one class of shares with full voting rights (owned by employees) and
- another class with restricted voting rights (owned by non-employees).
While there may be a reluctance to face up to some of these questions, the absence of clear rules on ownership of a family business can often cause serious difficulties, particularly in the context of a succession event.