Families are usually a complex mix of individuals with different abilities, attitudes, aspirations and financial needs. Each family member is likely to want different things, and in the context of a family owned business, this can produce tension and discord.
A well advised family business will, of course, go to great lengths to get a sound understanding of the different aspirations of the family members, to attempt to achieve a degree of alignment of ‘aspirations’ and ‘outcomes’, and then to document (formally or informally) the findings and any agreed strategy.
However, we find that the most effective strategies are under pinned by ‘structure’. We have also found that the share capital of the family business can be the right place to start.
What do we mean by ‘share capital’
Assuming the family business is carried on through a company, the shares owned by the family, and the rights that come with those shares, may well be the primary interface between the family owners and the business itself.
The rights attached to share capital are principally set out in the constitutional documents of the company but are also determined by company law. The main rights might include some or all of the following:
- Rights to share in the capital value – i.e. the right to a proportion of the underlying ‘value’ of the company. The shares may have a fixed capital value (usually called preference shares) or their value may vary as the value of the company grows or shrinks (usually called ordinary shares).
- Rights to dividend income, which again may be fixed or variable.
- Rights to vote, i.e. to control.
BUT not all share capital needs to be the same; the shareholders of a company can determine how rights are shared between them. This means different types of share capital can be used by families to spread risks, rewards, control, etc. between the family members in different ways.
Whilst not something that appeals to all families, creating multiple classes of share capital can help family members realise different personal goals, whilst all members still retain an interest in the family business. This can have obvious advantages such as protecting family unity or in the UK context, maintaining the valuable Business Property Relief.
Given the almost infinite variety of share capital that can be created, and the fact that the form of share capital can usually be changed quite easily, it may seem surprising that many family companies still only deploy one type of share capital. Each share owned by any family shareholder - regardless of age, risk profile, financial needs and level of active engagement - will carry the same rights as any other share. One class of shares is often seen as a way of maintaining ‘fairness and equality’ amongst family members. This is an important point for many families that I work with but equally, such a structure can ignore that not all family members necessarily want the same things!
A Simple Example
ABC Limited is a family trading business owned by the A family. Mr A founded the business 60 years ago and worked in the business as an extension of his life, but sadly died last year passing all his shares to Mrs A. Mrs A is now 82, has variable health and needs a regular income – she has no appetite for risk. Mr A and Mrs A have two children, who couldn’t be more different.
Son, the eldest, has always looked up to his father and wanted to follow in his footsteps. After a period of working outside the business, he now works full time in the family business as CEO. He is 55 and has two children – now 17 and 12.
Daughter has no interest in the family business and has always seen it as bit of a nuisance – she has pursued a very successful career in Australia and is married to a top lawyer in Sydney. They have no children. Mrs A wants to pass shares to her son and daughter – she wants to be fair, but wants to protect the family business.
A single share class structure
Suppose they maintain a single class of shares with Mrs A passing 40% of her shares to each of her son and daughter. Mrs A would retain 20% of the votes, dividends and value but her investment would be at risk of fluctuations in value. She also has no certainty of dividends, which are paid at the discretion of the Board and whilst she can vote, her health precludes her from actively participating. Son holds 40% of the shares, but cannot control, needing his sister’s co-operation to achieve anything. Looking to the next generation – things look even harder.
Creating different share classes
Suppose the shares are split as follows, with everyone holding the same initial value, but with rights more closely aligned to their respective wishes:
- Mrs A holds preference shares with a fixed value and fixed dividend rights, they do not vote. They provide her with a steady, secure income stream and the value of her investment is fixed, consistent with her risk appetite. In the UK the investment should also continue to qualify for Business Property Relief, allowing her to pass the shares on to the children (or even grandchildren) free of tax cost assuming the rules remain unchanged.
- A ordinary shares – which carry 50% of the remaining value and 50% of any variable dividends, if declared but 100% of the votes. These are held by Son, allowing him to control the company but sharing value fairly with his sister.
- B ordinary shares – which carry 50% of the remaining value and 50% of any variable dividends, if declared but crucially carry no votes. These are held by Daughter allowing her to share value fairly with Son but requiring no active participation or control.
Of course detailed legal and tax advice should be sought prior to implementing any such arrangement and such a share structure cannot solve all the challenges of a complex family situation and needs careful consideration as part of a broad understanding and analysis of a family’s holdings, operations and ambitions. Further thought is almost certainly also going to be needed in the future (what happens, for example in generation 3?).
In conclusion, whilst an overly complex share capital structure can, of course, create confusion, I would suggest that businesses should consider reviewing whether their share capital structure is still optimal, especially as ownership passes from one generation to the next.