It's obvious if you do the math: The longer a family business has been in existence, the greater the number of people who may own its stock. And that's the exact scenario that worried DeNean Stafford III, CEO of Stafford Development Inc., a second-generation diversified company in Tifton, Georgia. Currently, he and his two sisters (both of whom are inactive in day-to-day management) own stock. That's perfectly fine for now, but what happens in the future when generations of kids, grandkids and other assorted relatives end up with ownership interests in the family business?
"I've seen too many family businesses collapse on top of themselves because the stock was fragmented and owned by shareholders who had no interest in the business," Stafford says. So, to insulate itself, Stafford Development created and implemented a detailed plan for the redemption of its company's stock.
"It's ideal if a family business can do this before the stock certificates leave the founder's hands," says Peg Eddy, president and principal of Creative Capital Management Inc., a San Diego-based family business consulting firm. If that's not possible, she urges the shareholders and investment management to do it-and do it before the business runs into a warring situation.
Get With the Program
Shareholder wars don't necessarily result from one side of the family fence being more right than the other. It's often more a matter of stock owners simply having different agendas.
Those shareholders not directly involved in the business, the outsiders, often received their stock as an inheritance. And yet it doesn't turn out to be a great windfall: They can't sell it easily, and the money they earn from it usually pales beside the high fliers in today's markets. Outsiders often look for ways to shed this so-so investment and reinvest the money in a venture that's more lucrative and more liquid.
The insiders-those family members active in the business-have another vision. Perhaps they want to keep dividends low, so more money can be plowed into the business for growth and compensation. Or maybe they want a way out of being forced to confer with outside relatives when making decisions concerning the company's future.
Whatever the reason, it's imperative that family businesses put their own buy-back programs in place so shares to companies' stock can be redeemed by those who decide they want out. The always idiosyncratic makeup unique to each family business will determine the specifics of the plan, but "any plan considered should restrict people from selling to anyone outside the family and define when, who, what and how the company will redeem the shares," says Mike Cohn, a family business consultant and head of the succession-planning division of CFG Business Solutions LLC in Phoenix.
"Any of the four Ds-death, divorce, disability or disillusionment-can trigger the desire for a stock redemption," says Peg Eddy. "If the company has a buy-back plan in place, money is generally put away into a special, segregated account called a sinking fund, specifically used to redeem shareholders' stock."
But a company must maintain the right to control whether it will seed the fund each year so that it doesn't put itself at risk. Says Cohn, "It should only be done in years when the company has been profitable and has enough cash."
Things to Consider
Don't expect smooth sailing when pricing stock redemptions. Even with a professional appraiser involved, insiders and outsiders can get into real battles over the set value of the stock and how it's going to be valued.
But even then, the stock valuation is not so simple. Says Cohn, "If a business is worth $1 million, for example, and one-quarter of the shares are to be redeemed, the person will not be entitled to $250,000. That's because what is being sold is a minority interest that's non-liquid. Typically, there's a 30 to 40 percent discount for this nonmarketable, minority block."
And there are other variables to consider. Will the stock be valued differently if the person is redeeming simply because he's leaving to pursue another career rather than if he is leaving because he's been swindling the company? Will the value change if some of the stock is voting stock and some of it isn't?
"From an emotional standpoint, it's important for all shareholders to understand that, like an investment, there are price fluctuations in the stock over a period of time," says Eddy. So it's possible that one sibling might redeem 1,000 shares of stock at $50 per share one year, and five years later another sibling might redeem 1,000 shares for $85 each. "Everyone can't be guaranteed they'll get the same amount for the same number of shares," she says.
It's also important to form a plan that delineates how and when the payment of redemptions will be made. Will there be a window of opportunity for redemptions, sometimes from 30 to 90 days annually? Will the payment be immediate and in cash, or will it be spread out over a longer period of time? Will there be a minimum and maximum amount that can be redeemed annually? If shareholders want to redeem more than the company has in its own sinking fund, will all the requests be handled on a pro rata basis, or first-come, first-served?
Stock agreements are also subject to complicated tax laws, and the family should seek the counsel of appropriate accountants and lawyers when designing a stock-redemption plan to see whether the redemption will be treated as ordinary income (and taxed at the individual's normal rate) or as capital gains (and therefore taxed at a lower rate).
The bottom line is that these stock-redemption agreements can be tricky. Because each family is different, the final agreements must be customized. "Ideally, this redemption agreement would be drawn up the minute stock certificates leave the hands of the founders," says Eddy. Whatever its final terms, the plan should aid long-term family ownership, respect the important contributions and the varying needs of both insiders and outsiders, and be as savvy as possible about the tax considerations of redemption.
Patricia Schiff Estess writes family-business histories and is the author of two books: Managing Alternative Work Arrangements (Crisp Publishing) and Money Advice for Your Successful Remarriage (Betterway Press).