familyownedbusinessblog

Structuring the Business for Success: Choice of Entity

In Albuquerque recently, I presented this materials to owners of agribusinesses.  In the next several blogs, I share that presentation. 

In choosing an entity there are seven key factors to consider:

1. Purpose.  What is the purpose of the entity?  The entity chosen should be "right" for the purpose. One entity does not fit all purposes. For example, a going concern will have operations and may have real estate.  A S corporation may be right for the operations but wrong for the real estate (more on that in subsequent posts).  The "right" entity for the real estate is likely to be a limited liability company (LLC). 
2. Liability.  Limiting the owner's personal liability for the debts of the entity is an important factor in choosing an entity. Corporations and limited liability companies provide such protection to its owners.  Sole proprietorships and partnerships do not with the exception of limited partnerships.  In limited partnerships, the limited partner's contribution to the partnership is at risk but the limited partner is not personally liable. However, the general partner of a limited partnership is personally liable. Note that an owner can become personally liable by guaranteeing the debts of the entity.  The owner may also be personally liable for their own actions.  In this instance the personal liability arises out of those actions and not because of ownership of the entity.
3. Cost.  A factor to consider is the cost of forming the entity and the cost of maintaining the entity. Nothing comes free. There is a cost.  More on this in subsequent posts.
4. Size and complexity of the enterprise.  The choice of the entity or entities will be driven in large part by the size of the operation and the complexity of the enterprise.  A simple form of business is sole proprietorship but this does not allow for the addition of venture capital or partners.  Nor does this simple form protect its owner from liability for its debts or claims. In a complex operation with risk of liability, it will be desirable to have an entity that provides limited liability.
5. Regulatory requirements. The requirements on a particular operation may make one form of entity better than another form. In some personal services operations, the requirements and licensing is personal to the person delivering the services. This may make partnerships or limited liability partnerships more attractive than a corporation. 
6. Valuation.  If transferring business interests to a younger generation of owners is important, valuation of that transfer will be important, too.  The type of entity and the limitations on transfer will be factors in determining the value of the business interests.
7. Taxation.  How business entities are taxed is a significant factor in which entity is chosen.  The purpose served by the entity is largely a tax driven decision.  For example, C-corporations are taxed at the corporation level and dividends are taxed at the corporate and shareholder level (taxed twice).  Partnerships, LLCs, and S-corporations are pass-through entities meaning that the shareholder pays the income tax of the portion of the entity allocated to that shareholder.  Recognition of gain is treated differently among the entities.  Usually there is a recognition of gain when an appreciating asset is distributed to shareholders of a corporation.  Typically there is no recognition of that gain when the same appreciating asset is distributed to partners of a partnership or members of a limited liability company. 

 Next post:  Basic Governance Structure

Raising the Next Generation: Capital Accounts

Generally, the Legacy Family has four capital accounts which it attempts to keep in balance. Those accounts are:

1.  Financial Capital.  This is the money earned as well as the investments under management.  This account also includes wealth transfer strategies, family business operations, financial parenting and understanding the psychology of money.

2.  Intellectual Capital.  This is the family's experiences, its know-how and general knowledge. It includes education, career choices, mentoring/coaching, governing the family (how rules are made for future generations).

3.  Human Capital.  This is general parenting and grand-parenting skills, communication skills, values, morals, ethics, collaborative decision making and conflict resolution.  This account will also contain leadership training and team building so necessary to the Legacy Family.

4.  Social Capital. This is the philanthropy of the Legacy Family whether it is a donor advised fund or a family foundation.

A Legacy Family will engage in activities that build each of the four capital accounts so that the accounts are in balance. The Legacy Family will develop activities that provide for:

• effective communication among the family and other stakeholders;
• a process for collaborative decision-making;
• conflict resolution;
• identification of shared values;
• code of conduct that articulates the behaviors acceptable for family members;
• a process for acceptance of non-bloodline family members including partner choices;
• managing expectations of future generations;
• developing financial competency in all generations; and
• a process of accountability.

The following reading list will help in developing useful activities to build deposits in the capital accounts:

Eileen Gallo, PH.D. and Jon Gallo, J.D., Silver Spoon Kids:  Communicating about money in healthy ways. Teaching strong values and compassion. Preventing a feeling of entitlement, 2001, Contemporary Books.

Eileen Gallo, PH.D. and Jon Gallo, J.D, The Financially Intelligent Parent, 8 steps to raising successful, generous, responsible children, 2005, Penguin Books. 

Joline Godfrey, Raising Financially Fit Kids, 2003, Ten Speed Press. 

James E. Hughes Jr., Family Wealth, Keeping it in the Family: how family members and their advisers preserve human, intellectual and financial assets for generations, 2004 Bloomberg. 

Thayer Willis, Navigating the Dark Side of Wealth, A life guide for inheritors, 2005, New Concord Press.

 

Raising the Next Generation: Legacy Families

Like most families, financially successful families hope that each of their members in this generation and the next will be successful, happy, healthy, and content. To break cycle of rags to riches to rags in 3 generations will require intention and attention. 

It is important to remember that yesterday’s wealth is no guarantee of tomorrow’s success. The adage “shirtsleeves to shirtsleeves in three generations” is not unique to thos living in the United States.  Here and elsewhere there are many families who have been able to perpetuate their success for many generations. Their progeny have become new titans in business; assumed leadership roles in public service, etc. all by effectively developing their individual talents. Their extended families enjoy each other. Each new generation seems to build on the shoulders of those who preceded them. These special families are called “Legacy Families”.

What is it that differentiates a Legacy Family from all the rest? Legacy cannot be mandated or guaranteed. It is thoughtfully designed, carefully implemented, and perpetually nourished. It is also quickly lost and easily broken. Not all those for whom the legacy was created accept or appreciate their gift. For many it is not even a gift, but perhaps an unwanted burden.

A Legacy Family has four characteristics:

1. They have the capacity to add value to our society and to recognize the importance of contributions to the financial, human, intellectual, and social capital of their family and community;
2. They have the necessary skills and education as a family to develop the competencies to handle the responsibilities of wealth; to effectively utilize the opportunities that have been provided to them; and to become productive members of their communities;
3. They have a connection to their ancestors, current and future descendants including a connection to their heritage;  maintain positive family relations; communicate effectively; and promote generational governance structures, which will assure the success of future generations; and
4. They are generous of their time, talent and treasure; recognize their good fortune; and empower each family member to become the best he or she can be.

Fiduciary Duty vs. Standard of Care

Today at the regular meeting of the Oregon Family Firm Institute Study Group here at Ater Wynne, the discussion focused on the fiduciary duties that the professional owes the client and the standard of care imposed on the professional during the engagement.  We also discussed the difference between the two. It was helpful to the discussion to have the definitions in front of us which I share here:

"Standard of care" is the degree of care or competence that one is expected to exercise in a particular circumstance or role. "Fiduciary duty" applies to a special relationship in which one acts for someone else's benefit while subordinating one's own personal interest to that of the other person. It is the highest standard of duty implied by law. The elements are trust, confidentiality of information, good faith and candor.

Three members of the study group discussed their perspective. First to speak was the certified public accountant. He reported that the fiduciary duty of a certified public accountant involves a superior trust relationship, heightened standards and inherent application of the duty of a fiduciary. The duty of a CPA is not only to the client but to the public who is relying on the information provided by the CPA. The standard of care involved in the engagement between client and CPA involves independence, integrity and objectivity.

Next to speak as the registered investment adviser who reported that his fiduciary duty arises because the client has transferred the investment decision to the RIA.  This creates the special relationship that causes the RIA to act for the client's benefit. A broker/dealer typically does not have this special relationship because the investment decision remains with the client. The broker/dealer is making buying recommendations.  The standard of care for both remains the suitability of the investment under the circumstances of the client's risk tolerance.

last to present was the attorney who spoke of the special trust and reliance relationship existing between client and attorney.  This fiduciary relationship creates the duty owed to the client by the attorney which is a duty of loyalty and utmost good faith. This duty continues even beyond the actual engagement. The standard of care that exists during the engagement in addition to the fiduciary duty consists of providing diligent representation for a reasonable fee,  keeping confidences, and keeping client reasonably informed.

Many of those involved in the discussion thought that not infrequently professionals blurred the lines during the course of an engagement in two instances: 1) the financial self interest of the professional was put in front of the interest of the client; and 2) when there were multiple clients such as is often the case when representation family business owners. 

The latter issue led to a discussion of who is the client.  Because the duty owed is to the client (except in the case of a CPA who may owe a duty to the public, too), it is imperative to identify the client to the satisfaction of the professional and the client to avoid confusion or worse....breaches of the duty.

This discussion reminded us all that we need to understand the rules each profession and to identify clearly who is the client and communicate that to the client.

Family Governance: Family Meetings

One of the jobs of the family council (see post on May 12) is to organize the family meetings. What are family meetings?  Are these just family reunions that my family has every 5 years?

Certainly some part of a family meeting is a reunion. But it is a reunion with a purpose and an educational component.  The family meeting is where the work of the family council is shared with the family stakeholders. Here the stakeholders learn the elements of the stewardship which will be expected of them.

These meetings should be held in a location away from the family's business and a place that provides time for work and fun. Both are important and necessary. One without the other is boring and will not capture the imagination of the more remote stakeholders.

All family members should attend these meetings. They should participate in age appropriate activities but by the time the members are 14 years old their involvement should be substantive.  A forestry family took its younger family members on excursions through the forest teaching them about the trees while older members of the family met to learn about the harvesting plan for the coming year and the succession plan for the current leadership.

These meetings will also be the venue at which the family council proposes the family mission statement and vision for the family and its members. It is here that the family members learn about and live with what it means to be a member of this business-owning family.

It is very important that planning these meetings be thoughtful and thorough. The work that goes into them will be worth it.

 

Family Governance: Family Council

Business owning families find it useful to have structures for the governance of the family as a means of providing the education and communication necessary to create good stewards of the family business.  This is not a founder's priority but it is a cousin consortium necessity. In some family owning businesses, family structure begins in the sibling group by organizing the spouses of the siblings to provide a means of keeping the spouses informed and constructively involved.

The structure used is a family council. This council serves many purposes but at its core it is a means and method of informing family stakeholders about markets, finances, threats and opportunities of and to the family business. It is also the means and method by which the board of directors of the family business is informed about the needs and concerns of the family stakeholders.

The family council in smaller families may include all stakeholders; in medium sized families it may include most of the adult stakeholders; and, in larger families appointed or elected represent ives. These councils frequently are called upon to receive and disseminate the news and views of the company including its financial health or threats to its markets.

The council will develop the family's mission statement and organize the family meetings (discussed in another post). The Chair of the Board of Directors over on company side may call upon the council to develop an employment policy for how family members gain employment in the family business. Or, the Council may be called upon to identify the criteria for hiring a new CEO for the company.

Conflicts in any business are inevitable. In family business, it is no different within family business. These conflicts have the potential of threatening the very existence of the business. Before the threat is real, the council serves an important role of resolving these conflicts to the benefit of the family and the business.

It is not an understatement to say that the family council serves a vital role in the health and well-being of family owning businesses and the businesses they own.

 

Family Business: Mission and Vision

Business-owning families need to know who they are apart from the family business and the creation of wealth. These families do this through a declaration of what the family stands for- in other words a Mission Statement. Such a statement is a declaration of purpose for this family's money, time and energy. This statement tells the world that this family (we) serve a greater purpose than the creation of wealth. Our wealth is in service of something beyond the individual.  This is a robust and energetic statement, shared by the members of the family. This generation of this family own the statement of purpose. Tomorrow's generation must own its purpose....maybe the same, maybe not. 

To get to this statement, the family as a group need to answer this question: The purpose of this family's money, time and energy is to [fill in the blank].  This notion of understanding and expressing the purpose for the family's efforts is extremely important because of the calvinizing effort that having a purpose in life can have on the individual members and on the collective family.

As important as a mission statement is, seeing its effect over time is of equal importance. The ability to vision one's accomplishments helps to fix the mind on the reality of the mission. Is the vision for any individual member of the family or the family as a whole in conflict or conformity with the stated purpose? One way to find out is to test it. That test is to look out 5 years, 10 years 20 years at the accomplishments of the individual and the family.  An exercise that helps to bring this vision into focus is to put you in a time 5 (or 10 or 20) years from now. Answer this question:  As I look back on the past 5 (or 10 or 20) years, I am most proud of my accomplishment to [fill in the blank].  Write this story for publication in the local major newspaper (or a televised piece about you). 

Once you have done this, look at the mission statement developed by the family. Is it in conflict or is there synergy? If in conflict, what needs to happen to bring it into synergy?

This is hard work but very important work.

Business for Breakfast-Outside Directors

At the Business for Breakfast on March 10, 2011, Richard Simmonds, Simmonds & Associates, LLC, and Mike Henningsen, Jr, Chairman and President, Henningsen Cold Storage answered questions facilitated by Marc Kralj,Ferguson Wellman, about the role of outside board members on a board of a family-owned business.  Following is a summary of the key points made by Rich and Mike. 

1. The board of directors should have independent, outside members to provide objectivity and act as a sounding board for the President and management team.

 2. This independent board should be in place when there is a transition from founder to second generation.

3. The independent board members should provide an expertise needed by the company and be open, direct and honest.

The company should be prepared to pay reasonable compensation to these board members. Mike Henningsen engages a consultant to do a compensation study. As a rule of thumb the daily rate is based on the CEO's compensation per year by 200.   

Following are books and articles you may find helpful: 

Ward and Pendergrast (2011) Building a Successful Family Business Board, Family Business Consulting Group, Inc., Palgrave Macmillan, New York, NY

Jaffe and Davis (2010), The independent family business board, Family Business Magazine (Winter 2010), pp. 54-56.

LeCouvie and Pendergast (2010), Developing Your Board of Directors for Maximum Impact Webinar, CDE available from Family Business Consulting Group Inc, Marietta, GA.

Tutelman and Hause (2008), The Balance Point: New Ways Business Owsners Can Use Boards, Famille Press, Edina, MN.

Outside Directors in Family Owned Businesses

For a corporation to maintain its corporate status and limited liability company the corporation must have a board of directors.   Many family businesses have only the family members serving on their board of directors.  However, the family business may want to consider adding some outside board members.  The shareholders should determine the role of the board - will it be a board that merely "rubber stamps" the decisions made by the management?  Will the management be open to take direction from the board?   The board can provide strategic planning, make decisions regarding

An outside board member should be someone who is not a member of the family, an employee of the company or someone who provides services to the company.  Many companies will ask their accountant or attorney to sit on their boards.  However, this can create a conflict of interest.  You may want to have an accountant or attorney on your board because of their skills, however, it should be with the understanding that they and/or their firms will not be performing services for the company.

In selecting board members, the company should contact their current service providers for potential candidates.  The candidates should have business experience or an area of expertise that will be beneficial for the company.  You may want to consider a candidate who participates in her own family business.  The company should do a background check and contact references for each candidate.  This person will have a fiduciary duty to the company and its shareholders.  They will receive information about the company, the business, the financials, etc.  If you are concerned about the secrecy, you can request that the board members sign confidentiality agreements. 

Understanding Corporate Roles and the Family Business

The governance of family businesses begins with understanding the role of shareholder, board of directors and the officers.  In those family businesses where a few family members serve in all three roles, the boundaries between the roles is blurred. That blurring leads to problems which could be avoided with an understanding of the roles and attention to the role being played at any given time. Following is a summary of those roles.

1. Shareholders.  The shareholders own the corporation but do not own the business. The corporation owns the business including all of the assets of that business.  The role of shareholders is to elect and remove directors, adopt certain amendments to the articles of the corporation, approve major actions such as selling substantially all of the corporate assets, merger and liquidation.

2.  Directors.  Directors sit as a board and it is this board that directs the management of the corporation. The board sets policy, elects and removes officers, establishes compensation of employees, issues stock, pays dividends, approves contracts, approves loans, initiates new ventures, purchases equipment and recommends actions to be taken by the shareholders.

3.  Officers. The offices conduct the day to day affairs of the corporation at the direction and guidance of the board of directors.

With this summary description of the roles to be played within a corporation it is easy to see how the lines between the roles get very fuzzy when a few people serve in all three roles. One of the most significant issues is the liability that can attach to a person who is not mindful of keeping the roles straight. If the line between shareholder and officer is so blurred, creditors are able to pierce the protective veil of the corporation and reach the shareholder's personal assets.

In family owned businesses it is also important to keep the role of business distinct from the role as family. When that role is blurred, the whole fabric of the business is weakened. Good governance structures will strengthen the fabric of these businesses. Those structures will include objective criteria for family members entering the family business and merit promotions. Other issues to be addressed in family business is compensation, mentoring and succession.

Governance of any business requires attention and intention. It is critical to the success of a family business.