Conflict in the Family Business: Managing Conflict Through Legal Agreements

Conflict in the Family Business:
Managing Conflict Through Legal Agreements

Newsletter
by Robert B. Curran
Whiteford, Taylor & Preston

Disagreements and conflict among owners or managers of closely-held firms can have devastating consequences. A company’s inability to anticipate and resolve internal strife could threaten the very existence of the firm.

In many cases, such conflict can be prevented or resolved through carefully prepared legal agreements.These can direct parties on issues such as corporate governance, establishing and modifying compensation arrangements, circumstances requiring the withdrawal of a participant, and setting the price and terms for purchasing a department participant’s interest.

There are a number of tools and techniques from which to choose in implementing these types of arrangements, including:

      1. Classes of Stock:

A company’s governing documents (charter and bylaws) can have different classes of stock, each with its own set of voting rights, dividend rights, and rights on liquidation.Some companies provide for two classes of common stock, one with voting rights and the other without. This allows the parties to allocate financial benefits (i.e., dividends and liquidation or sales proceeds) equally among all participants, while concentrating control (through the distribution of voting stock) in the hands of one or more key participants.

One way to do this is to provide voting stock for participants who are active in the business, and non-voting stock for participants who are not active in the company.

Another technique is to provide one or more classes of preferred stock, so that preferred stockholders will receive dividend preferences and a priority share on liquidation or sale.This approach is commonly used to ensure that participants who have contributed case or valuable property will receive a return on their investment before profits are paid to other equity owners.

Important tax consequences may flow from the use of different classes of stock.For example, a company that has made a Subchapter S election may have more than one class of common stock, but may not issue preferred stock.

      1. Employment Agreements:

Many closely-held firms enter into employment agreements with owners and key personnel.Employment agreements can be used to achieve a number of objectives.

For example, the parties’ expectations regarding compensation, duration of employment, the employees’ duties, and his status and position with the company, can be detailed in an employment agreement.Special incentives can be provided through the use of bonus arrangements tied to gross sales or net profits.The company’s rights in its trade secrets and confidential information can be protected as well.

Finally, many companies have decided to strengthen their customer and client relationships by requiring senior executives to sign non-competition or non-solicitation clauses.Although the courts generally do not favor such clauses, they will be enforced in most states, if they are “reasonable” in terms of their duration, scope and geographic area.

      1. Stockholder Agreements:

Most companies with multiple stockholders should enter into agreements with all stockholders regarding the transfer of stock and other important corporate issues.A carefully drafted stockholders’ agreement can prevent the company’s stock from falling into unfriendly hands by restricting the stock’s transfer.A stockholders’ agreement also can provide liquidity for participants who die or leave the business for other reasons.They can be used to insure continuity of management and control as well.Sometimes, a stockholders’ agreement will deal with economic issues, such as the required payment of dividends to Subchapter S stockholders so that they can pay their income taxes.

One of the most important functions of the stockholders’ agreement is to establish the price and terms for purchase of a departing stockholder’s stock.This can be done by setting a price based upon a formal appraisal, by using a financial formula based on “book value” or a multiple of earnings, or by setting an agreed price, which the parties modify annually.One popular approach is the use of a “Russian roulette” clause, under which one stockholder has the right to invoke a buy-out by naming a price in writing.The other stockholders then have 30 days to decide whether they purchase his stock, or whether they sell their stock to him at the price named in the written notice.

Members and managers of closely-held firms should seriously consider protecting against disputes by implementing legal agreements.Usually, this process involves coordination and consultation among the company’s legal counsel, financial advisors, and lenders.