There are 5.5 million family businesses in the US and they generate 64% of our Gross Domestic Product (GDP). While many of these businesses find success and continue on for generations, others do not make it to the second generation. In many instances, family businesses struggle because they lack basic formalities and structure that are often times the hallmark of a non-family business. This is an understandable and common problem. Because family members are related to their business partners, they tend to relax their diligence and reduce their instinct to protect themselves and their family from the unknown. Furthermore, family businesses often face additional challenges as they grow because as more people become involved in the company, more potential for conflicts, mismanagement, and lax oversight exists; a common growth-related issue, but one which is exacerbated by the family dynamic. That is why it is important for family businesses to get a regular legal checkup. A review of the company’s governance practices and operations can help avoid future legal and financial problems.
Is Your Family Business Set Up Appropriately?
When two or more people start any business, they have to decide the roles and responsibilities of each of them. Hopefully, they quickly get an attorney to formalize the relationship of the owners and detail how the business will operate. This includes creating a business entity (corporation, LLC, partnership, etc.) and drafting appropriate legal documents (shareholder agreement, operating agreement, by-laws, employment agreements, etc.). An attorney can also advise regarding instituting appropriate governance policies to ensure that the company operates in compliance with all laws and that there are safeguards in place to prevent owners or employees from taking actions that would hurt the business.
The challenge with a family owned business is that even when owners have been advised about what they should do, the parties are more relaxed about following best practices because they are working with family. That misplaced ease can have serious repercussions. There are many horror stories of family members who mismanaged or worse, stole from, the business, or otherwise acted in a way that resulted in legal problems for the business. Sometimes, the malfeasance resulted in liability for the business and/or personal liability for its owners. Often times, the other owners were the literal and proverbial “last to know” because the person who performed the misconduct was a trusted family member and was not subject to typical oversight.
What Are Potential Problems that Can Arise?
While there are family members who are dishonest and greedy, those are still rare problems. More often, problems arise from carelessness about how a good business should operate. For example:
- One of the owners uses company money to pay personal bills.
- Money that should be paid to the company instead is paid to the owner.
- The owners fail to have shareholder meetings or keep corporate books and records.
These actions could result in personal liability for the owners in the event of a lawsuit. Normally, shareholders in a corporation or LLC are not personally liable for the corporation’s debt. However, this protection is not absolute. In certain circumstances, a court may allow a plaintiff to collect damages from individual owners. The failure to adhere to corporate formalities and commingling of personal and business assets are factors which can result in a determination of personal liability.
Problems may also arise because of the varying interests of the owners. A new generation may come into the business and some may not be interested in being actively involved with its operations and want to sell the business or be bought out. That desire is not right or wrong, but the owners have to determine how to address everyone’s interests or the business may be negatively impacted.
What Best Practices Should Owners Follow to Protect the Family Business?
Business relationships should always be formalized, and procedures followed even if they are with family members. It is not an indication that you do not trust each other. It is to ensure you are in agreement about your venture and want to avoid disputes that would affect your business and your family. Accordingly, important measures to take include the following:
- Have an attorney draft appropriate legal documents detailing your arrangement and complying with applicable laws.
- Adhere to corporate formalities, such as holding annual meetings and maintaining required books and records.
- Never commingle personal and business income and expenses and keep careful records of this.
- If you are an absentee shareholder, inspect records regularly so you know what is going on with the company.
- Institute checks and balances when it comes to finances and decision-making.
- Conduct regular financial reviews by an independent party.
- Get an annual legal checkup of your operations, recordkeeping, and contracts to ensure compliance with all laws.
If you are starting a new family business or are the owner of an existing one, take steps now to protect it and yourself, so that it will be viable for future generations. That first step is sound business advice. Contact us to discuss how we can help your family business.