Andrew Drake is a partner in the Family Business Unit at Boodle Hatfield Solicitors.
Young family members sometimes find themselves with a significant shareholding in a family business which does not employ them and in which they have little interest. What are the implications for the business and for other members of the family if they wish to exit? Andrew Drake explains
As any successful family business develops, there are two particular areas of growth: the value of the equity in the business and the size of the family. It is often said that the family grows faster than the business. A business founded by, say, three brothers, each of whom has a large family, can quickly become by the third generation a business owned by a very 'wide' family, with inevitably not all members of that family working in the business.
Some younger family members may inherit shares in the business but may not necessarily inherit the quiet acceptance of their elders of having all their wealth tied up in the business. If the business has been extremely successful, the increasing value of their shares may tempt them to sell and invest the proceeds elsewhere, particularly if they are not employed in the business. Also, as the family grows the possibility increases of a family member bequeathing his or her shareholding on death to a non-family member.
How does a business which wants to keep everything strictly within the family guard against this, particularly if a number of family members want to sell at the same time or the member wishing to sell, or the member bequeathing his shares, owns a substantial shareholding?
Trusts for subsequent generations
Should the family arrange matters so that this problem never occurs in the first place, by the older generation placing their shareholdings in trust for subsequent generations? There could be provisions in the trust documents authorising the trustees to retain the shares in the business and protecting against the possibility of beneficiaries breaking up the trust. Trusts can also be drafted to guard against an improvident beneficiary dissipating his or her share of the assets, or to give the trustees power to revoke beneficiaries' interests, or indeed to leave all decisions about payments of income or capital completely to the discretion of the trustees.
Take a closer look at the dividend policy
A younger member of the family who is not employed in the business is much more likely to be dissatisfied with dividend yield, particularly if he or she is not well paid by his or her position outside the business. Could the dividend yield be improved or will this prejudice any planned reinvestment programme? If there is scope for paying more dividends there may be merit in a share reorganisation, for example to create cumulative preference shares conferring an income stream but no voting rights (and with capital rights on a liquidation being limited to the amounts paid up on them). These could be issued to family members who do not work in the business, with both those new shares and existing ordinary shares (carrying normal dividends and all the voting rights) being issued to those who are involved with it.
If equity in the business does pass to the younger members of the family and one or more of those members wants to sell (irrespective of dividend yield), restrictions on sale, or on the persons to whom a sale can be made, can of course, be put in place either in the constitutional documents of the company or in a shareholders agreement. Similar restrictions can be placed on the persons to whom shares can be transmitted on death.
Other members of the immediate family, followed by members of the wider family, can be given prior rights of refusal in relation to the shares which are being sold or bequeathed, but what if none of the family wishes to buy or, as is often more likely, other members of the family would like to buy, but cannot afford the purchase price? One possible 'half-way house' solution might be to place a ceiling or cap on the maximum number of shares which can be sold in any one financial year, in the hope that other members of the family will then be able to purchase a seller's shareholding in 'bite sized chunks' over a period of time.
Restrictions on transfer or transmission are fine but if the business is left with a frustrated shareholder who wants, but is not allowed to sell, this can be damaging for the business. So what are the options if family purchasers cannot be found?
Purchase by the company
It is possible that the company could, if permitted by the relevant law, buy the shares itself but this often involves the company having sufficient distributable profits to do so, although in some circumstances it may be possible to purchase out of capital. The company could, therefore, consider following a policy of building up distributable profits in order to deal with this very situation, but care should be taken that this does not cause other problems such as dissatisfaction with the dividend yield or an inability to invest properly in the business. Also, will the purchase by the company from one shareholder open the company up to requests from other family shareholders to be bought out? Alternatively, consideration could be given to returning some money to the shareholders through a court-approved reduction of share capital. The company could also think about raising the necessary distributable profits to purchase the shares from the disposal of assets, for example by a sale of surplus real estate or a sale and leaseback.
If the family reaches the conclusion that it has no alternative but to admit 'outsiders' as shareholders, are the best outsiders going to be any non-family members that may hold management positions in the company? Should private equity finance be used to fund a purchase of shares by the managers from the exiting family members, thus providing the family with an opportunity to incentivise the managers?
Find a private equity or venture capital purchaser
Readers can refer to two recent articles, Tony Bogod's article in the May/June edition of Families in Business on the relationship between the venture capital industry and the family business and Jonathan Jenkins' article in the July/August edition on using OFEX as a cost-effective exit strategy.
A family could find it appealing to have all the shares which are being sold held by one entity (the venture capital house), as opposed to a number of individual shareholders. However, one of the difficulties with using the venture capital market to try and solve the lack of an internal market in the family business would be that the venture capital house will normally be looking at exiting in four or five years through a trade sale or listing of the whole business, something which is clearly not appropriate if the family wants to retain control. Can the venture capitalist be persuaded instead to sell back its investment to the family, in the hope that in the intervening period the family will have found a way of funding that purchase (for example, by boosting the company's distributable profits or increasing the wealth of family members)? It is interesting that in his tips for venture capitalists, Tony Bogod urges them to look at "non-traditional routes, such as selling back to the family".
Another aspect of a venture capital purchase which some families might find unattractive is that the business has not received any investment from the venture capitalist (the investment made has gone into the pockets of the exiting family shareholder or shareholders) and yet the venture capitalist will, depending on the size of its shareholding, still want a say in the running of the business, including perhaps a demand for a seat or seats on the board. Will the family look at this as 'interference' or will it welcome an outside view and additional expertise? When compared with a situation where the shares are bought by another family member who is a member of and understands the family and is quite possibly already on the board, the idea of a sale to a venture capital house could look unappealing.
Consider OFEX as an exit strategy
What about OFEX? There are a number of reasons why family businesses should consider OFEX as an exit strategy, including certain tax benefits. An introduction to OFEX (at a low cost, compared with many other markets) provides the company with access to a public market whilst allowing the family to keep control of more than 50% of the equity. The family will not be subjected to the same pressure (as it might be from a venture capitalist) to consider, down the line, a trade sale. Having said that, if the family does go down the OFEX route experience shows that it could ultimately be tempted into a trade sale.
Going down the OFEX route means the family places itself, to an extent, in the shop window. Whether or not there is ultimately a trade sale, the mere placing of a public valuation on the company's shares, whilst attractive to some families, could be offputting to others. The public valuation may pressurise the company into improving the dividend yield offered to shareholders (as might the involvement of a venture capitalist), as there are a number of private family businesses which pursue a policy of low dividends.
OFEX will allow the family to retain control over the company in an overall sense but shares traded on OFEX must normally be freely transferable. Therefore the family loses control over who owns those shares outside the family, unless it subsequently buys those shares back in through the market.
Families need to think ahead and plan accordingly. Thought must be given as to how to create an internal market and what to do if that market simply cannot absorb the exit requirements of a significant shareholder. The venture capital or OFEX route may well solve the problem where the internal market cannot cope, but the level of attraction is going to depend very much on the circumstances of the particular family involved.