Nine Times Out of Ten: A Litigator's View of Family Business Disputes

The American Dream might be described as follows: Apply your ingenuity and hard work to start and build a business that can then be passed to your children and grandchildren as an ongoing legacy to provide for your posterity. But building a family business is not just about establishing financial support for one's family. It goes deeper. For many, the family business is the family identity. And that identity, as much as financial stability, is the legacy that is passed from one generation to the next.

At least, that is the hope.

As a commercial litigation attorney specializing in shareholder disputes, I have counseled many individuals facing legal fights within their family business. Nine times out of ten, the dispute arises because of inadequate or non-existent business succession planning. In other words, participating family members failed to prepare, memorialize, and/or execute a plan whereby clear expectations for transitioning business operations and ownership could be accomplished. Many family businesses also do not have governing documents in place, such as bylaws and shareholder agreements, to provide a roadmap or at least ground rules for handling internal disagreements.

A lack of communication between generations is often a significant factor as well. Early in my career I was involved in a matter where a son and grandson had been sued by their father and grandfather in relation to their family business. The grandfather had started the business many years earlier and brought his son into the business. The two poured in their efforts to jointly build a successful enterprise. The grandfather gifted shares in the business to his son and the two enjoyed a productive business relationship. As time went on, the son brought the grandson into the business. The grandson started working at a young age performing menial tasks and learning the business. Over the next few years, the grandson was trusted with more responsibilities and earned that trust. As the grandson's role increased, the grandfather's involvement decreased to the point where the grandfather was not working full time and by perhaps inevitable implication, was not always involved in decision-making.

This led to the dispute.

The son eventually gifted ownership in the business to the grandson, just as the grandfather had done for the son. But this was not well communicated to the grandfather. The son and grandson also started making and executing plans they developed together as part of their vision for the future of the company. But, again, they did not include the grandfather in these conversations. After about a year of this situation, the grandfather felt alienated, undermined, and unappreciated. Worse, his misunderstanding of the son's and grandson's activities led the grandfather to believe that they were misappropriating assets and diverting customers from the company that the grandfather established. This misunderstanding led to litigation. The litigation led to hurtful allegations and in-family fighting. After three years of contentious litigation, the family relationship had been damaged likely beyond repair. The lawsuit ended in a bitter settlement, where the grandfather was bought out for far less than what he thought he was entitled to and the son and grandson paying far more than they thought the grandfather deserved. The legacy of this family business is forever tainted and the business that once was a reflection of family pride, mutated into a reminder of the family hostility.

Unfortunately, this is not a unique story. The specific facts vary, but the theme is common — family businesses not having discussed and documented succession plans. The data bears this out: 61% of family businesses do not have a written, formal succession plan in place.

Unwritten Promises

Perhaps one of the best perks of working in a family business is sitting around after hours sharing thoughts about the future. These conversations often include the founding generation pontificating on what might happen when he or she moves on. An off hand comment that "I want you to own the business" never gets documented but then becomes a fight years later when the founder passes away. Turning these water cooler chats into written agreements gives the family, including those not involved in the business, clear expectations on what will happen with the family business.

No Governing Documents

Akin to this concept is the reality that many family businesses lack governing documents. This includes statutorily required bylaws, as well as any sort of shareholder or buy-sell agreement. Family businesses are often bootstrapped in the beginning with efforts focused on bringing in the next sale rather than ensuring that voting requirements on corporate matters are memorialized. While this is understandable, it results in uncertainty. Informal corporate management and procedures are not always a hindrance to business success. But the lack of governing documents (and adhering to those documents) is often a harbinger of transition and succession difficulty and in-fighting.

No Voting Shares for the Next Generations

Even if the promises are documented and the corporation has bylaws and a shareholder agreement in place, often times the next generation of participants in the family business are not adequately integrated into decision-making. The up-and-coming family members participating in the business may be banking on one day having ownership, but there are not provisions in place to turn this hope into reality. Or, if shares have been gifted or sold, then sometimes these shares do not carry with them voting rights. Lack of meaningful participation in decision-making alienates the individuals who are expected to eventually take the reins of the business.

Unfunded Buy-Sell Agreements

Even where a buy-sell agreement is in place, the agreement can fail if there is no funding mechanism to carry it out. A buy-sell may obligate the company or the surviving owners to purchase a deceased or departing owner's interest, but that obligation is difficult to honor when there is no life insurance policy, no reserve fund, and no other source of liquidity available at the triggering event. The result is often a forced sale, a distressed loan, or protracted litigation over valuation and payment terms, which can itself erode the enterprise value the buy-sell was intended to protect. A buy-sell agreement without a corresponding funding plan can be worse than no agreement at all, because it creates an obligation the family cannot meet.

Failure to Have Succession Discussions

Perhaps the overarching theme in each of these situations is a lack of communication between family members. This includes inter-generational communication, in the situation of multiple owners, as well as between the first, second, and even third generation. Conversations about business transitions can be uncomfortable if expectations and visions do not align. These conversations also take time and effort, often times when everyone is focused on building the business rather than how to handle succession issues. These types of conversations can also involve sensitive issues, including whether the current owners are best served by transitioning the business to the next generation or instead selling to a third party. Without consistent, recurring conversations about the future, a family business will likely struggle transitioning to the next phase.

What Is the Cost of Not Having Documents and Discussions

The cost — both of time and resources — to engage in succession discussions and ensure governing documents are in place is far, far less than the alternative. Indeed, in my experience, the cost of not having these business matters resolved is the family relationships. The grandfather I mentioned before no longer speaks with the son and grandson he sued. The son and grandson want nothing to do with the grandfather, or the other family members who took the grandfather's side in hope that a bigger share of the family business might pass to their financial benefit. Family business succession is truly a situation where an ounce of preparation is worth a pound of cure — because there often is no cure to the loss of these family relationships.

What I Tell Business Owners

When I counsel family business owners, I consistently tell them to get their documents in order. If the entity is an LLC, I encourage the members to get an operating agreement in place. If the entity is a corporation, then I ask to see the bylaws and any agreement between the shareholders. If these documents do not exist, I encourage the owners to get these critical documents established. If the owners are coming to me in a pre-litigation or litigation posture, then I strategize with them on how to get to a point in relation to the dispute where these documents can be implemented, such as mediation to establish rules that might govern in the entity while litigation is pending.

Families work too hard for their piece of the American Dream to leave it unprotected due to lack of preparation and foresight. Proper succession planning, including converting discussions into binding written agreements, is a critical part of ensuring the family's legacy persists.