Understanding the distinction between governance, employment and equity in succession to the next generation.
This is one of an ongoing series of 10 articles on this topic. This article is the fifth in the series, and follows on from Sale of the Business as an Option in the Succession plan, Succession Planning: How to Bring Non-Family Members into the Business, Understanding Business Structures for Succession & Asset Protection and How to Create a Succession Plan.
The family Succession Plan should set out who holds ownership or controlling interests in the business (equity), who acts in a day to day operational management role (employment) and who sits as a director on the board (governance). Importantly, the updated Succession Plan, at any given time, should also indicate which of the next generation wish to continue in these roles, or take up such roles in future.
Shareholders in a trading company or beneficiaries of a trust have an interest in the equity of the business, but their shares or beneficial interests do not give them the right to manage employees, or sit on the board and dictate strategy. Their shares or beneficial interests usually allow them to vote, receive dividends or distributions and remove or appoint directors.
Managers are employees of the business, and run the business in an operational role. A management role does not allow a manager to vote, receive dividends or remove or appoint a director, and employment does not give the right to sit on the board and dictate strategy.
Directors are selected by shareholders to sit on the board in a governance role, develop strategy, and oversee the performance of managers tasked to deliver the strategic plans set by the board.
The next generation may be involved in one or more of these roles.
For example, a child may be employed in a management role as a winemaker, but have aspirations to become CEO, sit on the board and also own equity. Another child may be working outside of the business, gaining experience, with the aspiration to be employed by the family business in a managerial role in future as distribution and marketing manager, become a director and own equity. A third child may have no aspiration to be paid to work in the business, but would like to inherit equity to retain a connection with the family business and sit on the board.
Often, only the children who work in the business in a management capacity are the ultimate recipients of equity The current owners may, however, want all children to inherit equity equally, despite the fact that only one or two may have the qualifications, skills and experience to work in management and have the business acumen to be a director, for example.
Although the children working in the business will usually be remunerated for their roles (as well as possibly holding equity) the current owners should give consideration to whether the children working in the business may resent a non-active sibling reaping the benefit of a salary from external employment, as well as equal dividends from the family business (if it is a trading company) or income distributions (if run through a trust) generated through their hard work. That is particularly the case if the children working in the business are not given a salary at a commercial rate (e.g. if they are earning “sweat equity” by their contribution to the family business).
A good way of preventing these types of disputes is to make the distinction between equity, management and governance quite clear to all involved. All owners, employees and directors should be given a commercial return for their contribution. In other words, employees should be paid a market rate, directors should be paid a market-based fee and owners should share in the profits proportionally to their equity interests. That is a fair and legally sound outcome and should avoid resentment if it is transparent.
If all children are to receive equity, regardless of whether or not they are actively involved in the business, a binding agreement should clearly set out how and in what circumstances distributions or dividends will be paid, and how equity can be sold or transferred, to prevent future disputes.
In particular, the following should be made clear:
- The right to appoint directors of a trading company or corporate trustee and appointor of a trust;
- The loan account drawdown and dividend or distribution policy, setting out the circumstances or decision-making mechanisms for profits to be paid out, retained or reinvested in the business;
- How shares may be transferred. Should there be provision that equity can only pass to bloodline descendants, and should there be pre-emptive rights to prevent equity passing to a spouse and possibly out of the bloodline altogether;
- Mechanisms to effect exit from the business (including valuation);
- The key roles in the business, job descriptions and requirements;
- Reporting lines;
- The distinction between the rights and obligations of an equity holder, employee and director;
- The determination process for the remuneration of family members working in the business, for example with respect to salary, leave and benefits;
- The funding of the business;
- Cheque signing authorities and procedures; and
- Personal aspirations of the current and next generation.
The aspirations of the next generation will require ongoing consideration. It may not be possible for everyone to be the managing director or receive equity. This is where the skills and experience of the next generation must be weighed against the requirements of the available roles within the business, and the best successor or successors selected. Independent board members may be of assistance in the selection process and can assist in identifying further training, mentoring and development needs.
Circumstances change. For various reasons, the most appropriate successor or successors may decide that the business is no longer for them. Also things can go “bump in the night”. The business must remain agile enough to implement a contingency plan, and a well-considered and reviewed succession plan, and good governance structures will assist, should this occur.
This was originally published in Australian & New Zealand Grapegrower & Winemaker.
This Alert is intended as general information only. It does not purport to be comprehensive advice or legal advice. Readers must seek professional advice before acting in relation to these matters.