Bridging the Gap #2: Active and Inactive Shareholders in a Family Owned Business

by John McAlister and Chris Beringer

This is the second installment in the series “Bridging the Gap.” The focus is on active vs. inactive shareholders in a closely held business enterprise. Companies have inactive shareholders for many reasons, but typically they are in a multi-generational business where shares are transferred in some manner to the next generation, given to employees, or sold to friends and family. Many conflicts exist between active and inactive shareholders, including:

a. Desire of income vs. growth
b. Compensation packages for active shareholders
c. Family conflict that extends beyond the board room
d. Lack of control and impact on the family business for inactive shareholders
e. Desire of inactive shareholders to have children work in the business

These gaps and conflicts can have far reaching consequences that can result in the family enterprise failing or selling.
Family owned enterprises often have a focus towards growth. A popular phrase is “a business is either growing, or it’s dying,” and most businesses evolve over time. Business growth requires capital (both human and monetary) and the last thing on an active owner’s mind is paying out dividends.

Typically, the largest conflict in a family is inactive shareholders’ desire to achieve cash flow in the form of dividends or other distributions. Active shareholders should remain focused on longer range objectives which could be impaired by disbursing profits. Additionally, inactive shareholders often count on cash flow from the business, which might not be practical in lean times. This can be solved by a well communicated dividend policy, or by offering a liquidity mechanism of some type for inactive shareholders. If the company is not paying out cash flow and the inactive shareholders have no access to liquidity, a multi-million-dollar stake is worthless to them and only serves to create distrust, resentment, and sometimes disastrous consequences to both the business and an estate plan. This can be benchmarked by profitability from the company and availability of free cash flow. If the active shareholders wish to deviate from this policy due to a potential acquisition or desire to reinvest, transparency and continued trust is best served in the form of consistent and reliable communication.

A mechanism to sell part or all shares at pre-set valuations is also valuable to inactive shareholders. Often, inactive shareholders are loath to sell because they wish to participate in the long range growth of the business, status in the community and family legacy, but without a mechanism to create liquidity, they may as well own a pet rock. Liquidity can be created in a variety of ways:

Active shareholders purchase
Bank provides financing at a pre-determined valuation
Key management could purchase some shares
Shares can be sold to an ESOP that benefits the employees, financed by the bank
A private equity firm can be identified to make a minority purchase

There are pluses and minuses to each of these solutions and they need to be evaluated on an individual company basis.

A major sticking point of inactive shareholders is the compensation package of the active shareholders, especially when cash flow is not being distributed. Consider this, the active CEO is making compensation of over $1,000,000 a year (plus perks of travel, country clubs, health benefits), while his inactive family member lives on a teacher’s salary. The active shareholder arriving to his sister’s condo for a family visit in his new Porsche could be an unsettling optic. Inactive shareholders are not always qualified to see the larger picture of the business, so they focus on company expenses and compensation. The best protection for an active shareholder is to identity comparable compensation from other companies and pay themselves accordingly. Proving that they are not being overpaid and are being fully transparent is a solid mechanism.

There are several reasons why some family members are active and others are inactive. These reasons include aptitude, desire, direct family line, transfer of control, and, often, are just dictated by their parents. Many families suffer conflict that extends well beyond the board room. Sometimes the conflict is so devastating and unpleasant that the active shareholders simply sell the business. This conflict is best resolved and addressed well before it begins. The generation that makes the decision as to who will be the heir apparent and who will participate as an inactive shareholder should clearly communicate this before death, or with a letter accompanying the testamentary documents. Though not always the case, most inactive shareholders will honor the wishes of their parents. The more generations the business exists, the more the equity is spread across different family lines and is more likely that the inactive shareholders are distanced from those decisions.

Lack of control for inactive shareholders is often a problem. Inactive shareholders have no ability to impact the business and are often frustrated by key decisions made by the active group. Additionally, active shareholders are not always interested in providing full transparency, and this can aggravate inactive shareholders. Most families do best when there is transparency in the form of semi-annual or annual business reviews. This meeting should include financials as well as company direction to be most effective. One of the most devastating areas of conflict is created when inactive shareholders wish their children to work in the business. They may be unqualified, unwilling to perform certain tasks (i.e., “do you know who I am? I am not going to work the night shift, work weekends, or empty the garbage”), or pass information back to their parents about how the company is being run.

Transparency is one thing; seeing how the sausage is made or being asked to make it is quite another! This can cause a massive disruption to company morale as well as the overall function of the business. It is also often very difficult for an active shareholder to bring their own children into the business, let alone deny that opportunity for nephews, nieces, and other relatives. A firm employment policy should be in force. Ideally, family members should work for a company outside of the family enterprise for a certain period of time. A true test of their worth is for them to be welcome to return at any time. (i.e., you never want to hear the words, “thank goodness that person is no longer our burden.”) When they begin working in the family business, it would be best for them not to work for or report to a family member. They should be held to the same standard as other employees. The bigger the distance from the active shareholders and other family members, the better.

Active vs. non-active shareholders is one of the biggest gaps for a family business to bridge. Ultimately, a clear dividend policy, available liquidity, and transparency are the best ways to bridge this gap. Every family business dynamic is different, but bridging this gap is critical for the long-term success of both the company and the family.

Another way to get revenue and future opportunities to inactive shareholders without starving or killing your precious Golden Goose.