Thanks to Nick Di Loreto and Steve Salley of BanyanGlobal Family Business Advisors for this week’s thought-provoking article on what’s really “irrevocable” when a family enterprise can come to consensus.
There are three social systems in any family enterprise: the family, the business, and the ownership. Each system evolves over time, both independently and interdependently. Changes in the family – from marriage and divorce to birth and death – inevitably influence the formal ownership of the family business; changes in family relationships can also have a deep impact on the business. Likewise, changes in business – through organic growth, acquisitions, profits, and bankruptcies – have an impact on the other systems. The termination of a family member from the business can have repercussions that reverberate throughout the family system for years.
Curiously, changes in the ownership system and the family that is served by it – or trapped in the legal structures, contracts, and other documents that formally define it – affect the other systems too, but not as often as they should. This oversight is due largely to the fact that the ownership system is assumed to be unalterable and frozen in time or (as we often hear from lawyers describing documents in the trust and estate planning process) irrevocable. When this belief exists, the family and the owners concede too much power to irrevocability and they underestimate the power consensus has to modify formal structures to reflect today’s realities and relationships.
The alleged power of irrevocability needs to be challenged, not least because it causes the three systems to fall out of sync, leading families, businesses, and owners to become stuck in how they think about the meaning of ownership and power over time. How has the power of irrevocability become overestimated? In our experience, three factors contribute to this aggrandizement. Most obviously, the legal documents say that they are irrevocable, and the very word quickly dissuades owners from attempting to make revisions. At other times, documents may be expressly revocable – for example, corporate articles or shareholder agreements – but they are expensive to maintain and taxing to negotiate; owners typically don’t want to rock the boat. Finally, owners underestimate the power that consensus has to modify even the most “irrevocable” ownership structures. As a result, owners often underinvest in building the kinds of family and business relationships that are necessary to make consensus possible in the future, and they end up unnecessarily forfeiting flexibility and control.
The family as a vehicle for consensus is one of the most underappreciated assets of family enterprise. That’s a pity because consensus among family owners trumps irrevocability in almost every situation. Indeed, today the trend in the law is for even the most irrevocable of structures – contracts, trusts, corporate structures, partnerships – to subordinate formal irrevocability to the consensus of those affected. And that’s the rub. If a consensus doesn’t exist, and can’t be reached, then the family enterprise loses its flexibility, and irrevocability takes over. At best, the ownership agenda is not advanced; at worst, destructive conflict erupts.
Consider one client family (all identifying characteristics have been changed). Five siblings own a large, expanding business that they purchased from their parents. When they acquired the business, the siblings were in their late 20s, childless, and completely dedicated to growing the business. Forty years later, the business has multiplied in value many times over and is on the brink of another growth spurt. Adding to the complexity, some siblings have children working in the business and there are differing perspectives on their capabilities and potential. Clearly, both the family and the business systems have changed dramatically. Let’s look at what happened, or, rather, what didn’t happen in their ownership system.
The ownership did not evolve. All major legal documents, including a key Buy-Sell agreement, had gathered dust on a library shelf for 40 years. When the siblings finally dug out the Buy-Sell as part of their estate planning, they were stunned to discover a “last-man-standing” provision. This meant that on the death of any owner, the remaining owners had to buy shares from the deceased at a pre-formulated price. To fund that purchase, the Buy-Sell also required the business to maintain a life insurance policy on each brother.
Moving from the Buy-Sell to their business records, the siblings got another shock: The insurance policies that they were carrying were grossly insufficient to fund such a purchase. In fact, the policies would not cover even 1/20th of the value of the shares, which had grown considerably. Another worry: the business’ balance sheet would not cover the cash shortfall. In effect, the death of one owner would lead to a forced sale, or even worse, to the demise of the family business.
The siblings were stumped. Was the Buy/Sell Agreement truly irrevocable, or was there something they could do to avert eventual disaster? We advised them that changes could be made if the siblings could reach consensus among themselves.
After several weeks of work, reaching that consensus proved to be more difficult than anyone at first anticipated. It was relatively easy to agree on the Buy-Sell forty years ago when their interests were aligned, but times and relationships had changed. The siblings more recently found themselves disagreeing about the employment of their children in the business and about participation in future ownership. Their relationship was also strained by animosity that had developed when two brothers tried to force a third brother to retire because of their belief that he had “lost his edge.” To make matters worse, one sibling had developed a terminal illness that made the Buy-Sell agreement and the associated cash shortfall at the business immediately relevant.
What emerged from this potential deadlock – as in many other family ownership systems – is that the solution to “frozen ownership” lay not in the law, but in the owners’ relationships with one another, in their creativity, and in their desire and ability to negotiate. Simply put, true irrevocability depends on the ability of the owners to achieve consensus, a consensus that, in this case, proved elusive in large part because the breadth of the issues on the table was enormous. The siblings had to address forty years of changed circumstances all at once, and under tremendous emotional stress. A consensus eventually emerged that proved the resilience of the family ownership group, but the test was difficult and could have ended much less successfully.
How can the pain of situations such as this be avoided or minimized? In general, we suggest four principles for preventative maintenance:
- Agree to a process. Define a timeframe (every three years may be appropriate) to reassess whether the family, business, and ownership systems are still in sync. In this case, the siblings would have seen that the insurance policies were grossly inadequate and that the business balance sheet was insufficient to fund any buyout.
- Maintain discipline. Stick to the process, even if change has been minimal. If owners continually review their documents, then they strengthen their relationships, develop “muscle memory,” and build a track record to improve the chances of reaching future agreements.
- Tackle the tough conversations. Explore topics that owners prefer not to discuss. Avoidance is a very strong signal that issues are growing; left unaddressed, these issues will only be more difficult to tackle in the future.
- Involve advisors. Engage critical advisors in the review. Each of them will explore changes in the three systems using a different lens and will help to assess what adjustments are necessary to stay in balance.
Contemporary law is predisposed to allow apparently irrevocable documents to be amended to accommodate changed circumstances. Wills and trusts, contracts, and even legal structures are often surprisingly malleable when consensus exists for change. Irrevocability can be negotiated under the right circumstances because ownership documents are living things, influenced by human relationships. If you ignore these relationships, however, then you imperil future consensus, which becomes much more difficult to achieve under pressure, and often when it is most needed. And when consensus fails, then “irrevocable” does truly become irrevocable.
About the contributors:
Nick Di Loreto is a senior advisor at BanyanGlobal. He has counseled client families in North America, Asia, Europe, and the Middle East on governance and business strategy issues. Nick can be reached at email@example.com.
Stephen Salley, a partner at BanyanGlobal, is a tax attorney and family business consultant with more than 35 years of experience. He specializes in helping clients coordinate the many formal and informal structures of ownership with the dynamics of family and their family business. Steve can be reached at firstname.lastname@example.org.