This article will go into the basics for any shareholder that is actively involved in a small business. I will cover the basic rules and then go into the business implications related to these relationships. In addition, I lightly touch on the tax issues. Other articles will get into the more detailed situations and how to properly manage and address them. The goal of this article is to explain to the primary shareholder a basic understanding of shareholder dynamics in small business.
This is a rather lengthy article and I’m not from the current 20’s generation that is convinced that any problem can be solved in 30 minutes; like this is a ½ hour comedy show. Business is about having knowledge and using guidance to assist you in making informed decisions. Therefore it takes time to educate any small business owner related to business issues. I’m very confident that this article will be one of the longest on my website. So in advance, thanks for reading.
I’m going to start out with an example of why shareholder dynamics are important using a real life example of a family’s business investment. I have changed some of the facts (they don’t affect the final outcome but protects the family’s identity) to simplify the case.
In 1972 Jim opened up a small electric motor business. He had acquired his knowledge about electric motors and their corresponding circuits while serving in the US Navy. After retirement from the Navy, Jim used his savings to start his small business. Over several years the business grew and now many employees work at the shop. To protect the accumulating wealth, Jim incorporated the business and uses the S-Corporation status to reduce his overall tax obligation.
Jim has two sons and both of them earned electrical engineering degrees and they went to work with their father at the business. During the 90’s, the business expanded into design and construction of wind generators and large electrical motors for industrial application. The two sons married and have children of their own. The entire family depends on the business for their livelihood. Jim’s wife dies in the late 1990’s and it brought a lot of grief to all family members.
In the early 2000’s, Jim marries a much younger spouse and created a will that basically transferred the stock to his two sons in equal amounts and provided for his new wife from the rental income off the land and building Jim owned separately. Jim’s company had a 10 year lease with the trust that owned the land in benefit to his new wife in case of death.
As with most family situations, the patriarch dies and Jim passes away from cancer in 2009. The boys’ stepmother sought legal advice and of course the attorney saw dollar signs in front of his eyes. The company was performing remarkable well and generating several hundred thousand dollars per year in net income to the two sons in addition to their good salaries.
In the state where Jim died, the spouse has a right to ‘ELECT AGAINST THE WILL’; in effect take 1/3 of everything. So of course, this brought a lot of heartache to the two sons.
A meeting was arranged whereby the stepmother’s lawyer and the sons along with their CPA met. The lawyer explained and demanded an election against the will in order to provide for the stepmother. The CPA was not a lawyer, but immediately advised the two sons to agree and sign the paperwork which happened within three days. Naturally, the stepmother’s greed had her in the Company’s front office the next day making changes etc. She even announced that she was the new corporate president.
The two sons called a special stockholder’s meeting in accordance with the bylaws and the stepmother showed up with her attorney and the CPA was there too.
Now understand, the stepmother owned 1/3 of the stock of the Company. The two brothers owned 2/3’rds. At the special meeting, the two brother’s voting in bloc fired her as the President, reduced her compensation package to zero. In addition, they gave themselves raises to easily offset all profits earned by the Company. Therefore at year end, the Company’s net income was a big ZERO and the stepmother received no distributions or any type of earnings.
In addition, the lease for the building was due up within two years and the two brothers via a special meeting agreed to sign a new lease with another landowner if the Trust did not agree to significantly reduce monthly rent. That is, the stepmother was not going to have a tenant unless she agreed to a significant reduction in her current distributions from the Trust.
The above example is more common than what many people realize. Again, the Dad built a highly profitable company and a nonfamily member’s greed could have wiped out the Company. But knowledge won out over greed in this situation. This next section is going to explain to you the very basics of shareholder dynamics in a small business and how applied can prevent such greed from tearing a family apart.
One of the primary start-up concepts and decisions that any new business makes is determining proper ownership of the company. This ownership position determines many legal and accounting attributes for the company. In most situations you have a primary person that has the idea and knowledge to execute the operation. Most often this same individual brings the financial capital needed to start up operations and keep the company going as exemplified by Jim in the example above. In another large group of new operations, somebody brings the knowledge but not the financial wherewithal to achieve success. So other individuals, usually other family members participate with financial assistance. Sometimes, those individuals bringing capital are merely friends or business colleagues.
So the principal issue at stake is almost certainly ownership. Who is going to own what percentage of the business?
It doesn’t matter the mechanism used to establish ownership, the single most important issue is percentage of ownership. What I mean by mechanism is ownership via a capital account customarily found in partnerships or limited liability companies or in the form of stock which is in the corporate format. The legal document is irrelevant in the initial creation, the first and most important question is ‘Who owns what percentage of the business?’
Now before I continue, I want every reader to understand the single most important legal and financial issue related to business. You must own at least 50% plus one share or one more dollar of value of the company. Why? Because if you don’t you have no control over the business. This is often misunderstood by just about all novice and sometimes intermediate entrepreneurs. Without control, you have nothing.
So as an example, in the corporate form of ownership, if 100 shares are sold, then the individual owning 51 shares controls the company. Just by shear vote he can control the management team, control the money and ultimately control the profits.
Owning less than 50% means you own NOTHING! Ownership is only recognized via control. NO CONTROL MEANS NO TRUE OWNERSHIP – PERIOD.
Ownership in a partnership or limited liability company is usually dictated by the partnership agreement and almost all partnership agreements transfer control to the partner with the greatest amount of capital invested. So if you have partnership with 2 equal partners, the one partner with the most capital in their capital account is in control.
IN SMALL BUSINESS, OWNERSHIP DOES NOT EQUAL CONTROL. BUT CONTROL DOES MEAN OWNERSHIP. TO HAVE CONTROL, YOU MUST OWN AT LEAST 50% PLUS ONE SHARE OR ONE MORE DOLLAR IN THE CAPITAL ACCOUNT. 50% OWNERSHIP DOES NOT TRANSFER CONTROL TO THE SHAREHOLDER. TO HAVE CONTROL YOU MUST HAVE MORE THAN 50% OF THE STOCK.
Let’s go back and review the example from above. Through his will, Jim transfers ownership to his two sons. No stock was transferred to his young wife. However, upon death the wife legally opted for a third. Therefore, under the new ownership format, the ownership was 1/3 her and 1/3 each for the two brothers. The accountant understood this and with a united front, the two brothers had 67% of the voting control. Remember, control equals ownership.
So these two brothers turned around and fired their stepmother as an employee. She receives no income from the Company. Next, to eliminate profits, the two brothers gave themselves raises matching the profits of the Company. So on the last day of the year, the Company made zero dollars but the two brothers via their control took all the money out of the Company via their salaries. At the end of the day, the two brothers achieved via control the same results Dad desired in his will.
This is a hard lesson for many new entrepreneurs because often they give up control in order to get capital. And honestly, those providing capital also want control because they want to protect their capital. This is the common fight that is ongoing in small business. For you, the key is CONTROL.
So a lot of you are asking, ‘Well what is a fair ownership relationship between the one with the knowledge and the one with the capital?’ Well, I always like to use the thought process of Benjamin Franklin in his business model when he developed apprentices in the printing business. His basic relationship was always, 1/3 to the teacher (idea guy), 1/3 to the worker (operator) and 1/3 to the man that puts up the money. He is referring to splitting the profits of the company. I’ve always thought this model fair and reasonable.
In modern business, the idea guy is also the operator and manages the company. So usually the capital guy is just putting up the money. What the capital guy is concerned about is mismanagement of his investment. As an example, he is concerned the operator will decide to go on a gambling binge and waste away the capital of the Company.
To alleviate these concerns, the sale of stock to the investor can have restrictions related to the use of funds and thus protect the investor from undue risk. Remember, investors are passive in nature and have no desire to be involved in the decision process or address corporate day to day operations. So given these characteristics, the idea guy and operator should control the company and ultimately the profitability.
There are a multitude of financial tools to protect investors including restricted stock, convertible stock, convertible debt, voting rights and more. The key is to separate operational control from financial control and this is normal in more well to do small business operations.
For you as an owner, the key is control.
The secondary basic principle of shareholder dynamics lies in the reason for owning a business. Typically the number one reason is to make a profit. Small business owners do this to increase their family’s overall wealth. So the business exists to accumulate family wealth and based on this principle, it is inferred that the owner desires to keep that wealth in the family over an extended period of time. In accounting we refer to this principle as a ‘Legacy’.
So as an owner of a small business you need to get smart about this. The best tool to ensure family wealth is the six inches between your ears. Discuss with your attorney and your CPA how to make sure that if some unforeseen life changing event occurs that the Company continues to provide the financial wealth to the family. Now I can’t emphasize this enough so I’m going to state it twice:
- YOUR CPA IS PROBABLY SMARTER ABOUT THE METHODS TO USE TO KEEP WEALTH IN THE FAMILY THAN YOUR LAWYER.
- FOR EVERY 20 MINUTES YOU TALK TO YOUR ATTORNEY ABOUT THIS ISSUE, SPEND ONE HOUR WITH YOUR CPA TO DISCUSS THIS. The CPA will correct the attorney’s thinking process.
I hope I made my point. This is a financial issue and many lawyers are not trained in the business issues at hand or about the multitude of financial tools that exist to achieve a legacy.
In addition to the two basic principles of control and legacy there are a multitude of business issues to address too.
Now that I’ve explained the basic principles of control and legacy related to small business ownership I need to expand into the actual business operations and its impact on shareholder dynamics. There are several but first I’m going to remind the reader of the usual life cycle related to small business.
In the early years the focus is on gaining financial independence mostly related to cash flow. Once acquired, then owner usually shifts focus to growth and debt reduction. Once a clean balance sheet is generated, management then turns towards financial security for not only the company but the workforce too. Remember in small business, the number two reason for being in business is providing long term security for your employees. After all, they helped you get here and they too believe in the product or service provided.
Finally, the owner of the company can direct resources towards the long term security of the family and ensuring the legacy of the business.
Throughout this life cycle there are several business issues to address in order to achieve the ultimate goal of creating a legacy. In doing so, the shareholder dynamics will change. It generally changes over four steps. They are 1) risk increases, 2) expansion, 3) adding key individuals, and finally 4) corporate legacy.
The following sections explain each of these in more detail.
During the early years the primary focus is on cash flow. Because the risk factor of default is still high there is very little impact to the shareholder. The most common business implication relates to guaranteeing debt from financial institutions. In effect the shareholder is actually increasing their risk related to the business. Many small business owners firmly believe that owning stock via incorporation shields them from further financial exposure. Lending institutions sidestep this mechanism by using personal guarantees on debt.
Personal guarantees on debt will exist until the business has about 20 highly successful years. At that time, banks will compete for the opportunity to loan money and one of the terms offered to acquire your business will be ‘No Personal Guarantee’. So the reader understands how difficult this is to achieve, I recently reviewed the documentation for a loan on an apartment complex building owned by a single individual. The loan was for $6.8M and the complex was worth over $11M. The owner has over $4M in cash with the financing institution and carries about $7M in securities and investments. Yet the bank still required him to provide a personal guarantee. So in general, until your business has a net worth in the tens of millions of dollars, it is unlikely you will avoid the personal guarantee.
So as the business expands, the risk factor for the shareholder actually increases.
The primary goal of expansion is increasing the volume of profits to begin the process of debt reduction and increase the income to the family unit. Expansion is driven by acquiring market share via many different tools including marketing and increasing the skillsets of the personnel. In most small business operations, this expansion requires finding trust from your management team. Most often this trust is funneled to family members assisting in operations. If the business is knowledge based driven or requires certain forms of licenses or certification it gets more difficult to find personnel and once you do find them, it definitely gets more expensive.
To expand, sometimes the owner needs to bring in others with the degree status or certifications and to do this, must give up some ownership. Remember my rules above, ownership does equal control, however, control does equal ownership. The shareholder dynamic here is providing ownership without transferring control. As I explained above, there are a multitude of financial tools to accomplish this step. These include convertible debt, options, rights, profit sharing and many others. I have articles on this site that explain these various tools to access and retain qualified personnel.
In general expansion is really driven through finding qualified personnel to provide the services or build the product you sell. At some point one or two of these individuals will become a key man.
Every small business goes through this step. A key individual drives the overall performance of the company. Initially it is the founding shareholder but over time somebody else steps forward after gaining experience or trust from customers and begins to dominate operations. In most family businesses, it is one of the offspring or a relative brought into the company. Now we have a serious control issue as this key person realizes that the company would have serious problems without him.
Most often key individuals have a strong belief that they can get up and leave and take customers with him. It is here that control begins to shift from the owner to the key man. In my example above, I indicated that Jim’s company began to get involved in design and engineering of wind generators and industrial motors. This expansion is directly connected to the two sons and their respective education and certification. So even if the stepmother was able to control the company, these two brothers could easily quite, start their own company and take with them the best personnel from Dad’s company.
It wouldn’t be easy but very doable. So as a small business owner you need to be on the lookout for this; often it is right under your nose and you don’t smell the situation.
To address this concern, you must begin to shift ownership to this key individual to retain them for the long run. I’ve seen tools such as employee contracts to life insurance policies with cash values attached. Contracts are drafted restricting this key man’s skill if they quit or move away. At this point, you should discuss the issue with your CPA and read more in depth materials to assist you in addressing this high risk.
If you are able to successfully navigate this personnel issue there is only one remaining business implication related to shareholder dynamics. This is finally creating a legacy.
The ultimate goal is to create a legacy for the family and provide financial security for many years to come. If properly planned and executed, it is conceivable that the legacy will provide security for generations into the future. Look at the Mars family (candy) or the Walton family (Walmart). For you, you are more concerned with not only your generation of the family i.e. your spouse but also your children.
In most small businesses the legacy is achieved by including the children in the business operation and management. The final step is transfer of control to an heir. Notice I didn’t say transferring ownership, but transferring control. As the current controlling individual you really want to control this business until you can no longer make informed decisions. For most owners, you would desire to transfer control around retirement time.
To accomplish this step you will need to go beyond advice from a CPA or even your typical attorney. Now you need to seek out a high end tax attorney or business attorney. Most of these guys have a law degree and a Certified Public Accountant license. They have both backgrounds to assist them in guiding you in achieving the legacy step. They are not cheap; expect to pay several hundred dollars per hour for their services. To receive a bill in the $20,000 range is not unreasonable so please don’t think you can do this for less than $1,000.
In my example of Jim’s business above, Jim used a trust to own the land and building basically separating the business from another asset. By doing this, he was able to provide something for his new wife and at the same time transfer the business to his sons. Thereby separating his two families from each other yet assisting his new wife with income via a lease on the building.
The problem was that the lease was due up in about two years. The brothers decided that given their stepmother’s greed to punish her for going beyond their father’s wishes. They did this by going to the trust and basically demanding a reduction in the overall rent thereby reducing their cost for the company and transferring more wealth to them.
The trustee explained to the young widow that the likelihood of finding a tenant for that space at that price was remote. Due to the nature of the structure and its location, it’s not like residential real estate whereby there are many in need and only so many homes. This is a situation whereby it could take years to find an appropriate tenant and then the market rent rate was closer to what the sons offered.
Ultimately she accepted the reduce rent and had to modify her lifestyle accordingly.
With all of this in mind, shareholder dynamics are influenced by many variables and this is just the beginning. There is one dynamic that for some reason seems to be the number one reason why most small business owners opt for the particular tools to control the company and this is taxes. This next section covers the generalities of shareholder dynamics related to taxation.
For most small business owners taxation is greatly misunderstood. To them, it is something to be avoided. In reality, it is merely an expense of doing business. I always looked at it as a payment to the government to conduct business. The real goal is the overall lifetime of taxes paid against the overall lifetime of earnings. The primary goal is to pay the least amount and only the amount you are legally obligated to pay.
Many small business owners are shortsighted and target the existing year and will often forsake future years to eliminate or reduce the existing year obligation. I strongly encourage owners to think differently and look at the long term overall tax obligation and not just this current tax year.
But the most important tax implication related to shareholder ownership relates to this control issue. When an owner transfers control or some ownership to another party, most often there is a significant tax generated to complete the transfer. This is where it gets tricky. Often the transfer of ownership or control is a non cash transaction but the tax obligation is trigger and the tax is required to be in cash!
The driving force of the monetary tax value is whether this economic transaction is ordinary or capital in nature. Thus the tax obligation can be low via capital gains or greater under the ordinary income rules. Sometimes the tax obligation is more than the actual cash received. So for you, you need to understand your overall tax obligation to the IRS.
In accounting, we refer to this as book/tax timing differences and they accumulate from year to year. Discuss this issue with your CPA and he should be able to provide you with a schedule related to these timing differences. Any sale of transfer of ownership can trigger the payment of these timing differences so tread lightly. The key is to stay informed.
In my example above Jim’s estate will report the value of the business to the IRS. The heirs typically get a step-up in basis related to their ownership of the company. When the widow elected against the will and took 1/3 of the company, it changed the value of the company. How so you ask? Well in business the value of the company is often related to the ownership rights of the respective heirs. The two sons continue the value of the company due to their key man positions and certifications. However, the young wife brings no value whatsoever and in actuality brings a detrimental risk to the company due to her minority ownership position. Therefore the two sons will lose some step-up in basis value which will affect them when they in turn dispose or transfer their control positions to another party.
This gets back to my comment earlier about the value of the six inches between your ears. A well thought out plan executed for the long term benefit of the family reduces the overall lifetime of taxes paid.
In small business the number one issue for the primary shareholder is to maintain control. It isn’t about ownership; it is about ‘CONTROL’. The secondary issue and not as important is to create a legacy. Many of the businesses’ life cycle issues come into play when building this legacy. It includes generating cash flow, expanding operations, generating security for the company and finally creating a long lasting legacy to benefit the current and future generations.
Taxation has a bearing on many of the decisions made. For a small business owner it is sometimes better to pay more in taxes in order to maintain control and ultimately build a legacy. There are several other articles on this website that delve into the nuances of taxation related to a small business.
Finally and I’ll say this again and again, pay for some really good guidance from professionals and use the six inches between your ears to help you make well informed decisions. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.