Family businesses are a significant and wealthy sector in the Australian economy, accounting for around 70% of all Australian businesses with an average turnover of $12 million per year. For many, the idea of being in business with family is attractive: being involved with people you know and trust, working towards a common goal, building wealth and opportunity for future generations and leaving a lasting legacy for the family. However, entering into such a business should not be done casually or without serious thought. If not properly prepared for, family business arrangements can quickly turn to disaster, souring once healthy relationships and resulting in financial loss and stress.
Governance agreements (such as a shareholder and unit trust agreements) are just as important when going into business with family members as they are when going into business with strangers.
The most common traps when entering into business with family members include a lack of communication and understanding and a failure to agree on leadership, remuneration and exit arrangements. There may also be issues when family members marry or divorce, changing the structure of the family. It is easy to see how these issues could lead to disagreements. A survey undertaken in 2009 showed that only 34% of families in business had a formal board structure, only 12% had a constitution, and only 20% had a succession plan in place for their Chief Executive Officer.
When it all goes wrong
Take the following scenario as an example of the pitfalls of entering or participating in a family business without a Governance Agreement in place.
Case Study – The Robinson Family
John and Mary Robinson are a couple in their 50s. They decide to go into business with John’s brother Robert and Robert’s wife, Jane. John and Mary have two adult children who also agree to work in the business. Robert and Jane have no children. Upon agreeing to start up a business together, they hire premises and set up a company, ‘Robinsons Pty Ltd’, of which they are all directors and shareholders. They have no written agreements as to remuneration, leadership, or succession. They have strong relationships and believe that they can agree as they go along about how the business should be run.
After two years, Robert and Jane divorce. Robert moves in with a new partner, Kate, who he later marries. Kate does not get along with John and Mary. Robert insists that Kate should be a part of the business. When John and Mary disagree, he loses interest in the business and expresses a desire to leave. However, John and Mary cannot afford to buy him out and do not want him to leave, given his expertise. They agree to allow Kate to play a role (for a considerable salary) and Robert agrees to stay in the business.
It goes from bad to worse
Meanwhile, John and Mary’s son Josh has married and had a baby with his wife. As a result he is working less in the business. John and Mary’s daughter Erin is annoyed that she is working harder and getting the same amount of profit as her brother. She discusses her concerns with her parents, who are afraid of angering Josh. They tell her they do not want to say anything about it.
After five years Kate decides that she wishes to leave the city. She and Robert become embroiled in a messy separation which leads to divorce. In their property settlement Kate claims an entitlement to business assets, resulting in significant financial loss.
After ten years Erin dies suddenly in an accident. Her husband inherits her entire estate, including her shares in the company. He has no interest in the business and sells the shares to a friend who John and Mary have never met.
The importance of governance agreements
Unfortunately, people often only realise the need for governance agreements when it is too late. In the beginning they may think that the bond of family and the small size of the business make governance agreements superfluous. Legal structures may also seem daunting and costly. Ultimately, however, relationships can and do break down and substantial amounts of money could be lost without an appropriate agreement in place. The potential issues that could occur should be discussed and planned for. Every business, regardless of size, should have at the very least a Governance Agreement.
This Governance Agreement should cover:
• management of the business;
• dispute resolution;
• how directors and family members are remunerated;
• the process for declaring and distributing profits;
• how interests are issued to new members;
• what happens if a family member dies or is unable to work;
• succession planning for the exit and entrance of family members;
• how interests in the business can be disposed of;
• funding mechanisms for buying out family members;
• how interests are valued; and
• what happens if one family member wants to sell and the other does not.
Insurance is a common funding mechanism to ‘buy out’ family members and can allow a business to continue to trade without disruption. Where insurance is being used, Jamie Forster, Principal of Elston Assure highlights issues which require consideration and where specialist advice should be sought:
• how will insurance be held and in what entity?
• determining the appropriate amount of cover balanced with the costs of cover;
• incorporating different types of cover as part of an overarching individual and business succession planning strategy, including the use of life cover, TPD, trauma and key man insurance;
• deductibility of premiums; and
• taxation treatment of benefits.
A Governance Agreement could have made life easier for the Robinsons.
For example, John and Mary could have bought out Robert’s share, allowing him to cease work in the business and avoiding the later complications with Kate. Erin may have been better able to raise her concerns about profits and the division of labour, and could even have offered to buy Josh’s share. Upon Erin’s death, a Governance Agreement could have provided for her interest to pass to the surviving shareholders with an insurance pay-out for her husband, rather than her uninterested husband receiving her shares. Even if Erin’s husband were to inherit her shares, a Governance Agreement could have prevented him from selling to an outsider, keeping the business in the family’s hands.
Many of the benefits of a Governance Agreement come about before the document is even drafted. Discussing how the business will be governed raises potential issues which would not otherwise have been considered, allows family members to express differences of opinion and brings peace of mind to those involved. Even the most harmonious of families experience conflict, and it is better to air and plan for any grievances well before you are tied together in a business. Implementing a properly drafted Governance Agreement with appropriate advice from a business risk advisor will provide certainty for family members, creditors and employees and will ensure that your business is able to operate during the good times and the bad times.
For a comprehensive business succession strategy and Governance Agreement, contact the Private Wealth team at Chamberlains Law Firm.
P 02 6215 9100