Make your business last by preventing family squabbles
Lessons learned from a family business that failed.
Businesses that last share common traits. For example, they have written ownership agreements with key terms; they are structured to prevent conflicts and disputes between co-owners; and they have planned for timely succession to manage next-generation expectations and prevent frustration. Absence of these key fundamentals will likely cause lack of alignment between owners, preventing financially sound companies from lasting.
The focus of this article is on family businesses and the squabbles that frequently lead to business breakups. By their nature, family businesses are inherently susceptible to business breakups. It is easy to hold non-family members at arm’s length and treat them solely as business partners. But when they gave birth to you, you live with them you spend Thanksgiving dinners with them or you are the godparents of each other’s children, the dynamics of the business relationship change. There is no longer the comfort that comes with a non-family business in which the participants can just walk away and cut all ties without consequence beyond the four walls of the brick-and-mortar business.
Typical family business disputes arise between parents who founded the business and their children; between siblings who are wrestling for control of their parents’ company; between in-laws who have married into the family business and the founding parents’ children; and between spouses who have started businesses together and are in the throes of a marital divorce.
Family business disputes are typically characterized by lying, deception, back stabbing, self-dealing, attempted coups, theft, extra-marital affairs and jealousy. These, however, are the symptoms and not the cause. The true culprit is often lack of an agreement, or one that is either unclear on fundamental or key issues, or does not address them at all, leaving the family members to their own means to get what they want.
The following case study shows how my client got caught up in a family business squabble that ended in the breakup of the business, primarily due to the lack of clarity in a key provision in their ownership agreement. Though the case study involves a family business, the lessons learned are equally applicable to preventing disputes between unrelated business owners.
The case study
Don and his wife Sharon founded Electrix, an electrical supply business, each owning half of the company. With their combined hard work and business smarts, they brought Electrix’s annual sales into seven figure numbers in just a decade. The business, however, took a toll on their marriage and they eventually divorced. As part of the divorce, they entered into an agreement concerning their interests in Electrix.
The key issue between them was who would run the company. Don had always been the CEO and wanted to continue in that role for as long as he wanted. Sharon did not object, but she wanted to make sure her stake in the company was protected, and specifically that Don could not make unilateral decisions that affected her income from Electrix. Both Don and Sharon agreed that their two children, Mitch and Fran, would one day take over the company, and that Mitch would be CEO. But at that point, they were not sure when their children would be capable of doing so. Sharon and Don also did not want Mitch and Fran to have control over them and did not want Electrix to be run by a third party, such as one of their children’s spouses. Accordingly, their agreement provided that Don would continue to be the CEO for the “foreseeable future.”
To protect Sharon’s interests, Don had to obtain her consent to enter into any long-term leases, to pledge the company’s assets, extend credit to another entity or to sell or acquire significant capital assets. In addition, Sharon could attend board and stockholder meetings, had access to the books and records, and they would jointly decide bonus awards.
Recognizing that equal ownership of Electrix could result in voting deadlocks between them, Sharon and Don formed a deadlock committee as part of their agreement. Members of the committee were Mitch, Fran and Electrix’s outside accountant. The committee was tasked to resolve deadlocks concerning policy, the direction of the company and the decisions that required Sharon’s approval. Although arguably included in this provision, the issue of when Don would have to give up his role as CEO was not specifically mentioned as one that the committee would have jurisdiction to decide.
After Don and Sharon finalized their divorce, they both agreed to appoint Mitch the president and Fran the vice president and chief financial officer of Electrix. Mitch, eager to put his own imprint on the company, started holding weekly breakfast meetings to which he did not invite his father. Don also learned that Mitch tried to transfer a patent owned by Electrix to himself and change the name of the company. Mitch claimed that he approached his father to replace him as CEO and that Don agreed. When Mitch had papers drawn up to that effect, Don refused to sign them and denied that he agreed to give up his role as CEO.
Shortly afterwards, Mitch advised his parents that he had directed that all the company’s debts be paid and, as a result, they would each have to lend Electrix a six-figure sum to keep the business afloat. When Don delivered his loan check to the company’s bookkeeper, he discovered that Sharon had not yet made her payment. Outraged, Don demanded that the bookkeeper reimburse him for prior loans he made to the company. Mitch stepped in and explained that Sharon was waiting for confirmation that Don made the loan contribution. Mitch and Don had a heated exchange and Mitch stormed back to his office. A short while later, Don noticed all the employees leaving because Mitch had sent them home to avoid hearing any further family confrontations that day.
Don fired Mitch on the spot. In response, Mitch called a police officer friend who appeared at the office with Sharon, Fran and Electrix’s accountant to hold a meeting of the deadlock committee. The committee decided that Mitch was still president, two signatures would be required on all checks, and Don was not permitted to remove any corporate papers from the office. They specifically declined to determine whether Mitch would replace Don as CEO (the “foreseeable future” issue). Afterwards, Mitch came to Don’s desk looking for the office master key. Don resisted and they got into a physical altercation, at which point Mitch’s police officer friend arrested Don. Mitch lodged a complaint with the police and Don was temporarily restrained from entering Electrix’s premises.
The next day, Sharon announced an upcoming meeting of the board to discuss the incident. Because Don was barred from the office, he would be permitted to attend by phone. Before the meeting took place, we filed an order to show cause and complaint on Don’s behalf and obtained a preliminary injunction preventing the board meeting from occurring. There were two issues in the lawsuit: Don’s entitlement to significant sums owed to him by Electrix and whether he could continue on as its CEO. Although Don prevailed on his claim to a substantial monetary damages award, he was ultimately unable to maintain his title as CEO, as he died during the middle of the litigation.
The story of Don and his family business demonstrates why family squabbles are a red flag signaling business breakups. While disagreements between owners and executives are normal in every business, when mixed with family emotions, sometimes the toxic brew bubbles over into a business divorce.
There were two issues that set Don up for failure on the CEO issue. First, the phrase “foreseeable future” was completely amorphous and its meaning could not be objectively determined. Indeed, the court found that the phrase was ambiguous on its face. Second, the agreement between Don and Sharon did not set up a specific mechanism to decide this issue.
If I were involved in the drafting of the agreement, I would have advised Don differently. First, I would have drafted the issue in more concrete terms. For example, the parties could have agreed that barring mental incapacity, Don was to serve as CEO, if he wished, until a date certain, say until he was 70. At that juncture, if Don still wanted to continue as CEO, the matter could have been decided by Don and Sharon and, if deadlocked, the accountant could break the tie.
This would have eliminated Mitch, the interested party, and his sister, who may also have been biased, from participating in this critical decision. Another option would have been to submit the issue to binding arbitration with one or three arbitrators. Either option would have prevented the issue from being decided by the courts. On that score, the primary benefits would be to control litigation costs and know ahead of time who would decide the issue.