July 27, 2020

Family Business Succession Planning and Related-Party Contracts

by Gregory F. Monday

This article is an excerpt from The Lawyer's Guide to Family Business Succession Planning: A Step-by-Step Approach for Lawyers, Business Owners, and Advisors, by Gregory Monday (ABA 2020). (An introduction has been added to provide context.)

In family business succession planning, it is important to consider contracts with related parties.  If a person affiliated with the owners provides goods or services to the family business, that relationship should be formalized in a written contract to the extent that the owners would want that relationship to continue after the business transitions to the successors. Consider the following examples:

Real Estate and Equipment Leases

If one of the family’s companies leases real estate or equipment from a related individual or another family-owned company, the owners should sign a written lease that will continue to apply after ownership succession. In most cases, it should be a long-term lease, with automatic renewals and periodic rate enhancers that are specified in the lease or are tied to an objective measure, such as an appropriate consumer price index.

Leases should allow one party or the other to terminate the lease obligation if a particular change of circumstances occurs. For example, it may be appropriate for a building tenant to have a right to terminate the lease if the building is sold to a buyer outside the family. Similarly, it might be appropriate to grant the lessee a right of first refusal if the leased asset (e.g., building or equipment) is sold to a buyer outside the family.

Note that if the asset and the lessee currently are owned by the same owners, then there may be tax efficiencies or cash-flow considerations that dictate the optimal lease terms as long as the ownership remains the same. (The owners should consult their accountants and tax advisor regarding these arrangements.) In such cases, the lease should be reviewed as part of the owners’ estate planning process. If ownership of the leased asset and ownership of the lessee business will or may diverge under the succession plan, then the owners should arrange for their successors to be bound by a lease that is equitable to both lessor and lessee.

Service Agreements

If one of the family companies provides services to other family companies that are owned by different owners, or by the same owners but in different proportions, then the companies should execute a service agreement to ensure that the service relationship is equitable and will continue under similar terms. For example, if the family owns a portfolio of real estate, with each property in a different LLC, and the properties are managed by a separate management company also owned by the family, then service agreements will help ensure that the management company has cash flow that it needs to compensate employees and for other expenses of operations.

Employment Agreements

Family members who have chosen to work for the family business in a substantial capacity might assume that their employment status with the business and their compensation will not be adversely affected by ownership succession, but if they do not have an employment agreement, they may be at risk of being treated as an employee-at-will who may be terminated, demoted, or geographically displaced by a successor board or new management.

Therefore, if there are family members who rely on their employment with the family business and compensation at a particular level (sometimes including a history of bonuses), it may be appropriate to protect such family members with employment agreements that state they cannot be terminated or demoted without cause and that establish a minimum level of compensation, including perhaps cost-of-living increases and terms of bonus practices. The employment agreement also can provide for severance compensation and benefits upon a change of control (such as a sale of the business to an unrelated third party) or other change of circumstance that may warrant separation without cause.

If the employee is not an owner, it may be best for the business to include confidentiality, noncompetition, and nonsolicitation language in the employment agreement, but if the employee is an owner or may become an owner, then the confidentiality, noncompetition, and nonsolicitation agreement might be better addressed in the owners’ agreement. In many states, broad noncompetition provisions in an employment agreement are harder to enforce than similar provisions in an owners’ agreement. Further, if an employee is an owner, it may be appropriate to provide that if his or her employment with the business terminates, then the business or other owners may purchase his or her ownership interest.

Finally, although it usually is desirable to include alternative dispute resolution provisions in all family business agreements, an arbitration clause in an employment agreement might not be enforceable in some states.

Debt Obligations

If the business owes any sum to an owner or other family member or affiliated business, then the existence and terms of the debt should be clearly and formally documented. This will help ensure that successor owners and management will honor the obligation; it will help ensure that the payments are treated properly for taxes; and it will help ensure that the obligation will be given proper priority vis-à-vis the business’s other creditors. Such obligations may arise, for example, if an owner lent cash to the business, or if the business purchased assets from an owner on an installment basis, or if the business redeemed an owner’s shares on an installment basis.

In some cases, it may be desirable to grant the lender security (perfected, such as by recording a mortgage or filing UCC statements) to give the lender priority as against a tort creditor or in the event of the borrower’s bankruptcy. It is likely, however, that the lender will have to agree that the obligation will be subordinate to existing third-party debt. (Commercial lenders do not want their rights to be subordinate to, or even pari passu with, insider obligations.)

Contingent Liability

If owners have personally guaranteed debt of the business, each may be at risk of a disproportionate loss under his or her guaranty, unless the owners execute a reimbursement agreement with the business and contribution agreements among one another. This is particularly important for an owner who is exiting ownership but has not been released as a guarantor.

Under most commercial loan facilities, guaranties are joint and several, and in the event of a default, the lender can proceed against any one of the guarantors for the full amount, even without trying to collect from the borrower or the other guarantors. In fact, often the lender is allowed to release the borrower or a guarantor without the consent of the other guarantors. Further, a default may be something that neither the borrower nor the guarantors can control, such as the death or bankruptcy of one of the guarantors.

For these reasons, an owner who guarantees debt of the business should execute a reimbursement agreement granting the guarantor the right to be reimbursed by the business for any losses incurred under the guaranty. The lender may need to consent to a reimbursement agreement and will probably not allow it to be enforceable until the lender is satisfied in full.

Similarly, the guarantors should execute a contribution agreement among one another. A guarantor’s common-law rights to seek contribution from other guarantors for losses he or she incurs under a guaranty usually are not particularly effective. Often, they do not reflect the guarantors’ expectations. Under a contribution agreement, however, the guarantors can be clear about what percentage of the loss each guarantor will contribute and how the loss will be measured. As with the reimbursement agreement, the guarantors may need the lender to consent to the contribution agreement, and it may not be enforceable until the lender is satisfied in full.

Tort Liability Indemnification

Owners who serve as directors and officers or managers of the business should be protected against liability for their service for acts taken in good faith. Usually such provisions appear in a company’s articles, bylaws, or operating agreement. These should be drafted to include protection for directors and officers who are no longer serving in that capacity. If such fiduciaries are covered by directors’ and officers’ insurance, either directly or as a way to fund the indemnification, the coverage should include former fiduciaries as well.

For more business law content, visit businesslawtoday.org.

Entity:
Topic:

Gregory F. Monday

Attorney, Reinhart Boerner Van Deuren s.c.

Gregory F. Monday is a corporate law and trusts and estates attorney at the law firm of Reinhart Boerner Van Deuren s.c. who focuses his practice on family business law. He specializes in succession planning for family businesses; estate planning and trust administration; and governance and management of private companies and charitable entities. In addition to his position as a shareholder with law firm of Reinhart Boerner Van Deuren s.c., Greg is an adjunct professor at the University of Wisconsin Law School. He lives in Madison, Wisconsin.