For a family-owned business, the transition of ownership from one generation to the next is a critical step. This pivotal moment is not just about passing the reins of leadership but also represents a shift in the dynamics of the business and the family. A business in transition is at risk of losing its identity, culture, employees, and potentially its revenue pipeline if the customer base is strongly tied to the identity and personal brand of the founder. However, if managed with care and thoughtful decision-making, a business transition can weather the challenges and avoid the potentially fatal risks, while setting up the next generation for long-term strength and prosperity. This series will identify and discuss several legal and management tools to aid in the transition process, with an eye toward their impact on your business’s long-term success, financial stability, and legacy.

This article continues our series on the transition of ownership of family-owned businesses. Each article will focus on a different aspect of the business transition, resulting in a broad overview of the challenges commonly faced by business owners who leave their companies in the care of the next generation. We invite you to review the series in its entirety.

10. Update the Governing Documents of the Business

When a family-owned business transitions ownership from one generation to the next, the existing governing documents should be reviewed and updated. Whether referred to as an Operating Agreement, Shareholders Agreement, or Company Agreement, this document defines the rights, responsibilities, and obligations of the business owners. As the dynamics of ownership evolve, these documents must reflect the new structure and relationships within the family. A thoughtfully updated governing agreement provides a solid framework to prevent future conflicts and fosters alignment among the new generation of owners.

Ownership transitions often introduce significant changes to the business’s equity structure. The updated governing document should clearly outline the ownership percentages of all owners, including new owners brought into the company during the transition. This revision is also an opportunity to address the distinction between active owners, who contribute to the daily operations of the business, and passive owners, who do not. Specifying the rights, responsibilities, and expectations associated with each type of ownership ensures clarity and helps manage differing levels of involvement. Additionally, the agreement can include restrictions and procedures for transferring ownership in the future, protecting the business from external influences, and preserving its family-oriented character.

Transitions often shift the power dynamics within a family business, necessitating new structures for governance and decision-making. An updated governing agreement should outline how major decisions will be made, such as approving budgets, undertaking significant investments, or entering into large contracts. This might involve setting voting thresholds, defining the role of family meetings, or formalizing an advisory board to provide guidance and oversight. Embedding these processes in the governing document ensures that decisions are made transparently and collaboratively. Transparency reduces the risk of misunderstandings or resentment, and aids in building trust and accountability among family members.

Conflicts, while inevitable in any business, can be particularly challenging in family-owned enterprises where personal relationships and business interests intersect. Without the authority of the founding generation, the new leadership may face heightened tensions among family co-owners. Updated governing documents should include clear dispute resolution mechanisms, such as mediation or arbitration clauses, to address disagreements constructively. The agreement should also outline rules for future ownership changes, including buy-sell provisions, valuation methods, and succession planning protocols. These provisions not only reduce ambiguity but also help the family maintain control of the business while adapting to inevitable changes, such as the death or departure of owners.

Why it Matters for Success: The governing document of a business is more than just legal language – it is a critical tool to maintain the stability, unity, and vision of a family-owned business. Updating it during the transition of ownership can help define the rights and responsibilities of all owners in the new generation. By proactively addressing the governance, conflict resolution, and ownership concerns of the new owners, the updated governing document can provide a solid foundation for the company’s operations. The experienced attorneys at Rapp & Krock can assist in discussing the variety of concerns involved in drafting and negotiating these documents.