Stocks in Family Business: Voting or Non-Voting?

It is not uncommon these days to see family-owned businesses with two classes of stock. Typically, one class has both voting and economic rights; the other class has only economic rights. With this structure, a couple of things are possible. For one, this structure can facilitate a gradual transfer of the business to a new generation. The senior generation can begin to transition the business to the next generation by first issuing non-voting shares. This can give the next generation some economic “skin in the game” without handing over the reins or creating governance issues. This structure can also have economic and tax benefits if the business can support a lower fair market value for the non-voting shares. Another use of this dual-class structure can be to distinguish the ownership of those family members active in the business and those not active in the business. In this context, granting voting shares to those active in the business will ensure that the decision-making about the business will remain with those most familiar with it, but the economic benefit of the business can be shared evenly throughout the family.

In both of these contexts, the dual-class structure can be an effective tool for a family-owned business. But it is important to understand that each application of this tool can give rise to concerns or tensions that should be acknowledged from the outset. For example, when a family-owned business is using the dual-class structure as a transition mechanism, it can create an incredible temptation for the senior generation to further delay the ultimate change of control. Both generations need to be clear on the final objective and the timeline. Further, use of this tool could result in a shareholder base where those that own the majority of the economic interests cannot control the business, creating a situation where incentives are misaligned. Alternatively, when a family-owned business is using the structure to allocate between active and inactive family members, there are likely certain decisions that may not relate to the direct operations of the business, but impact the legacy of the business and the family name. In those sorts of decisions, a non-active family member might feel they have just as much right as an active family member to participate, but the dual-class structure would prohibit that.

It quickly becomes clear that the dual-class structure can resolve certain issues, but may also bring new concerns. This is yet another reason to keep in mind that it is almost always a viable option to address these issues with some form of shareholder agreement. For example, if a family wants only members of a certain generation to participate in determining the board of directors, regardless of who holds how much stock, that is something that can be included in an enforceable shareholder agreement. Similarly, if there are certain decisions that should be made by the board of directors, by a subset of shareholders, or by all shareholders, this requirement is something that can be specified in an enforceable shareholder agreement.

The dual-class structure can be a very effective tool to manage economics and governance in a family business. And for those operating through a Subchapter S corporation, it can usually be implemented without losing the Subchapter S status. But it does not solve every problem, and it is only one tool. It should be considered in conjunction with other tools, such as shareholder agreements, to create the balance that is right for each individual family.