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How can professional advisors smooth the process and ensure the redistribution happens efficiently?

September 2019 - Corporate & Commercial. Legal Developments by IR Global.

More articles by this firm.

The following article discusses session three in the IR Global Virtual Series on 'Redistributing Share Capital - Considerations for family-owned enterprises'

U.S - Texas - DL In the US, it has become normal to work using limited liability company agreements for private transactions and not public companies. But even in private transactions among public companies, the use of limited liability company agreements and complex partnership agreements is happening.

In the case of structuring wealth for families or bringing in employees, it's much more common to use shareholder agreements, or often no agreements at all.

I would say that most of our transactions use limited liability company agreements that are highly negotiated with details on the rights that are given to the minority investor. This includes control rights, security rights, methods of securing the investment and possibly even ways to increase their share if the company doesn't perform to the levels negotiated.

U.S - California - JF Do you see situations where minority interests are protected by the preferred status of their ownership interest, where any dividends or any distributions get paid to them first according to certain ratios?

U.S - Texas - DL With private equity investments, there's always a waterfall distribution method of drafting the partnership agreement.

As a tax lawyer the most material difference between a private equity limited liability company agreement and a non-private equity limited liability company agreement is the method of distributions and allocations of profits.

Private equity funds tend to draft all of their limited liability company allocation provisions on what is called the target method of distributions. The agreement drafts specifically how the cash is distributed, ensuring that the private equity fund has a certain return coming back to their investors. It’s based on cash and then the profits and losses are left to the accountants to figure out allocation. The private equity funds don't care, since all they're looking for is cash.

In a normal transaction between two businesses, the profits and losses section would be focused on what your share of profits would be, or what your share of losses would be and then distributions would always follow based on the capital account accounting.

U.S - California - SG I cannot resist the temptation to add that, whether it's a family situation or non-payment situation, cash flow is always important. Clients are always concerned about that.

In the family situations, we actually end up using LLCs quite a lot to establish different kinds of partnerships. This is especially true for assets like real property.

The entity structure and how we're going to govern businesses and assets from one generation to another is a big part of what we do as professional advisors. A big part of my practice in those transfers are multi-generational trusts, which probably would not be used outside of families.

I think the equivalent in Germany is a foundation. If you say foundation in the US, you're thinking of something that has a charitable requirement, but I think in Germany the foundation is a private family arrangement similar to a trust. We use all kinds of trusts to accomplish our goals as professional advisors.

We translate these structures in an intelligible way for our clients. It’s very common for us to use diagrams and charts to show the clients what the legal documents are going to do. Our family clients love seeing the diagrams showing how things are going to flow. It aids their understanding tremendously.

Germany - MS Some very rich families in Germany have a family foundation and this will hold 100 per cent of the operating business of the companies.

We work with a large company, where all the profits from operations go into a foundation. The foundation then aims to invest all the money back into the company. This secures the future of the company because the profits will not go out of the family.

The family members themselves only have salary agreements and they get a salary from the foundation for their services. You do not have minority shareholder problems, because in this foundation everyone is a member, rather than a shareholder with profit interests.

U.S - Texas - DL This is actually very interesting and something we would never see in my practice.

We're currently representing an international religious organisation doing some restructuring, which has caused me to look at something else that I had really never looked at before. That is the use of limited liability companies for non-profit 501 C 3 organisations.

Delaware and two other states have specifically authorised the use of limited liability company agreements for non-profits, and then another series of 20 or so states have permitted it.

The reason I raised that is significant, because the limited liability company is used so much due to its ease of preventing piercing the corporate veil.

State laws are very good at saying that the limited liability company does not have to follow all of the procedures for giving notices to shareholders and doing all the things you have to do in the corporate context. As a result, the limited liability company is an easy form to operate with and still maintain a limited liability for the members. In a non-profit organisation structure, the parent company with a large valuable church building as an asset, can operate its for-profit activities in a separate limited liability company agreement. If an accident occurs that would give rise to liability, this insulates the non-profit parent from that activity.

U.S - California - JF I'm working on one right now, where we have European owners and Californian owners of a business. They own the business equally and there's a conflict over the direction of the company.

We're working on a resolution to resolve the future of the company. My client is the Californian entity and only the California entity. We have to always be very careful about who we represent and we can't act in the middle between different parties unless we are formally designated as a mediator. It’s certainly the kind of thing that we get involved in on non-family business transactions as well, where we resolve disputes among owners by advising the parties.

One thing I want to add, is something interesting in California. It's called judicial reference for the solution of disputes.

There are problems with arbitration and there are problems with going to traditional courts to litigate. Judicial reference is a cross between the two, using a retired judge who works privately to resolve a dispute, almost like an arbitrator, but in accordance with all of the applicable laws of California.

The parties hire the judge and direct the judge in terms of the process, so it can be done privately and quickly. It follows the law, unlike arbitration which does not necessarily follow the law, and is subject to appeal. You get a ruling that you can take up on appeal if need be and it creates a very interesting statutory alternative in California.

U.S - Texas - DL We have judges and former judges that permeate our arbitration list, but the only way in Texas to have it subject to appeal, is if the arbitration clause specifically provides that the decision can be appealed if it didn't follow the law.

US - California - JF In California, it's all set up by statute, which we sometimes call our ‘rent a judge’ program.

France - BP As advisors, we always discuss with our clients the extent of the power they are willing to grant to new investors to avoid dispute on this loss of power.

I have seen disputes happen with a family-owned company, where one member of the family who runs the company, was not accustomed to discuss with foreigners the strategy of the company. With new investors, you will have to get accustomed to this, so the only question is how it will happen and to what extent.

What decisions will require the approval of the new shareholders is one specific point, while what kind of information will need to be provided is another.

It is also important to determine if the new shareholders are here just for a limited period of time or if they're here to stay. Some new shareholders have invested with no intention of selling the shares, but the situation is quite different when the new shareholders have decided they will sell, for instance, within five or seven years.

It is necessary during the investment process, to not only think about how the first investment is made, but also how the new shareholders can resell their shares within this period of time. In France, one solution is often an agreement between new and family shareholders, providing that if no solution is found for the sale of the new shareholders’ shares, the family has to sell the whole company.

This means that if you do not have a solution within five or seven years, the family company will no longer be a family company.

It is our duty as lawyers to explain to all the members of the family, the content and the impact of the new agreement, especially if it happens that there are only one or two key members of the family who negotiate this agreement with new shareholders while the other members of the family, do not participate in the negotiation.

We do not only discuss legal aspects, but also the details of the strategy of the company and also the needs of the members of the family. This includes what their plans are for the next few years.

For instance, if it is a private fund which invests in a French company, then they may not want distribution of dividends. All the members of the family would have to accept that, for four, five or six years, there will be no distribution of dividends. This has to be explained to them, otherwise a dispute may happen.

UAE - TP Typically, a shareholder agreement is the first thing to put in place. The key things to take into account are how to secure the distribution of the profit, plus proper governance structure.

If these aspects are properly taken care of in the shareholder agreement, minor disputes among partners are unlikely and, in any case, far more manageable.

To this end, we typically use arbitration clauses, or the court of the Dubai International Financial Centre, because it is a system which is more like English law and a perfect forum especially for investors coming from abroad.

Finland - TK Shareholder agreements are always relevant, as are articles/bylaws of the company. In that sense, it's possible to have a redemption condition in articles or bylaws that can be used in the same way as share classes, for instance voting rights.

Brazil - LJ It is important to work with the shareholders and the company to define a clear strategy and vision and a clear corporate governance with functions. Putting in place independent managers, that act apart from shareholders, is also a crucial part of the corporate governance.

Mexico - JC Negotiating an offering of share capital, will normally be formalised first by amending the company’s bylaws. Depending on the kind of transaction, the parties may also execute a joint venture agreement or a shareholders’ agreement. For matters involving family, they will execute a shareholders’ agreement and afterwards will execute family protocol that has been previously designated by a professional in the area.

Poland - RL The terms and conditions under which a new investor joins a family-owned enterprise are commonly subject to regulation of the shareholders’ agreement, in the case of a private company, and a supplemental partnership agreement in the case of a limited partnership. These agreements must define the scope of rights and obligations of a new investor.

Additionally, the following clauses ensure a smooth realignment and maintenance of control over the enterprise by family members.

The exact identification of the purpose of investment, plus ways of providing financing by a new investor (e.g. through increase of the share capital along with providing share premium.)

Clauses around the attribution of shares to the new investor, the future distribution of profit/dividends between family members and the new investor are worthwhile, as are buyout clauses of the shares of the investor by family members after execution of investment through a drag along clause and a clause relating to the new composition of management board/supervisory board favouring family members.

England - AC There are a number of ways that professional advisors can smooth the process to ensure that a redistribution happens efficiently and achieves its goals. These include project managing the process, by prompting the parties to discuss difficult subjects at the outset (for example, what happens if there is a dispute). We can also help to implement appropriate mechanisms or safeguards, by ensuring that the rights and obligations of the parties are clearly documented, with the aim of reducing the scope for disputes in the future.

The rules in accordance with which the company must be run are set out in its Articles of Association. Shareholders will often want to ensure that agreements between themselves and minorities remain between the parties. It is therefore essential that the shareholders consider putting in place a Shareholders’ Agreement.

Often when negotiating a Shareholders’ Agreement, a minority shareholder who has invested significant sums in the business will want to ensure that their investment is suitably protected. This is particularly key if they will not be appointed as a director, and therefore will not be involved in the day-to-day decision making of the company. As previously discussed, the family will want to ensure that it retains adequate control of the company. One method is to set out in the Shareholders’ Agreement, a list of matters which are fundamental and require key shareholder consents – these are often referred to as ‘reserved matters’.

If the shares have been offered to employees as part of an employee share scheme, then the documents governing the scheme should be drafted by a solicitor to make sure that they comply with the various rules and legislation. It is usual that these employee shares will be a different class, and will not have voting rights. The aim is to provide a form of financial compensation, without giving them rights in relation to running the company. The rules need to be drafted to ensure that this is the case.

If there is a dispute between two shareholders, then it is often recommended the parties consider mediation, however there is no legal requirement to follow this path.

CONTRIBUTORS

John R. Colter-Carswell (JC) Colter Carswell & Asociados, S.C. – Mexico www.irglobal.com/advisor/john-r-colter-carswell

Lavinia Junqueira (LJ) Tudisco, Rodrigues & Junqueira – Brazil www.irglobal.com/advisor/lavinia-junqueira

Markus Steinmetz (MS) Endemann Schmidt – Germany www.irglobal.com/advisor/markus-steinmetz

Alex Canham (AC) Herrington Carmichael – England www.irglobal.com/advisor/alex-canham

Bruno Pichard (BP) Pichard & Associés – France www.irglobal.com/advisor/bruno-pichard

John Friedemann (JF) Friedemann Goldberg LLP – U.S – California www.irglobal.com/advisor/john-friedemann

Steven M. Goldberg (SG) Friedemann Goldberg LLP – U.S – California www.frigolaw.com/steven-m-goldberg

Tuomo Kauttu (TK) Aliant - Finland – Finland www.irglobal.com/advisor/tuomo-kauttu

Thomas Paoletti (TP) Paoletti Legal Consultant – UAE www.irglobal.com/advisor/thomas-paoletti

Donald R. Looper (DL) Looper Goodwine P.C. – U.S – Texas www.irglobal.com/advisor/donald-r-looper

Robert Lewandowski (RL) DLP Dr Lewandowski & Partners. – Poland www.irglobal.com/advisor/robert-lewandowski