"Structure Your Business Entity to Fit Like a Well-Tailored Suit" by Andrew N. Karlen, Esq.

Originally published in Westchester Commerce, April 2008

Last month’s column focused on the legal criteria that motivate business owners to select one form of business entity over another. The limited liability company (“LLC”) and the corporation, which of course can be a Sub-Chapter S or C-corporation, are the usual finalists in the decision-making process, with the LLC being today’s “gold standard.”

Now comes the task of “tailoring” the selection so that it is most closely aligned to the owners’ operational and financial objectives.

The process of choosing the right form of entity is roughly analogous to buying a suit. The first hurdle is a series of qualifying criteria. For a suit, these include style; size; price range; climate and occasions for which needed; desired image, etc. In the entity selection arena the characteristics have names like limited liability and flow-through taxation.

But, satisfying those criteria is only half the battle. Except for the six or seven of us that are actually built like models or mannequins, the toughest part of buying a suit is having It tailored to our own unique shapes (and, of course leaving a little flexibility). The reward for a good choice will be confidence in a key situation. A likely penalty for a poor choice is one of those sickening ripping sounds that seem to occur at the most crucial times.

This article takes us from the general characteristics of the various entity formats discussed last month to how the chosen entity can be customized to facilitate its owners’ strategic, operational and economic business needs and goals. This is the equivalent of “trying-it-on” to see if, when tailored, it will serve the needs of the business it will clothe.

Limited liability and favorable taxation treatment are important. But, every business must also have management, ownership and economic structures that meet and can adapt to the operational needs of the business and the financial goals of its owners. The structure, rather than the form, of the entity is at the heart of this article. Let’s look at a few instances in which we’ve been able to help business owners achieve their objectives by customizing their business entities.

Management Structure

At the very heart of the operational side of a business is the way in which it is managed. How centralized or diverse do the owners want the management authority to be? How much authority do they want to give to one or a small group of people?

The LLC format allows its owners (called members) to structure the management of their business in virtually any way they wish. It also permits them to change the way the business is managed to meet future changes in circumstances.

For example, a relatively small group of members, all of whom will be active in the business, may opt for a general partnership-like management structure. Under that structure, each member may exercise direct management control of the business. This allows for a hands-on approach, but makes all partners agents of the partnership with authority to contractually bind the entity.

It may be that the members want management authority in general or in specific areas be delegated to one or more members. This structure is similar to the structure of limited partnerships where there is a general partner that is responsible and has the authority for managing the enterprise. This structure might be used where one member is the driving force behind the LLC and supplies most of the capital and expertise, while other members play subordinate roles.

An LLC can also be managed like a corporation, with by-laws, directors and officers. An example of a situation where this structure might be useful is when there is a large ownership group that relies on non-owners or a small group of owners to operate the business.

Recently, I worked with an aging father and his adult son who were grappling with business succession. Their operating contracting business was owned by a Sub-chapter S corporation, and related real estate was owned by an LLC. The challenge was to allow the father to maintain his majority ownership of the entities and at the same time allow the son to operate and manage them.

The solution we shaped was for the son to become the director and president of the corporation and the manager of the LLC. To be sure, the solution on the corporate side was less than perfect, because in a closely-held corporation the majority stockholders may oust directors and officers.

In this situation, however, the relationships were such that we were confident that the father would only take such action if he were losing his mental capacity. To prevent that eventuality, we drafted specific provisions defining disability of the father to include impaired ability to make decisions and exercise his authority in the prudent manner that had helped him build a substantial business.

The LLC management solution was more straightforward. An LLC operating agreement may provide that a specific person will continue to be the manager of the entity until his death or resignation. By providing that the son would be -- and remain -- the manager of the LLC, and giving him very broad authority in that capacity, we were able to ensure continuity of management in the event of the father’s incapacity or death.

Ownership

Differentiating between the rights of various owners of an enterprise is a way of recognizing and accounting for their monetary and other contributions. It also enables my partners and me to factor in the owners’ different agendas and stages of life when resolving ownership issues. Typical considerations are voting rights and preferences with respect to distributions of cash flow or upon liquidation. Additionally, people’s egos can easily generate angry disputes between majority and minority ownership factions, particularly when owners work in the business.

This occurred recently at a corporation in which 75% of the stock was owned by a married couple and their adult daughter and 25% was owned by a key employee. Unhappy with the bottom line, the family stockholders demoted the key employee and sought to bring in a new person as CEO. This executive wanted stock in the corporation but the recently-demoted 25% stockholder refused to allow any dilution in his voting power. The solution that we worked out was to re-arrange the corporation’s ownership structure through a technique known as a re-capitalization.

The corporation is a Subchapter-S corporation, which means that only one class of stock is permitted. A Sub-chapter S corporation can, however, have voting and non-voting common stock. By re-capitalizing the corporation, to create new non-voting common stock, we were able to leave the voting rights untouched and have the majority stockholders transfer small portions of their non-voting common stock to the new CEO. The CEO has the financial interest he sought in the corporation, the majority stockholders have the new CEO they wanted and the 25% stockholder retains the exact financial and voting rights he had before.

In short, win-win-win solutions can be shaped with some strategic adjusting. If tailors can do it in a sewing room, business owners and their legal advisors can do it in a workplace.

Exit Strategies

Closely aligned with a business’ ownership structure is the mechanism for owners to cash out. Here again, things can get dicey when there are majority and minority owners. Business owners dream of the day when they can reap the financial rewards of their years of hard work by selling their businesses at a hefty gain.

But, what about the minority owners? Most buyers of a business want 100% ownership. The majority owners don’t want minority owners to have the leverage of being able to prevent the advantageous sale by refusing to sell their interests. And, the minority owners may not mind being the minority to the current majority, but they may not want to have to deal with new majority owners. It’s as if the majority owners want to have the right to “drag-along” the minority owners along with any sale they want to do, and the minority owners want the right to “tag-along” in any such sale.

This challenge arose in a business with four stockholders, two owning 40% each and two owning 10% each. The two 40% owners were older than the two 10% owners and were the ones who had established and built the business. The time horizons of the two factions were decidedly different. The solution was to put in place “drag-along” and “tag-along” rights. The two 40% owners knew that they could sell the business without concern that the 10% owners could, in effect, hold their stock for ransom. On the other hand, the two 10% owners had the comfort of knowing that if there were to be a sale, the buyer would purchase their interests for the same proportionate consideration and on the same terms as those paid and given to the majority owners’ interests.

An LLC or corporation is, in a sense, a business’ suit of clothes. A primary reason for the popularity of the LLC is that it gives the tailor the most material to work with. Whatever the form of entity, it should be well-tailored so that it will withstand day-to-day wear and tear, be adaptable to the needs of the business and its owners, and, most of all, won’t rip just when you need it the most.

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Whatever the form of entity, it should be well-tailored so that it will withstand day-to-day wear and tear, be adaptable to the needs of the business and its owners, and, most of all, won’t rip just when you need it the most.