Due Diligence For Family Owned Business Succession
Introduction : Succession planning for a family business is a delicate subject. Founders of family-owned businesses often rely on oral understandings and family agreements in relation to future ownership and management of their business. This approach may be adequate as long as the founder retains majority ownership and control. However, upon his or her retirement or incapacitation, disputes may erupt in relation to ownership of shares, management control and entitlement to business assets. Apart from affecting family relationships, such disputes have the potential to derail the value of the business as well as its ability to attract investors.
Legal due diligence can be extremely helpful in such situations by addressing potential problem areas in relation to ownership, governance, tax planning, succession documentation and other commercial aspects. By identifying areas of potential conflict and helping to address and resolve them, legal due diligence can help to ensure continuity of a family business as well as its commercial and family value.
Ownership and Control: Establishing Legal Certainty
In relation to succession, ownership and control of the business remain at the core. A family business, particularly one that has been around for several years, has grown over time and has been nurtured by more than one family member. As such, there may be situations where the founder holds legal ownership of shares but delegates managerial responsibilities to his or her children while other family members are involved in the running of the business without legal ownership. Such an arrangement, although it may promote day-to-day running of the business, can cause complications in relation to succession since although the founder may transfer shares, key decision-making powers may remain with him or her.
It is therefore important to ensure that the ownership structure reflects the commercial reality. While examining the shareholding pattern, it is important to go beyond the publicly available information on stock exchanges or on the share certificate. The Companies Act, 2013 provides that the register of members must show the name and address of each member, the number of shares held by him and the class of those shares. As such, it is important to ensure that the register of members is correctly updated and that documents such as the transfer deed, declaration of beneficial owner and others are properly in place.
Similar checks must be carried out in case of a partnership or limited liability partnership, since the partnership deed or LLP agreement must disclose the details of all partners as well as any oral or written understandings in relation to succession of partners. Other documents that must be scrutinized in order to establish legal ownership and control of a family business include:
It is therefore important to identify such assets and take necessary steps to transfer them to the company or to the nominee/legal heir in order to avoid disputes over ownership and control.
Beneficial ownership – In some cases, shares may be beneficially owned by one family member but registered in the name of another. As such, appropriate transfers or adjustments must be made prior to succession in order to reflect actual ownership.
Nominee bank accounts – Similar to the above, bank accounts may be held by one person on behalf of another. Such accounts must be adjusted so that they reflect actual ownership.
Strengthening Governance for the Family Business Succession
While ownership is extremely important, it is only one aspect of family business succession. Another critical aspect is management and governance structure. It is often the case that a family business is heavily reliant on its creator, who has significant powers in relation to financial, management and other decision-making powers. Such a governance structure may be adequate while the founder is in active control of the business but can cause complications once he or she retires or passes away since the next in line may not have the same level of experience and authority.
As part of legal due diligence, it is important to review whether the company constitution, board practices and management structure provide for flexibility and whether upon succession, the next in line will have the requisite powers to make important decisions.
Similar to the ownership structure, management structure must reflect the commercial reality in order to avoid disputes. In other words, each family member must know his or her role and responsibilities. Not all family members who own shares must be involved in management while not all family members who are involved in management must own shares. In all cases, such roles must be clearly defined so that appropriate decision-making is in place without inviting family conflicts. It is important for the company to formalize such roles since oral understandings may not survive the test of succession and cause disputes.
Coordinating Tax-Planning and Estate Considerations
Legal due diligence for family business succession is not complete without considering tax-planning aspects. Taxation planning should not be viewed as an end in itself but rather as an integral part of designing a sustainable succession plan. It is often the case that promoters and founders view tax-planning aspects as the most important consideration while structuring a succession plan. While tax-planning considerations must be carefully taken into account, it is important to view them in the context of overall commercial viability. In other words, the tax implications of a succession plan must be analyzed and appropriate steps must be taken to ensure that the plan is commercially viable as well as legally compliant.
The first step towards tax-planning is to decide upon the manner in which ownership will be transferred. Some promoters prefer to gift shares while others opt for a Will. In some cases, private trusts are setup in order to hold the shares on behalf of the nominee. In case of large families, it may be appropriate to consider a structure where ownership is split between various family members while management responsibilities are centralized with a particular person or group of people. Each of these options has different tax implications in terms of transfer of ownership as well as future taxation of income and must therefore be carefully considered.
It is also important to consider estate planning since many promoters hold not only shares of the company but also other assets such as real-estate in their personal capacity. As such, succession planning must be coordinated with estate planning in order to ensure that transfer of ownership of such assets is appropriately structured. It is important to understand that the tax implications of transferring shares, immovable property and other business assets can be vastly different and tax planning for each must be considered separately.
Documenting the Transition to Ensure Smooth Succession
In many cases, disputes erupt due to oral understandings or family agreements, which means that the parties have not documented their understandings clearly. However, while such agreements may be satisfactory from a family point of view, they can become the source of serious disputes once the succession takes place. It is important to remember that the law only recognizes documented agreements. As such, it is important to document the succession plan as clearly as possible in order to avoid future disputes.
A will, if not properly executed, can become the source of disputes among family members and even lead to litigation. As such, it is important for a promoter to execute a will in order to clearly state his or her succession plans and the distribution of his or her assets. It is also important to periodically update the will in order to reflect any changes that may take place in the promoter’s personal or business life.
In addition to a will and a family settlement agreement, it is important to document the succession plan in a shareholders’ agreement. Such an agreement allows for greater flexibility while laying down the terms and conditions applicable to transfer of shares, management and other succession-related aspects. Many such agreements contain valuation and buy-sell clauses, which are helpful in determining the price of transferred shares, as well as dispute resolution clauses, which are helpful in resolving succession-related disputes. In the absence of such a document, differences over ownership and management can lead to deadlocks, which can severely impact the management of the company.
Conclusion
Succession of a family business cannot be viewed as a one-off exercise that takes place only upon the death or incapacitation of the founder/promoter. Rather, it is an ongoing process that requires due diligence, particularly in relation to legal aspects of succession. The risks of legal disputes during succession can be minimized through legal due diligence, which helps to identify potential problem areas and address them in order to minimize the risks. By addressing the key issues in relation to ownership, governance, tax-planning, documentation and other aspects, legal due diligence can help minimize the risks of disputes during the succession of a family-owned business.
Author: Tanmay Singh in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney
Endnotes
Companies Act, No. 18 of 2013, §§ 2, 88, 89, 92, 149–172 (India).
Indian Succession Act, No. 39 of 1925 (India).
Hindu Succession Act, No. 30 of 1956, as amended by the Hindu Succession (Amendment) Act, No. 39 of 2005 (India).
Indian Trusts Act, No. 2 of 1882 (India).
Income-tax Act, No. 43 of 1961 (India).
Kale v. Deputy Director of Consolidation, (1976) 3 SCC 119.
Narendra Kante v. Anuradha Kante, (2010) 2 SCC 77.
Organisation for Economic Co-operation and Development (OECD), G20/OECD Principles of Corporate Governance (2023).
International Finance Corporation, IFC Family Business Governance Handbook (2d ed. 2011).
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