Business Ownership comes in three flavors

Jason ShrenskyBusiness Ownership, Stewardship

Typically, the main factor that drives a family to pursue a formal wealth stewardship plan is the complexity associated with the family’s ownership interest in private business entities. At first glance, the complexity is not obvious. Why is owning equity (shares, stock, membership interests, etc.) in a private business any different or more complex than owning a house or a car?

The short answer is that:

  • the value of a business interest is often many multiples larger in value than that in a house or car,
  • ownership in a business is often not publicly recorded (compare the title system for a house or a car) and thus record keeping is vital to preserve a family’s interests,
  • ownership of a business is often shared among many people, and
  • there are a myriad of legal issues that differ from business to business that govern an owner’s ability to control and liquidate its equity interest.

A more complete analysis of the complexity of business ownership takes into consideration the nuance of how “close” a family is to its ownership interests. On account of this nuance there are three distinct “flavors” of business ownership. The paragraphs below flesh out these “flavors” and explain how each impacts a family’s wealth stewardship plan.

Closely-held Businesses

In discussing the concept of business ownership, the first example that pops into most people’s minds is the company they started and perhaps work at every day. This is the classic closely-held business, and what sets it apart from other forms of business ownership is the significant (possibly full) control the family wields over the business.  If the family has partners in the business, there are likely very few. Thus, the capital structure is easy to understand but requires clear, well-maintained documentation as to who owns which percentage of the company and what type of control (e.g., voting rights, transfer rights) the owners have over their interests. Because the company is closely held, it is not just a good idea to maintain these company records, it is mandatory because there is no public database of private company operating agreements, partnership agreements, and bylaws. If the owners cannot find them, it is as if these documents and agreements don’t exist.

Investments

The opposite of ownership in a closely-held business is ownership in a business solely for investment purposes. Examples of this type of business ownership range from making a small investment in a friend’s start-up company to being a limited partner in a private equity fund. The distinguishing characteristic of this type of business ownership is that the owner wields little to no control over the business and often does not have much visibility into operations of the company. In many ways, a family’s ownership of this form of business is no different than its ownership of stock in a large public company like Amazon. In both situation, the decision to become an owner (investor) is almost completely governed by the family’s interest in achieving a particular return on investment. But what sets this type of ownership apart from public company ownership (e.g., stock in Amazon) is that 1) good record keeping is required to prove ownership (compare with public stock where banks and exchanges maintain databases to keep track of all trades); 2) ownership may be governed by special rules that may among other things restrict transfer and/or require further capital contributions in the future; and 3) liquidation might take place over a long period of time and be quite convoluted (compare selling shares of Amazon). On account of these three characteristics, investments in private companies demand diligent management to protect the family’s interests.

Closely-held business that is an investment for others

While not common, some families may own and operate a company that exchanges some of its equity for investment from third parties. Examples of this type of business would be a family-operated hedge fund, real estate fund, or venture-backed operating company. The challenge of tracking this type of business is similar to tracking the closely-held business described above but complicated by a complex capital structure of different classes of equity and many investors. A family will have great difficulty understanding and evaluating its own ownership interest in this type of business if it cannot understand the ins and outs of its investors interests. Thus, it is vital for the family to invest the time to document these complexities.

 

For many families, ownership in private businesses accounts for the majority of family wealth. As a result, it is imperative for the stewards of family wealth to carefully track this asset class. Compared to other asset classes, ownership in private businesses is uniquely complex. Thus, stewardship over this asset class demands diligent record keeping and mindfulness concerning the nuances of the different forms of private business ownership. The best way for stewards to track and understand the impact of private business ownership is using a system like Complex Interests‘ family wealth software. Complex Interests’ specialists are well versed in the complexities of tracking private business ownership and are always available to take your questions on the topic.