The Hidden Issue in Firing Family Members

By Henry Krasnow

When a business fires an employee, it finds itself with an angry ex-employee who has only the normal rights of any employee regarding breach of contract or discrimination. Dealing with these rights is complicated, but not nearly as complicated as when the employee is a family member who also owns a part of the company.

When a business fires an employee who is also an owner, it finds itself not only with an angry ex-employee, but also with an angry shareholder with whom the owner may share future Thanksgiving or Christmas dinners. And, an angry ex-employee shareholder who, like many family members, has been in the “inside of the business” financial dealings can cause even more serious problems.

Of course, there are those few very large family businesses where angry family shareholders rarely cause problems. A family shareholder in a family business whose stock is publicly traded, for example, usually has little business motive to cause problems since he or she can sell stock at a fair market value. Similarly, a terminated employee-shareholder in a third or fourth generation family business whose stock pays regular dividends and is widely owned by both employed and non-employed family members, or in a business that has a well-established liquidity program that purchases stock at a fair market value, will probably do no more than sell the stock and avoid family functions.

But, in many smaller family businesses, the major advantage of stock ownership is the chance to go to work each morning. Even though the president of those businesses may have the perfect right to fire an employee who is also shareholder, the likely cost of that firing (once the ex-employee finds a clever enough lawyer) will be the purchase of his or her minority interest at a price higher than is comfortable.

From a purely employment-law point of view, as long as reasons for termination are performance-based and can be established, either through witnesses or documents, there is no significant difference between firing an owner and firing a non-family employee. Your legal case is further strengthened if the company has had input from an independent board.

But, a shareholder-employee enjoys the legal standing and insider knowledge to mount an attack on another front. Be prepared to confront the matter of buying back stock or having the company’s working capital sapped by the legal fees of defending what may seem like a frivolous lawsuit, but will be expensive and time consuming to defend.

In other words, firing a family shareholder in such a company will typically start a negotiation to buy his or her stock. And, since his or her ability to cause trouble greatly exceeds the value of the stock in the marketplace (a minority interest in a small company that pays no dividends and is controlled by the chief employee usually has no market value), the controlling shareholder should be prepared to pay far more than he or she thinks the fired employee’s stock is worth.

Why buy out a shareholder who has no right to be bought?

When the person being fired knows the location of every closet that hides a skeleton, and if there is a refusal to purchase that shareholder’s stock (and with it their silence), the stockholder has no option but to try to have all these skeletons marching across a courtroom as soon as possible.

How can a minority shareholder “force” a buyout? In many ways. For example, most states have a legal framework that allows a minority shareholder both to question the fairness of the salaries of the officers and to cause the sale of a company that is “abusing” the shareholders or breaking laws. “Abuse” is rarely clearly defined, thus giving judges broad discretion to correct perceived unfairness. Judges often think there is a premium on resolving disputes among family members and rarely think that there should be a financial premium placed on owning control of a small family business. Thus, when a judge who has very broad discretion hints that “abuse” is not providing any cash benefits for the non-employed minority shareholders, a purchase of the stock at more than its “market value” becomes an appealing compromise.

In addition, some business practices that are common in family businesses often provide the leverage necessary to force a buy-out. Many family businesses cut corners, particularly in relation to taxes and salaries. A client of mine once observed, “What’s the point of having your own business if you can’t cheat a little on taxes?”

Very few family business owners think of themselves as tax cheats. Yet, when their accounting methods are looked at in stark, cold focus, that may be exactly what they are doing. The ability to deduct personal dinners or travel on your expense account, the business purchasing and paying for personal cell phones, computers that are used at home, or tickets to sporting events even though no customer attends, are fairly common practices. Of course, when these “perks” are spread around to all the family members, no one has an incentive to complain. But when these perks are passed out in a preferential manner with non-employed family members receiving nothing, hard feelings quickly develop. Once this situation is presented by a dissident shareholder to his or her lawyer, the words “breach of fiduciary duty” immediately come into focus.

Similarly, in most family businesses, the payment of excess cash to shareholders as salaries has a distinct tax advantage over the declaration of dividends. When money is paid out as a salary, it is only taxed to the recipient. When money is paid out as a dividend, it is first taxed at the corporate level and is again taxed to the recipient. Privately held companies rarely pay dividends. Questionable salaries occur in numerous ways. The daughter who is a full-time college student might be paid a salary even though she never comes to work. Having the money taxed in her low tax bracket, as opposed to her father’s high tax bracket, has certain financial advantages. Or, a widowed mother might be paid a salary equal to her husband’s as a way of providing her regular income, even though her contribution to the company is minimal. Family directors might be paid handsome fees and travel expenses for going to quarterly board of directors meetings in exotic places.

But this practice has legal implications when looked at by a shareholder who wants out.  Officers, directors and shareholders of a corporation that approve questionable salaries also risk breaching their duties to the minority shareholders. It doesn’t require a lawyer with the mind of Clarence Darrow to quickly see this vulnerability as a tool for encouraging a buy-back of the fired shareholder’s stock.

So, what does this mean? That firing an underperforming shareholder/employee is never possible?

No, of course not. Firing an underperforming shareholder/employee is not only possible, but it is usually required for the business to survive. But, it must be done with the knowledge that the fired shareholder will want to be bought out and that realistic plans for meeting that desire must be made.

If asked, the company’s lawyer may correctly point out that the fired shareholder may have no “right” to be bought out. But, “does he have the right to be bought out?” is really not the right question. It is only the beginning of the analysis.

Think of it this way: if there is a goose that is laying golden eggs, and if all those eggs are going to the majority owner, the best and possibly only option for the minority owner is to threaten to kill the goose.