family-owned, limited close corporations and protection of ownership

Family-owned, limited close corporationsand protection of ownership

Lars-Goran Sund Æ Per-Olof Bjuggren

Published online: 6 July 2007

� Springer Science+Business Media, LLC 2007

Abstract Protected ownership and freedom of contracts are two basic parts of the

institutional framework of successful countries according to Douglass North, winner

of the Nobel Prize in 1993. The incentives to make long-term investments are

strengthened if ownership rights are protected and freedom of contracts is a basic

element in the process of efficient allocation of scarce resources. An important

engine in prosperous societies is the family firm. Most companies in these societies

can be classified as family firms and a major part of GDP is produced by family

businesses. Consequently, how ownership is protected in family firms is an

important issue.

Three important factors of private ownership of property are the rights to

determine use of owned assets, the return generated from them and to transfer the

assets at mutually agreeable terms to a new owner(s).

The incentives of a founder entrepreneur to put efforts into the establishment of a

firm are determined by all the three factors. We will here pay special attention to the

third factor, transfer of the ownership of the firm. The founder often places con-

tractual restrictions on such transfers to ensure that the structure of ownership is

stable and that the firm stays in the family. The possibility to do so is part of the

freedom of contracts and is associated with the extent of ownership held as well as

the incentives to invest in new businesses.

The paper was presented at The 2006 Hawaii International Conference on Business, May 25–28,

Honolulu, Hawaii, USA. The research has been supported by grant from Torsten and Ragnar Soderbergs

foundation.

L.-G. Sund (&) � P.-O. Bjuggren

Jonkoping International Business School, P.O. Box 1026, 551 11 Jonkoping, Sweden

e-mail: [email protected]

P.-O. Bjuggren

e-mail: [email protected]

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Eur J Law Econ (2007) 23:273–283

DOI 10.1007/s10657-007-9015-9

This paper is primarily about how protection of family ownership can be

achieved from a legal point of view and discusses the reasons to enforce these legal

relationships in the future for second, third, fourth etc. generations of family owners.

Keywords Protection of ownership

1 Introduction

This paper deals with restrictions on transfer of ownership of shares in family-

owned limited close corporations. In other words, it is the family-owned private

(non-listed) corporation that is in focus in our study. Most of the corporations

around the world fall into this category. Questions to be asked are: Why should we

impose restrictions on transfers? Are we not better off with fewer restrictions on

transactions of ownership rights? The perceived wisdom seems to be the opposite,

viz. that free movement of goods and capital, including shares in businesses, is of

crucial importance in a market economy. It will here, however, be argued that the

principle of free movements is not without qualifications, not least when it concerns

ownership in family non-listed businesses. The death of the (majority) owner serves

as a frame of reference to illustrate and analyze these exceptions.

The most important reason for a business owner to uphold the ownership

structure is that it provides the ultimate tool for control of management of the family

firm. An owner-family can directly, as CEO or as members of the board, lead the

company. This reason also applies to the case when the family, as a majority owner,

organizes a Family Council through which they can indirectly influence manage-

ment. This influence, directly or indirectly, requires stability in (majority)

ownership.

Another reason, for a business owner to protect ownership in the firm, is to

preserve a well functioning ownership structure. Such a structure often provides a

delicate, as well as fruitful, balance between the owners. If it is disturbed by an

unwanted new shareholder, it may become costly and time consuming to restore an

effective balance. A successful business is also dependent on a trusting relationship

between the owners. A new shareholder may have interests among competitors, be

unqualified as an active owner, or exhibit an inability to cooperate.

The third reason concerns intergenerational transfer of ownership. Restrictions

on ownership transfers can here be seen as a kind of bequest. By imposing

restrictions, the founder of a business can rest assured that the firm will be kept

within the family until the next generation takes over. To be assured of future

family ownership in this way provides an incentive to both make value-increasing

investments in the business and, step-by-step, hand over ownership to family

members. Gradually introducing family members into management and giving

them ownership shares is a way to provide for a successful intergenerational

succession. Many founders are highly likely to favor such transfers. If they are

denied this type of preparations for a bequest, it will weaken the incentives for

value-increasing investments (cf. discussions in Cooter and Ulen 2004, about

inheritance and bequests).

274 L.-G. Sund, P.-O. Bjuggren

123

According to a Swedish study, 80% of owners of family businesses want the firm

to remain within the family (Emling 2000). We find this attitude to succession of

significant importance when looking closer into how ownership structure can be

preserved through transfer restrictions. Passing ownership of shares to the next

generation demands control over shares owned by the older generation.

What is then a family firm? There are different ways to define such a business.

The one chosen here is the following: We define a family firm as owned by not more

than four individuals or families, of whom a qualified majority want ownership to

remain. Further, there has to be an influence on management, at least indirectly in

the form of e.g. a Family Council. To safeguard ownership it becomes highly

important to keep the firm within the family.

We define a family as spouses or cohabitees, their descendants (including

adopted children and officially recognized stepchildren) and siblings, as well as

nephews and nieces. Ownership can be spread among many individuals in each

family and the firm can still meet the definition of a family firm, as long as there are

not more than four owner-families.

Given the definitions of a family and a family business, the next question to be

addressed is: How can ownership structure be protected? Tools that can be used to

protect ownership are e.g. pre-emptive clauses and rights of first refusal in the articles

of association and shareholders agreement. Other instruments are marriage settlement

and a will. Drafting various agreements among shareholders is, as Moye puts it, the

attorney’s greatest challenge (Moye 2005 p. 209). We concentrate on measures that

can be used by shareholders to prevent conflicts concerning ownership stability. Thus,

we do not explore possibilities to enforce the duty of loyalty by claiming ‘‘unfair

prejudice’’ in litigation (Kraakman et al. 2004 p. 148 and Ferran 1999 p. 608).

The key question that is not addressed here is why should a society promote

protection of the ownership structure in family firms? Our presumption is that

preserved family ownership of a firm represents something valuable for the society.

The contractual restrictions described are the result of voluntary agreements

amongst the shareholders. A more elaborated model showing that these voluntary

imposed restrictions are Pareto sanctioned and that preserved family ownership

enhances efficient performance will not be provided. This paper does not explicitly

deal with this, with the exception of a short discussion in section 2.

A discussion of the economic rationale for keeping a firm within the family is

found in Bjuggren and Sund (2002). In that article we argue that idiosyncratic

knowledge of how to conduct business can be developed in a unique manner

amongst family members. Trust and loyalty as well as learning by watching and

doing are important ingredients in the development of such idiosyncratic

knowledge. Special information networks with customers and suppliers built on

trust and long-term relationships with the family enhance the value of such

idiosyncratic business knowledge. Contractual arrangements to make sure that a

firm stays within the family can be seen as a safeguard for preserving the value of

idiosyncratic family business knowledge. Bjuggren and Sund (2002) use a

transaction-cost approach in developing their arguments to why preserved family

ownership can be crucial for firm value. An earlier article that discusses family

ownership along the same lines is Pollak (1985).

Family-owned, limited close corporations 275

123

Hence, the underlying assumption is that there are good reasons to preserve

ownership structures in family businesses. Given that assumption, the aim of the

paper is to show how the ownership structure can be protected. The question to be

answered is the legal technical one of how this can be accomplished.

The paper is organized in the following manner: Section 2 deals with some

differences between family-owned firms and other businesses. Tools to use, with a

purpose to uphold ownership of shares in family firms, are briefly described in

Section 3. The importance of this protection is illustrated in Section 4, in which we

analyze the effects of an owner who dies without having prepared for ownership

protection. In Section 5 we offer some conclusions.

2 A short note on differences between family owned firms and other businesses

A rationale for keeping a firm within the family is that there are advantages to be reaped

for having cooperating family members as owners. This can be contrasted with a SME

which is not a family business. Such a firm is typically owned by a sole owner or two or

more companions, who after a shorter or longer period intends to sell the company.

The shares will not be inherited or otherwise transferred within a family. Compli-

cations seem to occur mainly in two senses, namely to find a buyer and excess capital

gains tax. In comparison, a family business that is inherited or transferred within the

family, during the lifetime of the owner, gives rise to a much more complicated

situation. Who will be the owner(s), who will become CEO and how will the costs for

transfer of ownership (e.g. taxes) affect the operations of the firm?

A successful family business is often based on mutual trust and a delicate balance

between the owners. If an outsider requires shares in the business, especially if he or

she has interests among competitors, a successful cooperation may be disrupted in a

way that is detrimental to the operations and jeopardizing the accumulation of

wealth. The balance may also be affected if the spouse of an owner through a

divorce becomes a new shareholder, or if the children in an unplanned way succeed

as new owners through inheritance.

The problems of succession are less severe in a listed family firm. The value of

shares in a listed company is easily appreciated as there is a daily quoted price to

rely on. The valuing of shares is important for example when a family member is

deceased. However, most family-owned businesses do not have listed shares. A

succession may for that reason be very time consuming and costly (Belcher 1994

and Tannenbaum 1998).

3 An overview of alternatives concerning protection of ownership

3.1 Introduction

In theory, the legislation of a country can exhibit two extremes. Either a country

prohibits in law any restraints on transfer of shares in limited companies or it is

totally, with no legal prohibitions, left to be decided in agreements between

shareholders, e.g. in the articles of corporation.


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A total legal restriction on limitations of transferability is only possible in theory.

It is a violation of the freedom of contract. Furthermore, in practice the shareholders

will find other tools to restrain transfers.

According to the other extreme a country can decide to put no legal limitations on

potential restrictions created by the parties. Then it is easy to understand that it

could lead to situations which are incompatible with principles of property law, e.g.

if the parties create a total restriction, unlimited in time, on transfer of shares in the

articles of association. What is referred to here is that especially a minority owner

would be forced into a situation of contractual restraints against her/his will. It

would leave some owners with no option but to reluctantly remain or strive to reach

bankruptcy. Neither is beneficial for a society based on a market economy.

3.2 Alternatives

Restraints on transfer of shares can be included in clauses in the articles of

association. These are binding for the company and acquisitions in good faith are

not possible. Restrictions can also be inserted in company by-laws. Yet another

possibility is to include them in the shareholders agreement. If a transfer of shares is

in breach of a clause in such an agreement, it is not binding for the corporation.

Thus, it may register a new shareholder, who has acquired shares in breach of a

clause, as the owner, with e.g. the right to vote at the annual meeting of

shareholders. Acquisitions made in good faith may be possible if the infringed

clauses are inserted in the shareholders agreement. Whether a restriction on

transferability is binding for the company and if acquisitions made in good faith are

possible varies between countries and legislations. To explore this requires another

paper.

Restraints on the ability for a shareholder to hand over ownership of shares are

subject to almost infinitive variation. They can be applicable for all shares or a

certain class of shares.

A post-sale purchase right clause gives a possibility, for e.g. the remaining

shareholders, to redeem shares after ownership has passed to a new owner(s). If a

clause instead contains a right of first refusal or, as we label it, a pre-emptive right

clause, it provides a right to buy the shares before ownership changes hands. A

consent clause requires permission (from e.g. the company board) before ownership

of shares is transferred. These definitions may vary in different countries and

legislations. If a clause contains a total restrain on transfer of shares, we label it a

prohibitory clause.

In theory, all clauses can, as mentioned above, be prohibited in the legislation of

a country. Alternatively, it can provide statutory e.g. pre-emptive rights. These can

be defined in law and require a purchase, or they may merely permit shareholders to

create preemptive rights in e.g. the articles of corporation or in shareholders

agreement (restrictive stock agreement; compare Belcher 1994). Legislation may

also be silent on these matters, thus leaving it to be decided by the parties and, in the

long run, by the courts (common law).


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Different ways to proceed are the following:

1. A clause containing restrictions on transferability can be triggered if a

shareholder decides to sell her/his stock, pledge, encumber or hand it over

through a gift inter vivos, or if the owner is divorced, becomes disabled, goes

bankrupt or terminates her/his employment. Such a clause can also be triggered

in case of testate or intestate succession. (Compare Belcher 1994.)

2. The rights to acquire shares may, in theory, be assigned to the company

(redemption or entity purchase), other or remaining shareholders (cross-

purchase), other persons (e.g. employees) or a combination of these buyers

(hybrid). (Tannenbaum 1998.)

3. A variety of purchase rights may be given once a triggering event has occurred.

The shareholder who wishes to dispose of his stock may have a right to require

a purchase by the corporation, if an entity purchase is allowed according to the

legal system of a country, or other shareholders. The latter may be bound by a

mandatory agreement to purchase, or they can have an option. (Belcher 1994

and Moye 2005 p. 466.)

4. Restrictions on transferability are often limited in time and they may include all

shares or a certain class of shares, which are explicitly determined in e.g. the

articles of corporation.

5. Clauses agreed upon by the shareholders mostly include exceptions, when the

restrictions are not applicable, such as if a new owner is a family member or a

descendant or a previous shareholder (permitted transfers).

6. A prohibitory clause may be limited in time or excluding only certain persons,

e.g. infants or bankrupts. (Cadman 2004, p. 77.)

Restrictions on transferability may under certain conditions be deemed void by a

court. For example, when there is created an absolute restriction unlimited in time

on the alienability of shares (prohibitory clause) or other unreasonable restraints.

(Moye 2005 pp. 458 and 465.)

Also a marriage settlement and a will can, on some occasions, have the function

of preventing unwanted acquisitions of shares, which we will come back to later in

subsection 4.2.4.

3.3 Main transfer restrictions in three European countries

With the aim of further illuminating various transfer restrictions, and combinations

thereof, we will describe briefly the main instruments for SMEs (closely held

private limited companies and ‘‘Gesellshaft mot beschrankter Haftung’’) in three

European legislations, Germany, the UK and Sweden. This is a difficult task, since

the relevant parts of the Company Law system of each country is dependant on 1)

other parts of the civil law (e.g. Contract Law) and the political, economic, social

and cultural background. Further, e.g. a pre-emptive clause may, in detail, entail

different rights from one country to another. With this in mind, we limit the

following to a short overview of transfer restrictions in the articles of association in

each of these countries.


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In the UK (England and Wales; the Scottish system is partly different) the

restrictions, in most cases, are either given the form of refusal powers or pre-

emption provisions or they may be combined. (Davies 2003, pp. 689–692 and

Pennington 2006, pp. 920–933.) The directors can be empowered to refuse to

register a transfer. This can be done on their discretion or on specified grounds.

According to a pre-emption clause, any shareholder who wishes to transfer his/her

shares has to offer them first to e.g. other existing shareholders. Such provisions can

be very detailed in private companies. According to a combined approach, the

directors has to give their approval to a subsequent transfer, if those who have pre-

emptive rights fail. The triggering factors can be many. (See further by Cadman

2004, pp. 64–77.)

Shares in German ‘‘Gesellschaft mit beschrankter Haftung’’ (GmbH) can be

assigned only through a contract in notarial form. Further, a transfer has to be

notified to the company. Legally, the shareholders can probably insert any form of

restriction in the articles of association. Clauses demanding consent from the

company appears to be common. However, no restrictions are allowed in the case of

the death of a shareholder. (Schmidt 2002, pp. 1045–1054.) The triggering factors

can vary. (Brun-Hagen and Kirchdorfer 1998, pp. 96–100.)

Sweden is one of the few countries where post-sale purchase rights are allowed in

the articles of association. Further, the shareholders can also insert a pre-emptive or

consent clause, or a combination of the clauses. However, a right of first refusal and

consent provisions may not give a right to aquire shares on transmission, such as on

the death or divorce of a shareholder. Thus, transmissions have to be included in the

shareholders agreement. The directors have no refusal powers, except according to a

consent clause. The triggering factors are manifold.

Shareholders agreements can be found in all countries. Limitations on which

transfer restrictions that can be inserted in this instrument depend on e.g. the

Contract Law of each country. (See further by, among others, Cadman 2004.)

4 An owner dies without having prepared protection of ownership

4.1 Introduction

In order to illustrate the importance of restrictions on transferability, we will analyze

the potential complexities that may rise when an owner is deceased and no

preparations have been made to protect ownership. Typical problems will occur when

the deceased, in a majority or minority position, has co-owners (subsections 4.3–4).

However, we will start with some complexities when the deceased is a sole owner of

the family business, and continue with cases of majority and minority owners.

4.2 Sole owner

A single and unmarried owner has obviously no direct need for restrictions on

transferability of shares, in the articles of corporation, due to a potential e.g. sale by

a co-owner. So, some would claim: Why bother!


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If the owner is married, the spouse may in a divorce process, as a result of the

division of the matrimonial property, become a new shareholder in the family

business. Thus, a sole owner also has reasons to implement at least some restrictions

on transferability in the articles of corporation.

Further, if a single owner initiates a succession process during his or her lifetime,

e.g. transfers shares to the next generation through a gift, the need for pre-emptive

clauses and other arrangements becomes obvious, especially if some of the new

shareholders are in minority positions.

When a single owner dies the shares will, dependant on each Inheritance Law

system concerning intestate succession, be inherited by a spouse or by joint children

or by the children of the owner. The heirs will be inheritance taxed, if a country is

taxing inheritances (with no exception for shares in family owned businesses).

If there is more than one heir and if they wish to continue together as

companions, they will have an interest in creating restrictions on transferability of

shares. This can be done in a shareholders agreement. Further, they may want to

implement restrictions in the articles of corporation. Depending on the Company

Law in each country, this may require a decision by a certain majority of

shareholders.

A sole owner can use various methods to meet potential threats to a stable circle

of owners. To avoid a spouse acquiring shares in a division of matrimonial property,

the owner can—besides restrictions on transferability—use a marriage settlement,

according to which the shares are made to separate property and thus will not be

included in the division. However, this option is dependant on the Family Law of

each country.

In order to avoid a split of the shares, in case of an inheritance, the owner can use

a will and thus make one of the heirs the sole new owner. This may not always be

possible, due to the Inheritance Law system of a country. Siblings may be entitled to

a lawful portion of the estate. To avoid this, other means have to be used, perhaps a

gift of all of the shares during the lifetime of the owner. (See further by Bjuggren-

Sund 2005.)

If a single owner knows that several heirs will become new shareholders, he or

she may implement transfer restrictions in the articles of corporation. This way,

potential conflicts among the heirs, since they may have to reach a certain qualified

majority for an amendment of the articles, can be avoided.

4.3 Majority owner

When a majority owner dies and no preparations have been made to protect

ownership, the other (minority) owner(s) will have no possibilities to buy the shares

without consent of the owners of the estate of the deceased. These may, according to

the civil law system of a country, be a surviving spouse and descendants. Property

that has been acquired through division of the matrimonial property and inheritance

may have a sentimental value for the receiver, which can make the situation for new

owners, as well as previous minority shareholders, highly emotional.

What once was a majority holding may, after division of the matrimonial

property and the estate of the deceased, have turned into several new minority


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positions. This may in turn make the balance between old owners, of which one may

find him- or herself in a majority position, and new shareholders highly

complicated. The balance will, for a shorter or longer period, be upset.

If the inheritance is taxed, it may contribute with additional complexities. A new

shareholder may have no alternative but to sell off parts of his shares, in order to pay

the inheritance tax. Assuming there are no restrictions on transferability, this may

result in even more new owners of the firm. Such a situation also highlights the

importance of creating, through clauses in a shareholders agreement, an internal

market among the shareholders. According to such a clause (buy-sell agreement),

other shareholders can be obliged to buy the shares at a certain price. This will be

further emphasized in subsection 4.4.

Another alternative for a new shareholder, after an inheritance, is to take a loan to

pay the inheritance tax. However, mortgages and interests will, in most cases, have

to be paid with money drawn on the firm. Any additional taxes, on a salary or a

dividend, will make the necessary withdrawals manifold higher than the actual costs

according to the terms of the loan. This may cause a financial strain for the business,

which affects the potential to make investments, as well as risk willingness among

the shareholders (Astrachan and Tutterow 1996).

With new owners of the business, there may be a need for changes in the

shareholders agreement. At least, there should be implemented restrictions on

transferability. Similarly, amendments in the articles of corporation are needed.

However, as previously mentioned (subsection 4.2), there may be a legal mandatory

requirement of a certain qualified majority among the shareholders.

A majority owner can use the same tools, as mentioned under subsection 4.2—

marriage settlement and a will—in order to resolve most of the potential

complexities mentioned above. Another alternative is to push for an agreement

on transfer restrictions (subsection 3.2).

4.4 Minority owner

On the death of a minority owner, the shares will be, mostly in accordance with civil

law rules concerning division of matrimonial property and inheritance, divided

between the owners of the estate, i.e. a surviving spouse and offspring. A minority

holding may become even weaker.

Assuming there are no restrictions on transferability, the old owner(s) will have

no possibility to force a buyout of the new shareholders, who in a worst case

scenario will sell their shares to outsiders, perhaps even a competitor. Usually there

is no market, though, for shares in a family-owned SME, which will make finding a

buyer difficult.

These occasions stresses the importance of an internal market, created through a

mutual agreement in the articles of corporation or in shareholders agreement.

Otherwise, since there will be no or only a bleak possibility to sell the shares to an

outsider, the new owners can be facing severe problems. (Moye 2005 pp. 13 and

468–471.) Inheritance tax and other costs have to be financed. As mentioned above

a loan may turn out to be very costly. If the shareholders have created an internal

market the problems can be solved, as well as the old owner(s) can avoid a new


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shareholder in the business. A buy-out can be financed by insurances. These tend to

be costly. However, on these occasions an insurance may turn out to be a very

important asset.

The depicted scenario is, again, underlining the importance of transfer

restrictions in the shareholders agreement and in the articles of corporation.

In order to avoid these complexities, a minority owner can use the same tools as

mentioned under subsection 4.2. Preemptive rights are generally essential for

minority shareholders, e.g. to protect their proportionate investment stakes.

(Kraakman et al. 2004 p. 147.)

5 A concluding discussion

In order to analyze the complexities spurred by the lack of restrictions on

transferability, we chose the death of an owner as our frame of reference. With this

approach, we believe that the importance of restrictions is well illustrated.

The approach is based on an assumption of the uniqueness of family businesses

that are worth preserving. They carry with them an ambition of continuity over the

generations, not merely to create an accumulation of wealth and to cash in. This

ambition is genuinely human. We all care for our offspring, as well as for our

businesses. Through cultural identity the firm often seems to become somewhat of a

part of the family. As such it has, as all family members, the potential to create

problems.

One of the challenges is the importance of a stable circle of shareholders. During

the lifetime of the owners stability is threatened by events like a sale or a gift. On

the death of an owner, testate and intestate succession creates other challenges.

Since a divorce may result in a new owner, also stability of family unions

becomes important. Marital dissolution may create costs for a family business

(Galbraith 2003). It further stresses the importance of carefully written transfer

restrictions, as well as the uniqueness of family businesses.

In the paper, we show that also a single owner of a family business has important

reasons to implement transfer restrictions in the articles of association. Further, if a

family firm has two or more shareholders and if any of them, of some reason, is

reluctant to implement restrictions in e.g. shareholders agreement, their lawyer has

convincing arguments. For example: When a shareholder dies, assuming there are

no clauses giving the remaining shareholders a right to acquire the shares, they are

facing several potentially catastrophic scenarios.

The definitions of a family and a family firm, in Section 1, may be useful on some

occasions, especially in a succession context.

It is of crucial importance for these firms that a country legally permits

contractual limitations on the transfer of ownership rights regarding transfer

restrictions in the articles of corporation and in the shareholders agreement. One

obvious limitation that is needed is an absolute restrictions unlimited in time.

In general, jurisdictions differ in approach and ambition concerning pre-emptive

rights and other restrictions, on transferability of shares, in closely held companies.

Some mandate the rights. Others grant them as the statutory default. In yet other


123

countries, pre-emptive rights are enforced only if they are enshrined in the articles

of corporation (Kraakman et al. 2004 p. 148).

Further research concerning transfer restrictions on ownership in family-owned

and managed businesses is necessary. Among other areas, we would like to mention

the complex relations between, on the one hand, a single, majority or minority

owner, and, on the other hand, other shareholders and potential new owners within

or outside the family. Further, there is a need for an in-depth study giving an

overview of all (or at least the most important) possible transfer restrictions, as well

as combinations thereof, and the usefulness of the variations.

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