Resolving voting rights issues in the Board of Directors
- uri234
- Mar 23, 2017
- 5 min read
As we all know, a company has three governing organs: management, board of directors and general meeting of shareholders.
While these organs are mainly a matter of formality in the first stage of a family business, they become very important after a generational transition, when they begin to actually fulfill their designation as managing and supervising organs.
Having an effective corporate governance structure, including effective management, board of directors and shareholders' GM is very important for ensuring a smooth generational transition, so I'll discuss this key issue in a separate post. In this post I want to focus on resolving voting rights issues in the Board of Directors in a situation of unequal holdings in ownership of the company.
Usually each member of the board has one vote, regardless of his share of ownership (and, if an outside director was appointed, there can be members of the board who have no ownership stake in the company). This is unlike GM of shareholders, where usually each shareholders' voting rights are based on his proportional share of the ownership of the company,
This situation can cause a lot of problems, as the board of directors is the ultimate governing organ of the company, and it makes sense that someone who has bigger stake in company's ownership would have a louder voice in company's governance and decision making.
Having unequal ownership, yet equality in decision making, strengthen minority shareholders, and can cause troubles like:
Making hasty decisions (while for large shareholders the business can be the center of life and only source of income, and therefore they examine carefully each decision, this is not the case for small shareholders)
Taking too much risk (in case things go bad, minority shareholders proportion of damage is smaller than damage to large shareholders)
Increased risk of "personal" decisions (in many cases the large shareholder is "handing generation", while the small shareholders are "receiving generation", with different agenda and different commitment to the wellbeing of older generation).
Therefore, it's better to prevent this situation in the first place, making sure that voting rights of directors match the stake in the company of the appointing shareholder.
Here is an example from one of my clients: two partners, each holding 50% of the shares of the company, passed their shares to the next generation. While partner A passed all his shares to his son (hereafter referred to as "Son A"), who worked in the company his whole adult life, partner B passed his shares to his three kids (each of them now holding 162/3% of the total shares of the company), none of them ever worked in the company.
Before this change the board constituted of the two shareholders, with equal voting rights, that represented their stake in the company. Son A wished to preserve this situation, and therefor demanded that the heirs of partner B will choose one of them to serve as member of the board. However, the heirs of partner B demanded to be represented separately in the board of directors. Unaware of the legal consequences of his action, Son A agreed to this, and all three heirs of partner B were appointed to the board of directors.
While at first things were going pretty well, as disputes arose, the heirs of partner B made it clear that according to the prevailing Companies Laws and according to the company's by-laws, each member of the board has equal voting rights, and therefor effectively they control the board. One of the major disputes was the salary paid to Son A for his work at the company, as the heirs of partner B demanded to cut it by half. After a heated debate a resolution was passed at the board that the salary of Son A will be cut by half. Of course all heirs of partner B supported this decision, while Son A objected.
What kind of solution can be suggested in order to prevent this situation from happening in the first place?
Here is the solution I suggest to my clients: company's by-laws should instruct that voting rights of each member of the board are determined by the ownership rights held by the appointing shareholder. In our case, for example, the Son A (or his empowered representative) would have 50% of the voting rights and each of the heirs of partner B would have 16.66% of the voting rights in the board of directors.
This simple solution prevents ugly situations in the first place, while allowing for a fair representation of shareholders in the board.
While this is pretty much straightforward, what happens if a decision is made to add an outside director, who has no stake in the company (and usually in not an employee of the company)?
The discussion about the pros and cons of having an outside director in a family business worth a separate post, as it's a very important issue, with a lot of aspects.
As a short explanation: an outside director is neither appointed by a specific shareholder nor is he employed by the company. Usually this will be a consultant who can provide insights to the discussions that are held in the board of directors. Usually an outside director is appointed by consensus between shareholders.
In this case there are two very common mistakes: the first one is to give the outside director equal voting rights. I'm sure that after you read the first part of the post you can understand why this is wrong: someone with no stake in the company receives the same power as those who are invested in the company. Besides, what to do if you accepted my advice, and each member of the board has different voting rights. What would be the voting rights of the outside director?
The second common mistake is to give no voting rights to the outside director, making him a nice decoration in the room, but with zero effectiveness. If you want other members of the board to seriously consider the opinion of the outside director, you should attach to that opinion some weight.
Here is what I suggest to my clients: the voting power of the outside director should be equal to 100 divided by the number of shareholders. For example: if there are three shareholders, each with 33.33% of the shares (and therefore, as explain earlier, each has 33.33 of the "voting power" in the board), the outside director will have 33.33 votes (and the number of total votes possible is 133.33). Another example: if there are two shareholders, each holding 33.33% of the shares, and 6 shareholders, each holding 5.55% of the shares (total of 8 shareholders), the outside director will have "voting power" of 12.5 (calculated as 100/8), and the total number of votes will be 112.5.
This solution ensures the outside director has enough power so his voice will be heard and his opinion counted, yet not too much power, so he won't be part of internal politics and can't gain too much influence on decisions (keeping in mind that he has no stake in the company).
One important exception: in case of equality of votes, the outside director votes shouldn't be counted. This is in order to prevent him from "tipping the scale" (again: making sure he is not drawn to internal politics).
As always: consult a lawyer before adapting these solutions, in order to make sure they comply with local Companies Laws.
And what about Son A and the heirs of partner B?
Well, after a long mediation process, my solution to the voting rights was adapted, an outside director was appointed, and peace and harmony were installed again to the business (and, no less important, to the shareholders). One of the byproducts of the outside director was better decision making!
Win-win.
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