Founders Forever with Multiclass Equity
With multi-class equity, founders can retain control of a business even after its ownership has been broadly dispersed by estate planning, equity incentive and other transfers.
Originating with dynastic enterprises that continue to control major U.S. enterprises, modern tech giants developed a more sophisticated approach that is useful to smaller enterprises. Although applicable to all business entities, corporate terminology will be used for simplicity.
Historically, buy-sell agreements and voting trusts have been used to maintain control of closely held companies. Permitted share transfers to family trusts and their subsequent distributions of shares to beneficiaries create uncertainty as the trust (prepared by the shareholder’s attorney) may not operate as anticipated due to death, incapacity or withdrawal of trustees or unforeseen contingent events. While usually enforceable, the objectives of buy-sell agreements may be frustrated by (i) a shareholder’s bankruptcy, (ii) unsatisfied corporate law proxy requirements, and (iii) arcane legal doctrines (such as the Rule Against Perpetuities) invalidating voting and family trusts based on hypothetical events and timing.
Anticipating contingent events affecting estate plans and third party arrangements is a challenge best avoided. If business control is the objective, narrowing the focus to a founder’s control of shares owned by trusts and other entities simplifies documentation and increases the odds of success.
Founder control can be organically preserved by granting in the corporation’s charter (certificate of formation) super-voting rights only to shares held by founders and, if the founder retains exclusive voting control and dispositive power over the shares, their estate planning entities (“Permitted Transferees”). Examples of Permitted Transferees include family trusts of which the founder is the sole trustee or an entity exclusively controlled by the founder through ownership, contract or other means. A founder’s loss of exclusive voting control or dispositive power becomes a “Conversion Event” with an automatic “step-down” in the voting rights of the affected shares.
Illustration
Three classes of common stock (identical in all respects except voting) are designed for the following shareholder classes:
| Holders |
Class |
Votes Per Share |
| Founders & Permitted Transferees |
C |
10 |
| Senior Managers & non-Permitted Transferees of Founders |
B |
1 |
| Key Employees & non-Permitted Transferees of Senior Managers |
A |
None |
Share Ownership
| Holders |
Class |
#Shs |
%Vote* |
% Equity |
| Founders & Permitted Transferees |
C |
1,000 |
91.0 |
33.3 |
| Sr. Managers & non-Permitted Transferees of Founders |
B |
1,000 |
9.0 |
33.3 |
| Key Emps & non-Permitted Transferees of Sr. Mgrs |
A |
1,000 |
0.0 |
33.3 |
| Totals |
3,000 |
100.0 |
100.0 |
* Class C (10 votes per share) = 10,000 of 11,000 votes; Class B (1 vote per share) = 1,000 of 11,000 votes.
Conversion Event. A founder transfers 500 Class C shares to a non-Permitted Transferee (which automatically convert to 500 Class B common shares in the hands of the non-Permitted Transferee):
| Holders |
Class |
#Shs |
%Vote |
% Equity |
| Founders & Permitted Transferees |
C |
500 |
77.0 |
16.7 |
| Sr. Managers & non-Permitted Transferees of Founders |
B |
1,500 |
23.0 |
50.0 |
| Key Emps & non-Permitted Transferees of Sr. Mgrs |
A |
1,000 |
0.0 |
33.3 |
| Totals |
3,000 |
100.0 |
100.0 |
Finale. At the time when none of the founders have exclusive voting and dispositive rights, all Class C shares (including those owned by their family trusts and other entities) automatically convert into Class B shares for a traditional single vote per voting share.
| Holders |
Class |
#Shares |
%Vote |
% Equity |
| Founders & Permitted Transferees |
C |
0 |
— |
— |
| Sr. Managers & non-Permitted Transferees of Founders |
B |
2,000 |
100.0 |
66.7 |
| Key Emps & non-Permitted Transferees of Sr. Mgrs |
A |
1,000 |
0.0 |
33.3 |
| Totals |
3,000 |
100.0 |
100.0 |
Flexibility
Founder control structures may be calibrated to specific targets by class voting arrangements and different definitions of Conversion Events (IPO, minimum ownership, disability, etc.). Publicly traded companies frequently exempt additional situations from voting step-downs to spread control among broader groups of family members and senior management.
Relationship to Buy-Sell Agreement
Dual class equity structures focus on control to enable founders to pursue their vision for the business. Buy-sell agreements (see part II of Family Business Succession Planning) for privately held companies remain important for preserving the economic benefits of ownership through share transfer restrictions (shareholder bankruptcy, death, default, disability, divorce, etc.), rights of first refusal (by class), push-pulls, drag-alongs, tag-alongs, shareholder contributions and insurance funded buyouts.
Neither this post nor any other content on this website creates an attorney-client relationship or constitutes legal advice for any particular situation.
JD
