Closely held businesses

What Is Closely Held Businesses?

A closely held business is a company whose ownership is concentrated among a small number of shareholders, often family members, founders, or a tightly knit group of investors, and whose shares are not publicly traded on a stock exchange. This business structure falls under the broader category of business structures and is characterized by a limited number of owners who typically have significant control over the company's operations and strategic direction. Unlike publicly traded corporations, closely held businesses are not subject to the extensive disclosure requirements mandated by regulatory bodies like the Securities and Exchange Commission (SEC) for public companies. Their private nature often means decisions can be made more quickly and confidentially, reflecting the unified interests of the controlling shareholders.

History and Origin

The concept of closely held businesses predates modern corporate structures, with many early enterprises, from family-run farms to guilds and partnerships, operating under similar principles of concentrated ownership and control. As formal corporate laws evolved, distinctions emerged between businesses that sought public capital and those that remained private. The legal framework surrounding closely held businesses has largely developed to accommodate their unique characteristics, particularly regarding capital raising and governance. For instance, in the United States, legislation like the Small Business Act of 1953 aimed to support small businesses, many of which are closely held, recognizing their vital role in job creation and economic growth. Organizations such as the Organisation for Economic Co-operation and Development (OECD) regularly highlight the significant contribution of small and medium-sized enterprises (SMEs), a category that frequently includes closely held businesses, to national economies through innovation, competition, and employment.¹⁰, ¹¹, ¹², ¹³

Key Takeaways

• Concentrated Ownership: Closely held businesses are defined by a small group of owners, often family members or a few individuals.
• Limited Disclosure: They are generally exempt from the rigorous public reporting and disclosure requirements of publicly traded companies.
• Operational Control: Owners typically maintain significant control over management, strategic decisions, and day-to-day operations.
• Illiquidity: Shares in closely held businesses are not easily bought or sold on public markets, leading to lower liquidity for owners' equity.
• Succession Planning Importance: Due to concentrated ownership, effective estate planning and succession strategies are crucial for long-term viability.

Interpreting the Closely Held Businesses

Understanding a closely held business involves looking beyond public financial metrics typically used for larger corporations. Key indicators for these entities often include strong relationships with customers and suppliers, deeply ingrained company culture, and the personal reputation of their owners or founding families. Their value is frequently assessed through different valuation methodologies than those applied to public companies, often focusing on discounted cash flows, asset-based valuations, or comparable private transactions, rather than market capitalization. The control premium associated with these businesses can be substantial, reflecting the ability of owners to direct the company without broad shareholder approval. Furthermore, the absence of publicly traded equity means that their financial health is often gleaned from private financial statements and internal projections.

Hypothetical Example

Consider "GreenLeaf Organics," a company founded by two siblings, Anna and Ben, specializing in sustainable agricultural products. They each own 50% of the company's shares. GreenLeaf Organics is a closely held business because its ownership is concentrated entirely within this small group of individuals. Anna serves as CEO, overseeing daily operations, while Ben manages product development and supply chains. All major decisions, such as expanding into new markets or taking on significant debt, are made jointly by Anna and Ben. They do not issue stock to the public, nor do they seek external shareholders beyond a few close family friends who provided initial seed capital. This structure allows them to maintain complete control over the company's mission and growth strategy, prioritizing long-term sustainability over short-term quarterly earnings often demanded by public markets. When considering future expansion, they might explore securing a private equity investment rather than pursuing an initial public offering.

Practical Applications

Closely held businesses are ubiquitous across various industries, from small technology startups and local retail stores to large family-owned manufacturing firms. They represent a significant portion of the global economy and are instrumental in job creation and fostering innovation.

• Family Businesses: Many closely held businesses are family-owned and operated, where multiple generations contribute to the company's growth and management. Corporate governance in these entities often involves balancing family dynamics with business objectives.
• Startups and Small-to-Medium Enterprises (SMEs): New ventures often begin as closely held entities, relying on founder capital, angel investors, or venture capital rather than public markets. As they grow, they may consider various capital-raising options. The SEC offers various "exempt offerings" such as Regulation D (including Rule 504, Rule 506(b), and Rule 506(c)), Regulation A, and intrastate offerings, which provide avenues for closely held businesses to raise capital without full public registration, though specific requirements apply to each.⁸, ⁹
• Professional Practices: Law firms, medical practices, and accounting firms are typically structured as closely held businesses, often as a partnership or limited liability company, where ownership is restricted to the active professionals within the firm.
• Succession Planning: A critical application for closely held businesses involves strategic succession planning to ensure a smooth transition of leadership and ownership, particularly in family businesses. The Financial Times has highlighted the significant challenges and critical importance of robust succession plans for family enterprises to thrive across generations.⁵, ⁶, ⁷

Limitations and Criticisms

Despite their advantages, closely held businesses face specific limitations. A primary concern is their inherent lack of liquidity. Unlike shares in publicly traded companies, ownership stakes in closely held businesses cannot be easily sold or converted to cash, which can pose challenges for owners seeking to exit or diversify their wealth. This illiquidity can complicate capital gains realization and make it difficult for shareholders to value their holdings accurately.

Another significant drawback is the potential for governance issues, particularly in family businesses. Conflicts among family members or managing the transition of leadership from one generation to the next can lead to internal disputes that impact business performance and longevity. Without formal corporate governance structures typical of public companies, closely held businesses can be vulnerable to disagreements over strategic direction, dividend policies, or operational control. The absence of external scrutiny from public markets and independent boards might also lead to less transparency in decision-making or a lack of accountability, though this is often balanced by the direct involvement and shared vision of the core owners.

Closely Held Businesses vs. Publicly Traded Companies

The fundamental distinction between closely held businesses and publicly traded companies lies in their ownership structure and access to capital markets.

While closely held businesses prioritize owner control and privacy, publicly traded companies opt for broader access to capital markets in exchange for greater transparency and regulatory oversight.

FAQs

What are common legal structures for closely held businesses?

Common legal structures include C corporations, S corporations, limited liability company (LLC), partnership, and sole proprietorship (though a sole proprietorship is by definition one owner). For tax purposes, many closely held corporations elect to be taxed as an S corporation to avoid double taxation, where profits are taxed at both the corporate and shareholder levels. An S corporation, also known as an S Corp, passes corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes, similar to a partnership.¹, ², ³, ⁴

How do closely held businesses raise capital?

They typically raise capital through various private channels. This can include personal funds from founders, investments from friends and family, bank loans, venture capital, angel investors, or private placements under specific exemptions from securities registration, such as those provided by Regulation D from the SEC.

Why would a business choose to remain closely held?

Businesses often choose to remain closely held to maintain strong owner control, protect privacy, avoid the costs and complexities of public reporting, and preserve the company's unique culture and long-term vision without pressure from external shareholders focused on short-term financial performance.

What is the biggest challenge for closely held family businesses?

One of the most significant challenges for closely held family businesses is effective succession planning. Ensuring a smooth transition of leadership and ownership from one generation to the next, while managing family dynamics and potential conflicts, is crucial for the business's long-term survival and prosperity.

Can a closely held business become a publicly traded company?

Yes, a closely held business can become a publicly traded company, typically by conducting an initial public offering (IPO). This process involves selling shares to the public for the first time, registering with the SEC, and listing on a stock exchange. This transformation provides access to a much larger pool of capital but also introduces extensive regulatory requirements and public scrutiny.