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Governance mechanisms for unlisted family businesses

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Family business need to adopt effective governance practices such as family office and on board independent directors. In this article, Browne & Mohan consultants describe what, when and how to go about implementing these in family businesses

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Governance mechanisms for unlisted family businesses

  1. 1. Page 1 of 5 Governance mechanisms for unlisted family businesses Dr TR Madan Mohan and D. Balasubramaniam Abstract: Family business need to adopt effective governance practices such as family office and onboard independent directors. In this article, Browne & Mohan consultants describe what, when and how to go about implementing these in family businesses. Family ownership is the most prevalent form of ownership structure in many countries. Family owned business can be a single-owner firm to large industrial houses. In a family ownership the family members don several roles, common ethos, identity and principles transcend multiple- generations, and munificence is a major driver of business. Each family owned business has unique set of challenges. According to Inc magazine 65% of small companies in USA, around 10 Million are likely to exit during the next decade. While no official statistics is available on their closure, anecdotal data and secondary information indicates just about 20% survive for a first generation transfer and 95% of them become defunct within two decade of demise of founder. Many entrepreneurial families do not have a clear demarcation between personal and business assets and have lost even their personal fortunes because of business liabilities. In many families, the time required by existing family members to manage the assets distracts them from effectively manage their family business. Unlike a corporation, family members and their extended relations may have different rights, expectations and responsibilities in the business. This sometime can lead to conflict and jeopardize the sustainability of the business. Unique privileges, access to privy information and independent management are issues family businesses have to grapple with. Many family businesses suffer from: 1) limited use of capital budgeting, risk management and working capital management techniques and long term planning 2) no clear plan to sustain the profitability of their business 3) limited wealth management and long term investments portfolio, 4) lack of a corpus, 5) fraud and risk management, and 6) lack of succession planning and business continuity. Governance plays two important roles in family businesses. Firstly, it safeguards the interests of all stakeholders and improves transparency. Family business that move from founder to next generation to siblings or cousin consortia can employ following approaches to improve on governance, viz., 1) creation of a family council, 2) induction of independent directors, and 3) separation of business and family. Family council Family council or a family office is a personal operating setup that can act as a single decision making body with various matters on behalf of the family. It is a legal vehicle, often employs in- house staff, to provide asset management, wealth protection, succession planning and tax mitigation. Family council provides centralized focus and control over family finances, legal, tax and administration issues including risk management. From a legal perspective, family office can be a LLC, Branch office, HUF, private trust or Foundation. The primary difference between the
  2. 2. Page 2 of 5 family office and traditional wealth management and financial services is that the idea of one trusted fiduciary acting on your behalf to manage many different professionals providing their services to the family; for example, trust management, legal advice, tax planning, estate planning, and investment management. Formation of family council Family office can have representation from multiple generations to ensure fair coverage and responsibilities. Family offices define the processes that define “family affairs” and “governance affairs”. Family office clearly laid out roles for effective communication, reporting, fora and rules governing meetings, accountability, dispute resolution and administrative institution. Like a company, family office must have a memorandum of association (MOA) that define the very purpose of family office and procedures similar to articles of association. The MOA can act as a family constitution detailing the vision, values, relationship of the family with businesses. It could also detail number of board representation, voting rights, nomination, decision rights, for a and meeting rules, accountability of trustees, removal of members, dispute resolution mechanisms, financial and proprietary audits must all explicitly documented for effective functioning of a family office. Few areas that must be addressed in creation of a family office are: 1) broader representation of the family, skills on boards at trustee and supervisory levels 2) young adult inheritors have in depth involvement with the family office 3) continual board refreshment and democratic election of chairman 4) ensuring no “special resolution” routes for key decisions by one person or group to hijack 5) platform for board members of different business entities attending other business meeting 6) structure that does insulates, promote dependencies in task management and shields family from taking risk 7) family office personal sharing of information and administration While “family office” does provide an institutional mechanism to manage risks and wealth, family business must also invest in: 1. regular family meetings that address the needs and aspirations of each generation 2. empower and support both intrapreneurship and entrepreneurship platforms for next generation 3. encourage transitions, and 4. appropriate information sharing within the family, and the executives 5. conduct an annual family office meeting with all family members (children is a choice) similar to an annual business plan meeting on the status and directions of the businesses. Independent directors Law in many countries require at least one or two independent directors to offer advice that is professional, unbiased, consistent and appealing to their way of doing business. Independent directors can be initially for 5 years and at most extended to 10 years in some countries. Independent directors propel adoption of appropriate governance practices. Roles of Independent director in a family business Independent director can be either “active” or “passive”. Active independent directors not only involve in strategy making and but also participate in deeper reviews on implementation
  3. 3. Page 3 of 5 process. Successful active independent directors go about doing their job without actually interfering with the CEO and the senior managers. Passive directors on the other hand limit themselves to their advisory role. Irrespective of the nature of their role, independent directors are expected to contribute in terms of following 1) Provide guidance. Family owned business like independent directors to offer guidance and assistance in finding opportunities for the firm to grow, align with new partners, explore new markets and change the status quo. In some companies, the family ownership may be seeking specific guidance to reduce CEO stress and bringing in professionalism. 2) Improve visibility and network value Independent directors participate in firm sponsored events as experts and consultants to showcase talent and provide key networks. 3) Act as a sounding board and a confidante In many a first generation family business independent directors are seen as sounding boards where partially defined or tentative plans can be bounced off to obtain feelers. Moreover, they may also be involved to act as a neutral party to minimize “self-seeking behaviour” of the family members and to arrest “private gains over company losses”. 4) Ensure fiduciary requirements are met, and finally Independent directors act as audit committee members, validate whether the taxes are paid in time and regulatory requirements are complied. 5) Provide consistency, longevity and knowledge for the company Independent board members play a unique role of checking for continuity of ideas and assumptions, longevity of plans and efforts and learn from historical perspective. Selection of an independent director Independent director in family businesses need to have following characteristics. 1) Solid industry background. Independent directors with loads of year of experience are sought to help master the nuances of the industry and prepare companies to succeed in the industry. Family businesses seek our directors who not only stimulate good discussions on industry, but offer deep insights and share experiences on what not to do. 2) Deep knowledge of the market. Family businesses prefer independent directors when they are expanding to newer markets where their prior experience may not stand much water. Family businesses that are entering newer customer segments or distribution models prefer directors with a good understanding of the industry nuances, the competition, government laws and markets, etc. 3) Broad governance experience. Experienced family businesses at the crossroads of transition or inter-generational transfer prefer to bring in independent directors for prior board experience. Family businesses planning to raise capital from markets and professionalizing their management also prefer directors with broad governance experience. 4) Connect across generations. Independent directors in family business must be able to connect to aspirations and learnings across generations. They must be open to discuss, and highly empathetic. Independent directors and governance management
  4. 4. Page 4 of 5 Independent directors in family owned unlisted firms need to raise up to following challenges. 1) Ensuring independent neutral advice Independent directors realize the family’s choices and decisions may not be in the best interest of the firm and must exhibit their independent views and advise. Major areas of disagreements would be in placing loyalty over performance, leadership changes, ownership and responsibilities, investments and exits. Documenting disagreements and revisiting the plans is one best strategy that works best. 2) Prioritizing the change process Many family owned businesses, especially the SMB, lack formal planning process and the change management process is often ad hoc. Independent directors add value to the company by bringing in a method to manage the priority of changes and ensuring the governance of change is managed well. 3) Managing “guidance” fatigue One of the biggest challenge independent directors must be prepared is the pace of change may be limited by resources and in many quarters the governance guidance may not be varying much. Sticking to a rolling plan with same objectives and keeping the motivation and guidance at highest becomes a challenge for most independent directors. 4) Familial role & conflicts Unlike a corporation, family members and their extended relations may have different rights, expectations and responsibilities in the business. This sometime can lead to conflict and jeopardize the sustainability of the business. Unique privileges, access to privy information and independent management are issues independent board members have to grapple with. Other key areas of conflict are succession and distribution of wealth. Independent directors must stick to their professional role , and offer solutions that mitigate the business continuity risk , but also preserve the family harmony. Bibliography Anderson, R and Reeb. D (2004), Board Composition: Balancing family influence in S&P 500 firms”, Administrative Science Quarterly, 49, 209-237. Barach, J.A. and Ganitsky, J.B. (1995) ‘Successful succession in family business’, Family Business Review, Vol. 8, No. 2, pp.131–155. Chien, C. (2012) Work Toward Reward: Building Business Value Today for a Well Deserved Future, Universe, Dyer Jr., W.G. (1986) Cultural Change in Family Firms: Anticipating and Managing Business and Family Transitions, Jossey-Bass, San Francisco, CA
  5. 5. Page 5 of 5 Huse, M (2000) “ Board of Directors in SME: a review and research agenda”, Entrepreneurship & Regional Development, 12, 270-290. Johannisson, B and Huse, M (2000) “Recruiting outside board members in small family businesses: an idealoogical challenge”, Entrepreneurship & Regional Development, 12, 353-378. Kevin, H.P, Kiel. G.C and Nicholson, G. (2010) “How Boards Strategise: A Strategy as Practice View”, Long Range Planning, Vol. 43, 33-56 Miller, D. and Le Breton-Miller, I. (2005) Managing for the Long-Run: Lessons in Competitive Advantage from Great Family Business, Harvard Business Press, Boston, MA Neubauer, F and Lank, G.A (1998) “The Family Business: its Governance for Sustainability”, Routledge, New York Varottil,U. (2010) Evolution and Effectiveness of Independent Directors in Indian Corporate Governance, Hastings Business Law Journal, Vol. 6, No. 2, 281-286. Ward, J (1987), Keeping the family business healthy, Jossey Boss, CA

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