Recent well-publicized corporate scandals have highlighted the need to improve corporate governance. But many family-owned businesses are not using their boards effectively. Some families make the mistake of fixating on “best practices” such as having independent directors, while overlooking the issue at the heart of today’s corporate governance problems: accountability.
The reality is that many of the “best practices” touted by experts are at odds with the fundamental nature of most family companies and could harm family unity. These governance codes come from a market model of corporate governance, which is relevant for companies with a widely dispersed shareholder base. By contrast, typical family businesses exhibit characteristics of a control model of corporate governance, which involves companies with concentrated shareholders (see table below).
Control model of corporate governanceThe control model applies to companies with concentrated shareholders. Typical family businesses exhibit characteristics of the control model.
Setting
• Prevalent in continental Europe, Asia, Latin America
• More reliance on private capital
• Illiquid ownership
• Concentrated shareholder base often overshadows minority shareholders
• Shareholders view company as more than an asset and are interested in financial and non-financial returns
Elements of governance
• Secretive
• Focus on long-term strategy
• Shareholders have control rights in excess of cash flow rights
• Shareholders have connections to the company other than financial (i.e., managers, board members, family)
• Insider board members
• Ownership and management overlap significantly
Market model of corporate governanceThe market model is relevant to companies with a widely dispersed shareholder base.
Setting
• Prevalent in U.K., U.S.
• More reliance on public markets
• High ownership liquidity
• Shareholders are anonymous investors, not managers
• Widely dispersed shareholders
• Shareholders’ connections to the company are only financial
Elements of governance
• High level of disclosure
• Focus on short-term strategy
• Independent board members
• Shareholders view company as one of many assets held
• Ownership and management are separate and at arm’s length
For a family business board to be effective, the family must focus on (1) implementing the structure necessary to provide accountability; (2) developing a board that is accountable to shareholders; and (3) ensuring that the board holds management accountable. In short, family business boards must be competency-based.
The Loyola Guidelines for Family Business Boards of Directors, described below, will lead to greater board accountability and positive, identifiable results in board and company performance.
1. Your board must have the competencies, processes, and structure in place to ensure accountability.
Criteria for director selection. Business competencies and diversity of skills and background are important, but these criteria are not enough. The most critical qualification is the determination to hold the company accountable and the discipline not to interfere in company operations. To ensure strategic guidance of the company, family business board members should communicate well and be comfortable with expressing dissent openly when necessary. They should understand business and be willing to collaborate with management.
Size. Although smaller boards may be more manageable, a larger board can be an option as long as individual board members have the competencies to render good judgment and allow their judgments to be evaluated. They must also be amenable to openly discussing disagreements. A board with seven to 12 members is most effective for the typical family firm.
Independent outsiders. Many recommendations call for minimizing the use of insiders and including a significant proportion of independent outsiders. However, outsiders can be swayed by pay, perks, recognition and business dealings. To promote objectivity, a director must be held accountable, and his or her opinion must be unfettered by extraneous influences or considerations (such as personal financial or other gain). These criteria are more important than whether the individual works in the business.
Frequency of board meetings. The purpose of board meetings is to provide a forum for regular and purposeful communication and conflict resolution. In order for this to occur, the board of a typical family business should meet three to six times per year. This helps keep communication open between the board and management, and between the board and shareholders.
Board meeting content and process. Agendas should include all key matters brought forth by senior executives and a review of past activities to ensure accountability. A simple majority vote is the best board decision-making process because this fosters consideration of proposals based on their merits. While many recommendations for family firms suggest that board members should make consensus decisions, such decision-making enables the most powerful board member to sway the opinions of others.
Board member selection. Most corporate governance experts hold that a nominating committee should be formed to manage the board selection process. A nominating committee also has the important role of building unity among the board, often by eliciting opinions from all board members, sharing ideas on board needs and criteria, and building agreement on proposed nominees based on all the directors’ input. To ensure accountability and to aid in building shareholder unity, the nominating committee should include board members as well as stakeholders who do not serve on the board.
Board term and turnover. Companies typically set board term limits for internal political reasons. A recommended tenure system involves a minimum term limit of approximately three years and an extensive review process after that three-year period. Along with this tenure system, there must be a process for evaluating the progress of the director, as well as clear criteria for “keep/let go”decision-making.
Board evaluation process. Although evaluating aggregate board performance is necessary, it is not sufficient. To promote accountability, board members must be evaluated individually. A high-performance board must be able to distinguish good contributions from poor, and, above all, ensure that all directors act to hold themselves and the company accountable.
Board compensation. Many corporate governance experts advocate compensating board members according to market norms. However, it’s important to note that family businesses often provide non-financial returns to family owners. Instead of the market rate, directors should be paid for their time commensurate to CEO compensation. A simple formula is to divide the CEO’s annual pay by 250 working days and then pay each board member the resulting amount per day for each day spent on board matters. This communicates that the board is as important as the CEO.
2. Your board must be accountable to shareholders.
Shareholder influence on board composition. Control-model companies—particularly family firms—must ensure adequate board composition, but not to the detriment of minority shareholders. One way to influence board composition while not alienating minority shareholders is through cumulative voting, which allows shareholders to split their vote among multiple candidates or concentrate it on a single candidate. An effective nominating committee that works in concert with the board review process helps ensure the protection and promotion of all interests.
Communication between shareholders and the board. Communication between the board and family shareholders is crucial. The board must understand the needs, vision and goals of the shareholders it represents, and family shareholders need reassurance that the board is attending to those matters. The board should communicate basic strategic plans, family/company values, and industry and supplier information to shareholders; it should also seek out shareholders’ views through surveys and meetings. On the shareholders’ side, regular letters to the board, family meetings, family council sessions and other gatherings enhance communication and promote accountability.
Shareholders’ involvement in strategic decision-making. Unlike many market-model companies whose shareholders leave decision-making to the board and management, shareholders of family firms should establish the values, vision and goals of the business and should serve as partners in strategic planning. This means helping management and the board understand owner goals as a basis for developing business strategy, and embracing and supporting the strategy that is proposed by management and endorsed by the board.
3. Your board must hold management accountable for their actions.
Monitoring strategic execution. Boards should critique and, when satisfied, approve management’s strategic plans. Management should continually be held accountable for fully executing board-approved plans. These plans should be benchmarked against long-term indicators such as market share, profit margins and economic value added. By continuing this monitoring function, board members can help identify obstacles and determine how to overcome them when performance falls short.
Executive compensation. Even though privately held family businesses are not obligated to announce executive remuneration, family businesses must create an atmosphere of trust and transparency among family members. Compensation information should be easily available to family shareholders and reviewed annually by the board.
Boards should tie compensation to the organization’s mission, annual business performance, long-term financial results and non-financial measures. Family businesses are well advised to develop a written compensation policy to help ensure that the family’s value system and vision are consistent with the way the business operates.
Different paths to accountability
In the typical family business, the shareholders are concentrated in the family. Often in such cases, family shareholders are active in the business (Quadrant 1 in the figure below). However, as family businesses move away from the typical control model, shareholder activism diminishes and the number of shareholders increases. In these circumstances, family businesses migrate toward a market model (Quadrant 4), and ways to ensure accountability may shift.
When members of the family firm become less active in business management (a shift from Quadrant 1 to Quadrant 3), but family shareholders retain their ownership stakes, the family owners become passive investors and view the family business as another investment in their portfolio. Once these “portfolio model” shareholders lose interest, they may sell shares. If they are unable to do so, they may sue.
Another scenario occurs when the business moves through generations. Some family members may remain active in management or the board, but the family has expanded and become less unified. This “dynastic model”of governance (Quadrant 2) is unstable, and the lack of unity can result in family owners who want to sell their shares.
No single model of corporate governance can account for the many possible configurations of family, shareholders and business conditions. The guidelines presented here are best suited to the typical family company. With careful analysis and consideration of family, ownership and business characteristics, these guidelines can be tailored to meet most family business situations.
Joseph Astrachan, Ph.D., is director of the Cox Family Enterprise Center, holds the Wachovia Eminent Scholar Chair of Family Business and is a professor of management and entrepreneurship at Kennesaw State University, Kennesaw, Ga. Andrew Keyt is executive director and Suzanne Lane is program director at Loyola University Chicago Family Business Center. Kristi McMillan is associate director of the Cox Family Enterprise Center. For a longer version of this article, contact the Loyola University Chicago Family Business Center at loyolafbc@luc.edu.