GOVERNANCE
Siblings and cousins must
confront governance challenges

BY MIKE COHN

First and second generation family businesses often transfer ownership from parent to child in a vertical succession. Those who work in the business often become the next generation owners; those not "in" the business may be excluded from ownership.

As family businesses grow and evolve, however, third and fourth generation companies are finding a new and different set of issues confronting them. These new challenges involve the sharing of ownership with siblings and cousins.

As ownership becomes diluted, it may be increasingly inefficient to use the business's working capital to buy out family members. Furthermore, as ownership is shared among siblings and cousins, control of the family business may not reside in any one family's hands.

Maximizing shareholder value often becomes a primary goal surpassing shareholder buyouts. These same third and fourth generation businesses may be professionalizing, moving away from entrepreneurial management styles. Clear boundaries between management and ownership must evolve as more family stockholders elect career paths outside the family business, while retaining ownership of their family company. A more professional style of management often includes a greater tolerance for inactive shareholders. (See Comparing Management Styles below.)

The succession planning challenge, therefore, must be redefined. Instead of simply providing financial security for mom or dad and deciding that only those who are "active" in the business should own it, the issues become more complex. A central question may involve a redefinition of ownership in terms of family and business responsibility. Issues may be tougher to solve since there may not be examples to follow from the previous generation.

As management in the family business becomes more professional, family business owners need to mature in creating and respecting the boundaries between themselves and the family business. A professional management style also requires the family to examine its expectations concerning the business.

This examination should address the risks inherent in the family business, both internal and external forces that will drive future decisions. We believe what must evolve is an understanding of business governance: the method or system of governing or managing a business.

While many advisors believe that governance of the family business automatically means a board of directors, we believe this is only a partial solution at best. Generally, family business owners who have not addressed business governance issues first will not be successful at assembling a competent board of directors or advisors to help them maintain their family business in the long term.

An important first question in governance centers around the concept of shareholder value: Is it the goal of all shareholders to maxi­mize business value, and what does that mean? Can you imagine, for example, an operating philosophy which does not have improving business value as a primary goal?

We have several clients for whom that is a point of contention. For instance, Tom owns a large manufacturing plant with his two inactive brothers. Tom uses profits each year to buy newer, faster, better equipment, but the company's net income hasn't grown over the past 10 years.

His brothers accuse Tom of being an equipment junkie" hooked on machinery purchases. As shareholders, they haven't seen any improvement in value from Tom's acquisitions or from his management. A recent business appraisal supports the inactive brothers' suspicions, but Tom believes "shareholder value" lies in future capability, not past projects. What will it take to bring the three brothers together in their thinking?

Another client believes corporate profits should be used to support local religious institutions and other charities; her cousins disagree and worry that corporate debt could be paid off if profits weren't diverted to charitable causes. Can improving shareholder value include both community involvement and amortization of debt?

Arriving at a consensus for governance in a family business requires focusing on several areas:

• Determine the goals of the family. This includes articulating realistic expectations of return on equity, which often can be determined by analyzing public information from peer companies. Another big issue for the family: Should capital be withdrawn by individuals as needed through redemptions or through distributions (for S corporations)?
• Determine the goals of the corporation in profits, cash flow, quality, and customer service. What should the investment policy be for new ventures such as research and development? How should existing line business be assessed? How should sacred cows be handled?
• Have stockholders commit to an operational plan of action. Include short term goals (1-3 years) and long term goals (3-5 years) to create a baseline of expectations for family and business objectives.
• Determine available cash flow and assign allocation priority.

Consider which is more important: family first or business first? These initial steps of governance help establish boundaries between family and business, and they include solving such issues as who can work in the family business and who can't; how they will be trained; who will assess them; how they will be held accountable and how family members are compensated.

Establishing a board of directors/advisors with qualified outsiders can provide a valuable resource. Qualified outsiders means people who are familiar with the industry in which the family business operates or who have such broad expertise and experience they can bring new ideas to the table and a perspective for helping the family business reach its goals. Qualified outsiders are usually not the current CPA, attorney or banker. For a quick test on corporate governance, see our measurements evaluation.

At some point on the road to increasing shareholder value, the family may decide that external, rather than internal—outside, rather than home-grown—management would be in everyone's best interest. If family members are not capable or willing to lead the company, guidelines must be established to recruit the "best and the brightest" to come in and run the family business or to run operational divisions.

Governance also includes establishing a compensation committee to reward key executives on the basis of performance. Often these compensation plans are tied to future retirement benefits. Budgets need to be established (in advance of performance) so that shareholders can measure management performance against expectations.

As family businesses become more professional, sharing information becomes increasingly important. Shareholders must be confident that the information they are receiving is timely, accurate, and relevant. What internal controls or changes in the corporate culture will be needed to foster communication?

Buy-sell agreements often need to be revised so that stock can be transferred down family lines during lifetime to future generations rather than being sold at death. If this is the case, these agreements need to anticipate the possibility of some shareholders needing liquidity at different points during their lifetimes.

How will liquidity be provided by the company? Some clients' businesses have elected to create an annual financial window so that stockholders who need to sell a few shares can do so at specified intervals. Buy-sell agreements may need revisions in stock pricing mechanisms, using a fair market value pricing methodology rather than outdated (and sometimes arbitrary) below market value determinations.

The evolution from a "one man band" to family governance is often a difficult tran­sition. It may involve a lengthy process of creating or rebuilding trust among members. Sibling and cousin relation­ships often require a redefinition with a new perspective. Sometimes examining and discarding old myths and habits—successful in a previous generation but not today—is the outcome. We encourage and applaud those family businesses that can share ownership and create a process for governance. The odds of their future business success increases dramatically over those that either don't have the time for the process or don't have the interest.

We believe the stewards and future leaders of family business will be those who have embraced the concept of governance and devoted time to it, and along the path they will find they also have enriched and reaffirmed their family's values.