GOVERNANCE
Fairness and Openness in Shareholder Representation

BY MIKE COHN

Ask most family businesses about "governance" and a typical answer is having an active board of directors to oversee the affairs of the business. But there is a big gap between knowing what a board does and having an effective one that represents shareholders—especially when there are shareholders not active in senior management roles.

This was confirmed in the 2002 American Family Business Survey, which reported that many (about 50%) boards only meet once or twice a year, while 1396 reported they never met. Most (70%) reported no board subcommittees (audit, compensation, etc.) and a substantial number reported weak board performance. Most family businesses do not use their boards in the CEO succession process, one of the most important roles for the board. When an ineffective board fails to represent and speak up about shareholder concerns, it should be no surprise when conflict inevitably erupts.

Having a competent board, and empowering it, means addressing basic issues of representation and linkage. Representation means exercising a voice (as a shareholder or family member) at appropriate places and times; for example, when electing members to the board or speaking up at a family council meeting. Linkage is where and how the family/owners and the board connect; how the board learns what the family, as owners, will and will not support and what their expectations are. Sometimes linkage means knowing where to draw the line between family issues (to be solved by the family) and business issues (to be addressed by the board).

When policies for representation and linkage are not implemented, conflict often festers. Families willing to address linkage often find that educating family shareholders to select board members to make business decisions on their behalf is a daunting task. But if governance is to work in family firms, it must be understood and practiced by its members.

For the past year, I have worked with a large company, owned by its 12 (very independent) second generation siblings who have been addressing the questions of representation and linkage. All 12 own voting shares and, although there are differences in ownership percentages, no shareholder owns more than 15% (the company has stock plans which grant additional shares to those in senior positions), so all are minority shareholders. There are 45 in the third generation. Their goals at the outset were straightforward: maintain family harmony, maintain and grow their successful family business, and create opportunity for competent and qualified family members in the business. Typically, though, as the consultant peels layers back, more compelling issues begin to surface.

Representation for this family meant asking questions of the active family members when on family vacations. Formal shareholder meetings were informative, but there was a sense that the older siblings made decisions for all 12. Board seats (with no terms) were occupied by the four eldest siblings. In many ways, this family functioned as a partnership with two classes: senior partners (the older siblings) and junior partners (the younger siblings).

The senior partners weren't sure the junior partners should have much say in major business decisions. Tthe senior partners reasoned that they had been running the business pretty well so why change. The junior partners argued that they had worked just as hard, although maybe not as long, in the business; and it was time for their voice to be heard. The inactive family shareholders weren't sure what voice they had or how to exercise it and didn't want to stir things up—but they weren't sure the status quo would continue to work either.

Over the past year, representation has been redefined: The board has expanded to nine (five family and four unaffiliated outsiders) with at least two of the five family seats filled by non-active family shareholders. An existing family council has been given a new responsibility: to nominate inactive family members to the board. Board terms have been agreed upon and a nominating process has been implemented for all board positions. The board meets quarterly, and its committees are chaired by the unaffiliated outsiders. All shareholders who own voting shares (including non-actives) now have a voice in the selection of board members through a formal voting process.

But the linkage question remained. The answer for this family was to create an ad-hoc Stock Committee. Eight siblings (the CEO and COO of the business, the head of the family council, and the head of the family foundation, plus four others) have met monthly over the past year to address stock issues while I serve as facilitator.

The committee's recommendations go to either the family council or to the board, as appropriate. This committee represents all family through a networking process. Some issues, such as a recent committee decision to recommend the creation of new non-voting shares went to the next family shareholder meeting for discussion before being submitted to the board. The at-large family can bring issues to the committee by first going through the family council.

Over the past year, this committee has debated, reached consensus, and made recommendations to the family council and/or the board about::

• The Board make-up to address board seats and terms, the role of the nominating committee, and family and non-family classes on the board, resulting in new by-laws for the company;
• New non-voting shares, including transfer provisions for non-voting shares and a process to approve eligible charities to hold non-voting stock;
• A new Stock Restriction Agreement for transfers of voting shares, including options among shareholders (and the company) to buy and/or sell shares, redemptions (on death or disability), post-transfer adjustment clauses, and expansion of estate planning options for current generation to transfer shares during lifetime;
• A revised share valuation process understood and agreed upon by all family members;
• A reconfirmation to continue existing stock incentive and purchase plans for active family members in senior positions;
• Expanded responsibilities for the Family Council including appointing members to board nominating committee, and approving family charitable gifts of non-voting shares;
• A Voting Trust Agreement as the vehicle to hold a block of voting shares, a process to select trustees, and a process for the voting trust to purchase shares from family shareholders.

This family recognizes that, over time, the next generation may not be in the top positions of the company, and they want to insure that family members who are in senior positions will substantially influence the business. Therefore, trustees of the voting trust are made up of active and inactive family members (the Family Council nominates trustees). In the event there are no eligible (active in senior management position) family trustees, then those trustee seats will be filled by other family members.

It hasn't been easy for the 12 siblings to reach consensus on these issues. But they know there are big stakes, and they are committed to the process. At the end of the day, their process is as important as what they decide upon—the decisions may change in the future as new family members become involved. But this family's process, emphasizing fairness and openness, will be what is learned and passed on to the next generation.