How Sophisticated Does Our Governance Need to Be?
By Jennifer Pendergast, Ph.D.
One of the keys to long-term success for family businesses is the development of separate governance systems for family and business. These governance systems facilitate decision making and ensure accountability. While family business experts advocate the value of business governance in the form of a board with independent members and family governance in the form of a democratic decision-making body such as a family council, most family businesses don’t start out at that level of sophistication.
Governance systems evolve over the life of family and business. Family governance typically starts with informal meetings among family members where issues related to family and business can be discussed among the group. These informal meetings move to more formal meetings with structured agendas, routine occurrence and a selected leader or facilitator. The final evolution of family governance is a family council with a charter defining selection of council members, structure of the council, authorities and responsibilities.
Business governance evolves along a similar path. While corporate businesses are required by law to have a board of directors, the board often does not function as a governance body. Initial family business boards are often composed entirely of family members who may not meet other than to fulfill annual meeting requirements imposed on all corporations. Long-term decisions related to the business may be made in conjunction with management meetings or informally among owners at the dinner table. As business governance evolves, the family board may meet more informally. It may be accompanied by an advisory board, where advisors who are not employees or owners of the business provide input to the ownership group. The final evolution of business governance is a formal board of directors whose membership includes independent directors with no tie to the business or owners.
Each family business is unique and many will not follow through on all steps of the family or business governance evolution. However, these are the typical paths. So, if governance is an evolution, what is the appropriate position for your family and business along the evolutionary path?
Evolution is something that occurs over time. However, time is not the only determinant of evolution. Another logical determinant is the size of the business. However, size alone does not determine governance requirements either. Consider these two contrasting scenarios. In one situation, a multibillion-dollar manufacturing firm in the third generation of ownership is in the early stages of family governance, holding informal family meetings on a nonroutine basis. Its business governance is only slightly more sophisticated, with an informal advisory board and a formal board (composed of family members) that never meet. Yet, this business is highly successful and the family has relatively few problems.
Contrast this case with another multibillion-dollar family firm, this one in its second generation of ownership. This firm has a formal family council, including second and third-generation members and a highly structured board with independent members and a functioning committee structure. The owners believe that the board and council are both needed to make decisions effectively.
So, what drives the need for differing levels of governance sophistication in these businesses? It is obvious that business size and age are not the only drivers of governance sophistication. There are several differences in these situations that are not evident from the initial descriptions. First, the ownership group of the first business is composed of one second-generation member and his three third-generation sons. The oldest member of five in the third generation is in his teens. The ownership group of the second business comprises the first-generation founder and his 10 children, five of whom lead operating units of the business. There are more than 50 members of the third generation, with the oldest being in their late 20s.
Another difference is the nature of the business. The first business manufactures a limited product line of high-dollar items primarily for government contracts. All top management functions are held by family members. The second business is a holding company consisting of five different businesses that sell products internationally. While family members head each of the divisions, there are several key non-family managers.
While there are some differences, there are also similarities. Owners are still actively involved in management. The elder generation, while still involved in a limited capacity, has ceded control of the business to the next generation, and the generation in control is in their 50s, so there is no succession looming on the horizon. Both businesses are highly successful and the families are relatively stable.
What is relevant about all these details? They all have an impact on the governance systems of family and business. While books and experts would suggest that a large, successful, multi-generational family business should have a strong independent board and a family council, these examples show that this blanket recommendation may not be valid. While age and size of a business are two drivers of governance sophistication, there are several others. Below is a list of factors that impact family and business governance.
Size of ownership group. The larger the ownership group, the greater the need to develop a family governance mechanism for making decisions regarding family and ownership issues. Smaller ownership groups can function more informally and may incorporate ownership and family decision making with business decision making, particularly if all owners are employed in the business.
Percentage of owners employed. If all owners are employed in the business, their needs are often more consistent than ownership groups where some are employed and some are not. Owners not involved in the business value the oversight and accountability provided by a strong board of directors. When all owners are not involved in the business, the family also needs to develop a structured forum for family and ownership decision making, since it cannot occur within the business context.
Owners’ involvement in senior management. As businesses involve more non-family members in senior management, there is greater value to formalizing business governance. Independent advisors or directors can provide oversight and accountability to non-family members as well as family management. The decision to hire the first non-family CEO is often a catalyst for involvement of independent directors on the board. The decision to move senior management decision making outside of family control is one that often requires significant deliberation by the family. So, more formal family governance is valuable in making this transition as well.
Number of generations in management. When multiple generations are involved in management, opinions on how to run the business often diverge. There can be a need for a functioning family board supported by outside advisors or formal directors to ensure effective business decision making. With multiple generations in management, a succession event is inevitable at some point in the future. Both family and business governance need to be prepared to support the succession process.
Proximity to business leadership transition. Leadership succession in a family business is one of the most critical and challenging events the business and family can face. Both groups require a forum for discussing the succession process for the succession to go smoothly.
Size of the business. While we have seen that size alone is not a driver of the need for governance sophistication, size definitely has an impact. The larger and more sophisticated a business, the greater the value of independent directors. And a more successful business typically provides more resources to the family, who need a forum for determining what to do with these resources.
Crisis in business or family. When the business and family are functioning well, there is less need for structured governance than when a crisis occurs. In fact, it is often a crisis that generates the desire to increase the sophistication of governance. An illness in the family or a disgruntled family shareholder may be the catalyst for a formal board or family meetings. It may not even be an obvious crisis, but rather the pace of change that requires more sophisticated governance. Businesses that operate in stable environments may require less sophisticated governance than those operating in rapidly changing or highly complex situations. Similarly, families that are less stable require more support.
This list highlights the fact that governance requirements will certainly be unique from one family and business to another. By evaluating the family and business on each of these dimensions, you can determine what level of governance sophistication is appropriate for the situation.