Corporate governance in family businesses

Various recent and highly publicised corporate scandals have led to demands for more rules that aim to mitigate the type of opportunistic management behaviour that result in reduced shareholder returns.

Conventional corporate governance in the UK is mainly contained in codes and guidelines that apply to companies whose shares are publicly traded. It is often suggested that the structures and practices recommended for plcs can be adapted for use in privately owned family enterprises, such as the role of non-executive directors and the creation of various board committees. However this advice should come with a “health warning”, because the codes’ recommendations are based on assumptions that do not always fit the needs and expectations of enterprising families. The governance gap between UK plc and private enterprise might be about to widen if there is a new round of legal intervention in business affairs, and advisers should not rush to fill this gap by suggesting that private enterprise clients would do well to mimic their more troublesome plc relatives.

The following table summarises the mismatch between the UK plc version of corporate governance and the needs of most family enterprises.

The source of the mismatch is that conventional governance is largely based on the external investor’s distrust of management, which has probably increased a bit recently. In contrast family enterprises often operate best using structures and practices that reflect relationships of loyalty and trust, based on kinship and wider personal relationships.

Ownership and responsibility

In a family business, management responsibilities are often allocated among family members – and the “insiders” who are treated as “family” – based on trusting each other’s talents. They know each other well enough to understand their respective strengths and weaknesses, and therefore trust each other to deliver. As a result, each business function is handled by the fewest number capable of doing so; you don’t need others looking over their shoulder. Hierarchical, top-down governance structures, with excessive monitoring and reporting, are replaced by horizontal relationships, openness and a commitment to teamwork.

This “trust” based structure can contribute to speedy decision-making at management level. In place of elaborate rules and control mechanisms, decision making in family enterprises is often marked by informality and pragmatism (e.g. a lack of board and other meetings), including a willingness to waive rules in exceptional circumstances, especially where the right result has been achieved. When trust is high, people feel that they will be judged by the result achieved, rather than by whether or not they have followed the prescribed procedure, and, if necessary, they expect to receive the benefit of any doubt. This all helps to keep an entrepreneurial attitude to risk alive in the family enterprise.

At the ownership level of governance, family enterprise owners who know and trust each other often feel a shared responsibility to protect the “family silver”. They are willing to take a long-term view of their investment return, thereby securing the significant competitive advantage of cheap capital.

The owners are also often driven by the desire to achieve returns on investment other than shareholder value; for example, the desire to preserve a legacy of family ownership, attachment to a particular place and a sense of responsibility to employees. It may be claimed that it is this type of sentimental approach to business that causes failure among some family enterprises. Apart from the questioning on what basis an outsider such as an adviser can respectfully criticise a family if they deem such returns to be worthy of their endeavours, such returns can be particularly valuable during a recession. For example, if the shareholders accept a below-market return on investment in order to fulfil a sense commitment towards employees, they probably expect this to be reciprocated in long-term service. A pattern of long service helps to build up knowhow in the workplace and avoid the disruption caused by high levels of staff turnover. Not so daft after all.

The role of non-executive directors

The contrast between the conventional approach and the needs of family enterprises can be illustrated by the role of non-executive directors (NEDs) and the use of board committees.

NEDs can add value to a family enterprise in several ways. They bring outside experience and independent judgement to bear in major matters requiring board decisions. They can act as a link between the board and the shareholders, provide the benefit of their personal contacts, and help to ensure that the overall governance of the family enterprise operates effectively.

In order to strengthen the autonomy of these NEDs, the corporate governance codes and guidelines advocate that NEDs should be “independent”, free of any commercial or personal ties that could impair their ability to probe and challenge the board.

In privately owned family enterprises, in contrast, these requirements on independence can be difficult to apply. The choice of NED is often influenced by a prior relationship that helps to increase the levels of trust and respect (always important ingredients in family enterprise governance) between the controlling family and the NED. This does not mean that NEDs in a family enterprise should not be “independent”; it just emphasises the importance of NEDs having an independent mindset and the courage to base decision-making on the merits of the decision rather than extraneous influences or considerations such as relationships with family members. These are important characteristics and attributes that should be tested when selecting NEDs.

The role of NEDs in the governance of public companies has increased in prominence in response to investors' concerns about excessive executive remuneration, control over board appointments, evaluation of board performance and the relationship between the board and the company’s auditors. To address these concerns in UK plc, the governance functions of audit, executive pay and the nomination of directors are referred to permanent board committees in which the majority, and sometimes all, of the members are NEDs.

The recommended terms of reference and composition for these committees basically reflects investors' distrust of management making decisions in these important areas. A version of this distrust may exist in family enterprises; for example where there are non-working owners who feel vulnerable in the absence of any controls over executive rewards (even where, or sometimes especially because, the executives include their relatives). The idea of a remuneration committee might be a good idea, but maybe not one modelled on the plc version.

The committee might be better to include a balance of interests between non-working owners and executive management rather than be comprised of NEDs. The desired balance of interests between owners and executives might be better achieved by a dividend policy that reassures non-working owners on their level of investment return and an incentive scheme for management that links their bonuses, in some part, to dividend return. This might be a better way of achieving the desired alignment of interests between owners and management than just forming a plc type remuneration committee.

The natural state that every family enterprise strives to achieve is a balance among different and often competing interests of the owners, the wider family and the business. Advisers to enterprising families need to explore where the family’s interests are best served, and it should not be assumed that importing the UK plc version of governance is going to provide a complete blueprint for their needs.