Best practice governance for family businesses: a new dawn

The European Confederation of Directors’ Associations (ecoDA) has recently published a very important set of corporate governance guidelines for unlisted companies. This grouping of 10 national institutes of directors, including the UK Institute of Directors, believe that improved governance can promote growth and sustainability and underpin entrepreneurship in progressive unlisted companies.

Given that these companies account for more than 75% of European GDP, it is perplexing that the governance needs of ambitious unlisted companies have, until now, been neglected compared to publicly traded companies; hence these guidelines fill a yawning gap and are very welcome.

The ecoDA document contains 14 principles that shareholders and directors can use in a stepped or phased approach to design a governance framework to suit their particular needs, taking account of various factors like the size of the company and the complexity of the ownership group. The principles are not intended to be binding, although it is hoped that “these ecoDA principles will provide a foundation for the development of more country-specific corporate governance principles at the level of individual EU member states”.

Family governance mechanisms

Principle 9 is of particular interest to family businesses: "Family-controlled companies should establish family governance mechanisms that promote coordination and mutual understanding amongst family members, as well as organise the relationships between family governance and corporate governance."

Key points

• The choice of family governance processes will depend on the size of the business, the number of family members, and the degree of involvement of family members in the business.
• A family constitution or protocol should outline the vision and objectives of the family for the business.
• It should define the roles of family governance bodies, and their relationship with the board of directors. It should also state key family policies, e.g. relating to family members’ employment, transfer of shares, and CEO succession.
• Family governance bodies – such as a family assembly and a family council – provide family members with a forum in which to discuss the affairs of the family and the family business, and assist the development of a coordinated family approach.
• A clear distinction in governance status must be made between family institutions and the formal governance structures of the company. The role of the board, shareholder meetings, etc, must be fully understood by family members.
• The ecoDA principles reflect the fact that family governance has moved from good to have, to a must do. Best practice for families in business together means that the governance of the family requires as much attention as the business, and while family governance is different from corporate governance, its standards must be equally high in professionalism and accountability.

Governance and complexity

Part II of the document goes on to explain that principle 9 states that family businesses need more formal governance because they become more complex due to the changes that occur naturally over time:

• the increasing demographic complexity in a growing family;
• fragmentation of ownership as it passes down through generations or the introduction of structures (like family trusts) to consolidate ownership and prevent fragmentation;
• the challenges generated by the business itself as it grows, matures, diversifies, contracts or expands.

It makes intuitive sense to introduce formal structures and policies to cope with this increased complexity and to replace the informal practices that exist in every business family. Informal governance – based on assumptions, understandings and expectations of what the family deems acceptable in private and business life – exists in every family business. But what works for an entrepreneur and his or her nuclear family is less likely to serve the interests of a group of siblings (and spouses and grandchildren) who become involved in or attached to the family business, and it is really going to struggle by the time the business passes to a generation of cousins. It is more likely that an accumulation of mistaken assumptions, misunderstandings and unfulfilled expectations will contribute to the demise of the family business.

The oft-repeated cliché about family businesses is that they go from “clogs to clogs in three generations”. There is some truth in this but it is not because all family businesses are poorly run or because business families are “dysfunctional”. The reason is more prosaic; it’s because family governance is not updated to keep abreast of the increasing complexity in the family as well as the business. The simple message permeating the ecoDA principles is that this is predictable, and if a family wants to build a successful multigenerational business, they need to get organised

Where to start with structured governance?

Principle 7 emphasises the importance of “a dialogue between the board and the shareholders based on a mutual understanding of objectives”. The first step to improved governance requires the family shareholders (and possibly the wider family, including the next generation of shareholders) to articulate why they want to be in business together – at all? The family needs to agree their objectives and communicate these to the board so that the directors know what they are aiming for and how they will be held accountable.

The importance of a shared purpose

The greatest strength in a family business is a clear and strong sense of shared purpose among the owners and the wider family that the board understands and can translate into business practice. This shared purpose can generate a sense of belonging and worth among owners, who are determined to create, preserve or extend a legacy of being a family-in-business together and, over time, to build wealth and opportunity for the family and others.

On the other hand without a shared purpose, as time unfolds, there will just not be enough “glue” to bond the family members to each other and to their collective investment in the business. In the absence of this “glue”, no amount of governance, or technical structures, will prevent things falling apart, often at the cost of much conflict and unhappiness.

Each family needs to define their version of “success” and then work through how this will be reflected in governance of their business, including the policies recommended by the ecoDA principles. The family first has to decide who will participate in articulating the shared purpose. There is a lot of value in holding a family meeting of those over a certain age whose lives will be affected by the family business, now and into the future. A family meeting for this purpose needs careful planning and there might be a role for an external facilitator who can help make sure that there is a thorough debate in which everyone has an opportunity to express their views, so that the shared purpose is based on consensus and not the views of a dominant family member.

Other families might prefer to leave the decision to family members whose views are respected and who are trusted to do the right thing in the overall interests of all stakeholders. The choice will depend on each family’s attitudes and beliefs; but what is important is that there is a cleared shared purpose and the owners, family members and the board know what it is. Only then will these stakeholders be able to decide if they want to be involved in the family business. If, to the contrary, someone feels that the shared purpose for the business could thwart their own aspirations, it is far better to find a way for them to exit gracefully rather than bind them reluctantly into structures that could cause much unhappiness and conflict.

The returns on investment that families seek – their version of “success” – may be singularly financial, or a combination of financial and emotional reasons. For example the shared purpose could include the following:

• providing the desired level of financial security for a growing family: each family has their own ideas of “enough” and “too much";
• preserving and extending a legacy of responsible and successful ownership to pass to the next generation;
• providing career opportunities for family members;
• attachment to a particular industry or geographical area;
• putting something back through philanthropy;
• keeping the family in touch and connected with each other through shared ownership of the business as individual family members grow up and grow apart.

How the shared purpose affects governance

The following brief example illustrates how a shared purpose flows through into the type of practical governance arrangements recommended by the ecoDA principles.

Assume that the family has agreed that the reasons they want to remain in business together are as follows:
(a) to provide reasonable financial security for a growing family;
(b) to preserve a legacy of private ownership to pass to the future generations;
(c) to remain involved in the type of business that has been inherited (because the family name is also a brand product name); and
(d) to remain in the local area where the business has always been located.

In this case the ownership policies should reflect the expectation that owners should hold on to shares rather than sell them. If someone wanted to sell, the custodian attitude to ownership might mean that sellers will receive a discounted valuation, rather than full market value, to reflect the fact that the overall objective is about protecting and passing a legacy to the next generation and sale is contrary to this purpose.

The financial return on investment for owners could well be affected by their desire to remain present in a certain geographical area. Relocation might reduce operational costs and secure other efficiencies, leading to increased profits for shareholders, but that would not be tolerated since part of the shared purpose is to retain the family’s attachment to a particular geographical place. Furthermore, the dividend policy would need to balance the desire to provide reasonable financial security for owners (not too much for shareholders but by no means a zero cost of capital for the business) with the intention to reinvest for the longer term.

These details of what goes into the ownership policies flow naturally from the family being clear about their shared purpose. It also helps in implementing principle 1 of the ecoDA recommendations, which (as explained in part II) is that “There should be a formal schedule which states which matters are specifically reserved for the shareholders’ decision and which are delegated to the board”. In this example it would be consistent with the shared purpose for the family to control decision-making in relation to the following since they lie at the heart of the shared purpose, rather than these matters being delegated to the board:

• any changes in ownership including issue of new shares or share based incentives;
• any change of location, becaue this is part of the shared purpose;
• any changes in the brand/logo (which is the family name);
• any diversification away from the core business, to which this family is particularly attached.

The family may also want the final say in any decisions that could involve a major financial or reputational risk. Principle 2 of the ecoDA document contains a list of decisions that shareholders may want to retain power to make, but this should not be treated as a tick list. Far better for a family to start with their shared purpose and then adapt the ecoDA guidance to suit their own needs and aspirations.

The board in the above example would be expected to understand the family’s shared purpose and willingly accept what others might consider to be limitations on executive decision-making, in return for the competitive advantage of having the clear commitment from a group of shareholders who are in it for the long term. The directors would be clear about the scope of their delegated authority, which will help to mitigate the risk of unintended conflicts caused by the board taking decisions they assumed they had power to make but which the family retrospectively challenge. The shared purpose would also mean that executive rewards (including any incentives) would need to be structured in a manner that was aligned with achieving the shared purpose; in other words, not just financial measures.

An alternative scenario

In contrast to the above example, if the family’s shared purpose was to maximise financial returns for shareholders, there would be larger dividends, more opportunity for shareholders to sell shares and redeploy their investment if they thought the business was underperforming, and the executives would, in this case, be held accountable based on financial performance alone. The shareholders' decision making would focus on financial risks and the board would expect to be criticised by shareholders if they took account of any of other factors in their decision making.

Another good rule

These examples illustrate how a clear shared purpose breathes life into governance structures. It is an essential step in translating the ecoDA principles into reality. To help further we’d commend the “rule of reasonable interpretation” as explained by John Carver, another leading practitioner in governance.

Carver would agree with ecoDa’s recommendation that it is wise to have a clear set of decisions that are reserved for shareholders and whatever is not reserved to shareholders is deemed to be delegated to the board. But however carefully this boundary is drawn, it is important that shareholders and directors interpret the words reasonably to implement the spirit of what is intended. This will be far more likely to happen if the shareholders, the wider family and the board apply sound judgment based on an understanding of the family’s shared purpose for their business.