Solid foundations

James Olan Hutcheson is founder and president of Regeneration Partners. jim@regeneration-partners.com

Good governance is the bedrock for effective family businesses – transparency and objectivity are key requirements in the process. Experienced and qualified outsiders on the board is a must if a company is to achieve success, writes James Hutcheson

Trying to run a family business without the people and policies of good corporate governance isn't like trying to walk a tightrope without a net — but it's close. Sage advice stipulates that every business needs both a chief executive to lead and a board of directors to review and evaluate the CEO's work. Yet most family business owners either haven't heard or don't follow this advice.

A study of Standard & Poor's 500 companies found that 78% of board members were company outsiders — one of the key ingredients of an effective board and corporate governance. Yet when nearly 200 small and medium-size enterprises were examined, only 44% of directors were outsiders. Sam Lane, a Fort Worth, Texas based family business specialist, estimates that less than 15% of directors of family firms are independent and non-family.
 
These statistics are indicative of the reluctance of family businesses to embrace the principles of effective governance. In fact, despite the withering publicity played on such spectacular governance failures as Enron and Tyco International, a majority of family businesses regard many of the elements of effective governance as unnecessary evils.

Corporate governance typically improves business performance by making the chief executive accountable. Because effective governance involves input from experienced and knowledgeable outsiders who frequently challenge the "this is the way we have always done it" syndrome, management no longer gets a free pass on inbred conventional wisdom. This process helps hone corporate judgment and as a result improves long-term financial performance.

Finally, legal changes are making it imperative, not optional, for many companies to institute more robust corporate governance. In the USA, the passage of the Sarbanes-Oxley Act (SOX) has greatly increased the requirement for corporate transparency and accountability. While many family firms view SOX as an unreasonable burden, it's also inescapably part of a growing worldwide trend toward stricter public oversight.
 
Governance is the broad term for oversight and control. All corporations must have a board of directors and it doesn't matter if the directors do anything more than simply sign their name to the corporate minutes each year. Public companies must use directors to satisfy the rules of governance. Private companies, including family firms, may have corporate directors, such as a treasurer, secretary, chairman and so on, to satisfy the legal requirements but may choose to use a board of advisors for oversight. With burgeoning corporate litigation, most family firms choose to use a board of advisors instead of directors. Likewise, would-be directors in closely-held firms generally prefer advisor status.
 
Whether director or advisor, a family business cannot simply overlay the cosmetic appearance of a governance system on top of a flawed foundation. Like a well-engineered building, effective corporate governance requires a solid foundation.
 
Setting up a useful family business board probably sounds like a lot of work and planning – it is. But it is worth the effort. Consider the construction of an office building in an earthquake prone area – building design and construction are necessarily more costly. But if a tremor should occur, all the cost and effort pays off. In the same way, building a solid foundation of governance may save your firm in its darkest hour.

A board of qualified and experienced individuals is the most critical piece of the governance foundation. The board is charged with reviewing and approving the selection of corporate objectives and with monitoring and evaluating how the management team performs. If acquisitions or divestitures are carried out, the board should wield the hand of approval. The same is true of strategic plans and operating budgets.
 
An important responsibility for a board is the approval of promotions to the senior management ranks, succession plans, and exit strategies. Inside managers and family members are notoriously poor at objectively evaluating major leadership changes and moves involving the sale of the business. A board can take some of the emotion out of these decisions and ensure that good solutions are selected and implemented.

Not just any board is sufficient to meet the challenges of all these responsibilities. The make-up of a board will depend on the industry, size, challenges, and aspirations of the owners. But the most vital piece of the puzzle, as well as the one most often overlooked by family business leaders, is that the board should have some independent outside directors.
 
Outside directors add value by expanding a family firm's contacts, experience, and wisdom. They may appeal to capital resources, suppliers, potential customers, and other valuable assets not available to insiders. Independent directors inspire confidence and build the aspirations of family business leaders by making them aware of attractive opportunities for personal growth and corporate expansion. The presence of a well-respected business leader on a company's board can do wonders for corporate image.
 
A board with outsiders is also useful for avoiding inbred decisionmaking that often leads to disaster. There are many examples of unrestrained CEO's creating havoc. This occurs in public and private companies as well as in family firms. One that played out in the mid-1990s involved Morrison Knudsen, a construction firm co-founded by Harry W Morrison in 1912. The Boise, Idaho, company grew into one of the world's largest engineering and construction firms building marquee projects such as the Hoover Dam.
 
In 1988, however, newly hired CEO William Agee convinced the board to approve a disastrous venture building rail cars. Agee, the former CEO of the Bendix brake manufacturing company, had strong personal relationships with board members that resulted in little control over his actions. By the time of his ouster in 1995, Agee had led the company to the verge of bankruptcy. Morrison Knudsen emerged from reorganisation a year later by merging with a much smaller, but financially stronger, company and today its once-revered name has disappeared from the scene.

One way to avoid this is to increase the size of the board. If it is a family requirement to allow all family members to sit on the board, then add more independent and qualified directors. Remember, adding more directors, however, doesn't add diversity of opinion and experience; adding more qualified and experienced outside directors adds more diversity of opinion and experience.

Generally, boards should not exceed 11 nor should they have fewer than three members. Simply being an owner of the company is not sufficient experience or a qualification to serve as a board member. Board membership is a privilege that must be earned, not a right granted by surname or ownership of stock.

One key qualification of a board member is that they should bring experience and wisdom in an area that is not internally available. Board members should not just be friends, long-time business associates or advisors of management. Inviting someone to sit on your board is not an appropriate way to say "thank you." Above all, directors must be independent-minded and not afraid to ask hard questions – even of a powerful CEO. The company must commit to providing board members with complete, uncensored financial, operational and other data.

Board members will need to devote time to meetings, which normally occur quarterly but no less than semi-annually. Total board business should require a commitment of between 80 and 160 hours each year. Chairman and heads of various committees can count on spending a few additional hours each month. Also, to demonstrate the importance of board business, meetings should be scheduled at least a year in advance to give everyone time to plan and prepare.
 
Those family firms that do not have boards have long been concerned about paying directors. Voluntary directors are great for charity and community work but in corporate settings directors should be compensated for their time and wisdom. Appropriate compensation will encourage a business-minded approach to the task as well as attract qualified professional directors.
 
There are some things a board should not do, such as make decisions about day-to-day matters. Boards are there to review, evaluate, and approve. If management is deferring operational decisions to the board, it is evidence of a crisis of leadership, not a properly functioning corporate governance system.

Nor is it always appropriate for a family business' board to have hire-and-fire power over the CEO. In decisions of this magnitude a family council may need to step in with their approval before termination of a CEO family member. In any event, however, the board members should be able to speak their minds and let it be known that current leadership is or is not fulfilling the objectives.
 
A board is sufficient foundation for governing most companies, but for many second and third generation and beyond,  the family council, is helpful in keeping the family connected as well as giving an overview into company actions. The council's goal is to ensure that the family's values and objectives for the business are fulfilled as well as to have input on business policies.
 
Membership on the family council is open to all adult family members – here surname is credential enough. This means spouses, children, parents, and grandparents and, in some cases, even relatives that do not have an ownership interest in the family business. The family council provides a way for interested but inexpert family members to communicate their wishes.

The task of the council is to set policies that affect how the business will interact with family members. Further, they frequently get involved in key issues such as hiring, compensation, and termination of family members employed in the business. The council may also become involved in settling family disputes, establishing and enforcing guidelines for avoiding conflicts of interest, structuring shareholder buy-outs, and managing the nomination and approval process of adding or removing directors on the firm's board.

Councils often start by writing a mission statement or an expression of core values that the family wants the business to support. Family members may also turn the spotlight on themselves, describing standards of behavior that they should adhere to in public and in the community. Conversely, the family business council can devise methods of protecting the privacy of the family.

Family councils are not just about the business. They can deal with educating family members about the business' history, help develop offspring for careers in the family firm or elsewhere, create and manage charitable and social service activities, and even plan family outings.
 
Roger Welder, the CEO of a sixth generation ranching family, believes that their family council has guided discussions and decisions related to items as small as painting the bunkhouse to selling legacy assets. "But when the family council comes together, we all know their decision represents the best interests of the family."

Just as a board isn't appropriate for every family firm, good governance isn't a panacea for solving business challenges. Even a well-constituted board backed by a robust corporate governance system can lead a company into hot water.
 
AMP Inc, a maker of electrical connectors founded in 1943 by Robert Hixon, learned the hard way. More than 50 years after its founding, the company's board had 11 members, only one of which bore the founder's surname. Three others, including the chairman, were current or former members of management. Some of the other members had been on the board for as long as two decades. However, misguided loyalty and lack of outside input was, in large part, responsible for what happened a few years after the company's 50th anniversary.

Following a series of unsuccessful diversification efforts, the publicly traded company's stock tanked. As might be expected, given the character of the late 1990s on Wall Street, a larger firm made a tender offer for a controlling percentage of the depressed shares. That offer was unsuccessful but other buyers quickly surfaced.

The board adopted an unusual and probably emotionally based policy of defending the company's independence regardless of the cost. It was also a policy that the Hixon family, which was the second-largest shareholder group, opposed.
 
Nevertheless, despite the Hixons' preference for an open auction, which they felt would maximize price, the board approved an $11.3 billion stock swap sale of the company. Unfortunately, the buyer was Tyco International, a conglomerate, which shortly became synonymous with even more egregiously bad governance.
 
Tyco CEO Dennis Kozlowski was forced to resign in 2002 and eventually charged with looting the company of $600 million during his reign. Interestingly, the CEO who replaced Kozlowski fired the board that had selected him as one of his first moves, on the theory that they were accountable for allowing Kozlowski's reckless acquisition binge and for funding his notoriously extravagant personal lifestyle.
 
Tyco avoided bankruptcy by the narrowest of margins and today is on a relatively sound footing. But during the process the founding family saw sickening drops of 75% and more in the value of the Tyco shares exchanged for AMP.
 
This brings us to the real bottom line of corporate governance: accountability. Family business leaders, including board members, must be held accountable by the family stakeholders for the company's performance. There must be a mechanism for removing a CEO or director who does not uphold the charter of the family values and objectives.

When such a director is identified, shareholders should be able to replace the unsatisfactory director. That way, the true responsibility for running the business will lie where it should, with the family. Like walking on a tightrope resting on the ground, governance is a low-risk endeavor.