Happy Family Inc.

Happy Family Inc.

Best practices for business governance

Good governance practices can enhance the value of a family-controlled business in many ways. They can improve the business’ financial performance, protect the owners’ other assets, overcome deficiencies in succession planning and provide a way to avoid or resolve conflict among the owners without litigation.  

Senior generation owners and their managers might (rightly or wrongly) view business succession planning as something that can be deferred to a later date, but good business governance practices are always needed and can provide both immediate and long-term benefits. Good governance of a family-controlled business requires a combination of appropriate business organization documents, insider contracts and estate-planning mechanisms.

I’ve identified seven rules that can guide family business owners, managers and advisors in using a disciplined approach to help family businesses increase return on investment and minimize family acrimony arising out of the business.

Be Fair, Not Equal

When organizing, re-organizing and growing a family-controlled business, and especially when planning for the succession of ownership from one generation to the next, the owners should be guided by sound business principles. They should adopt mechanisms that:

Allocate management authority to the best managers;

Compensate and incentivize managers at market rates;

Provide a reasonable return for the individuals whose capital is at risk in the business (regardless of whether they earned that capital or inherited it); 

Allow owners a reasonable means of holding managers accountable; and

Provide an exit for the disgruntled or unworthy.

Karl Marx advocated, “From each according to his ability; to each according to his need.” The family-owned business in the United States isn’t the place to test that theory, although many senior generation owners feel compelled to give it a try when planning for the succession of their business, and many non-management, next generation owners, who otherwise would be staunch economic conservatives, become communists when it comes to what they expect to receive from the family enterprise.  

On the other hand, to paraphrase 19th century historian and moralist Lord Acton, “Power corrupts; absolute power corrupts absolutely.” Family members who manage the family business may also be prone to an unreasonable sense of entitlement with respect to their interest in the business. Their compensation should be transparent and consistent with the market, and they should be held accountable by objective standards.

Use Checks and Balances

The best model of governance for a family-controlled business may be one in which everyone is accountable to someone else—like staircases in an Escher drawing that each lead to another staircase. This may not be a viable suggestion while the founder is active in the business, but may be a mechanism that can be worked into the succession plan. This requires attention to the business’ charter, bylaws or limited liability company (LLC) agreement and the senior generation’s estate-planning documents.

Management leadership. The executives will run the day-to-day operations of the business. Executive hierarchy and each executive’s authority can be set forth in the bylaws, or it can be left to the discretion of the board of directors to be set forth in resolutions. The board can limit the authority of even the top executive, which may require that the board specifically approve certain actions of the executives in advance. The board will also determine compensation of the top executives. Usually, the bylaws will provide that the executives serve at the pleasure of the board and, thus, can be removed with or without cause. However, the board can approve an employment contract that compensates an executive who’s terminated without cause.

Although a family-owned business can provide employment opportunities for family members, executive leadership should be reserved for individuals inside or outside the family who are best suited to lead the company to success. The directors should be allowed to choose those individuals based on merit and should actively and objectively review their performance. Family members who do serve as executives should be incentivized and rewarded, but shouldn’t be overcompensated. The directors also should maintain an updated plan to replace the top executive if an unexpected event occurs, such as death, disability or wrongdoing. 

Fiduciary board. Founders and family members who are executives of a family-controlled business will often resist the idea of constituting and empowering a board of directors that has objectivity and authority. They don’t want a board that will cramp their style or second-guess them. While the founder is serving as CEO and the ownership interests are “all in the family,” the company may be able to succeed with the CEO serving also as sole director or with a rubber-stamp board of family members. However, that model usually doesn’t translate well into the next generation of owners.

Requiring the board of directors to include a fiduciary board made up of outside, independent members can have numerous advantages in the family business. With independent directors, the board can provide formal and objective oversight, expert advice, a means of approving insider transactions and an internal mechanism for addressing owner concerns or resolving owner discord that family directors might only exacerbate.

The charter or bylaws should set forth the number of independent directors required, their terms and how they’ll be elected. It may be advisable to stagger the directors’ terms to provide stability on the board from year to year. Also, it may be desirable to classify board seats, so that different lines of family members are each represented on the board by at least one independent director. Companies may also want to adopt cumulative voting, so that minority owners can pool their votes to elect at least one director, notwithstanding the voting of owners with larger positions.

Even if the founder won’t permit a functioning fiduciary board to serve during his tenure as CEO, the owners should put in place documentation that will immediately install such a board in the event of the founder’s exit. Such provisions can be worked into a shareholders’ agreement (or LLC agreement), or they can be implemented by fiduciaries pursuant to directions in the founder’s estate plan. It may be wise for the founder to establish an advisory board of individuals who can be kept apprised of the company’s activity and, thus, be prepared to serve as the company’s fiduciary board upon the founder’s unexpected exit. 

Trust ownership of company stock. The preceding section mentions some mechanisms available to help allocate representation on the board of directors among the owners, such as classification of board seats or cumulative voting. In some cases, however, the family members who hold (or may succeed to) ownership of the company may be too inexperienced, uninformed or contentious to responsibly exercise the shareholders’ rights to vote for directors or hold the board accountable. (Note that in most jurisdictions, minority owners have no fiduciary duty to the company or the other owners with respect to how they exercise their voting rights or other rights that accompany stock ownership.) In such cases, it may be necessary to insulate the company from the beneficial owner by allocating legal ownership to a fiduciary for the beneficial owner.  

This issue can be addressed through trust ownership of the company stock or membership interest. A key decision in planning for such trusts is to determine who will have authority to vote the ownership interests and who will have authority to appoint, remove and replace such persons. Often, corporate fiduciaries may be best at the ministerial duties of a trustee, but completely inadequate to exercise an owner’s rights in a family-controlled company. In such cases, a directed trust may be the most appropriate approach. Under a directed trust, the trustee’s authority and discretion with respect to ownership in the family business can be delegated to a special fiduciary or board of advisors, who exercise all the trust’s ownership rights and even decide whether the interests should be held or liquidated.  

The voice of beneficial owners. The terms of a directed trust (or other mechanism for delegating share voting control) can dictate which beneficiaries or other persons can appoint, remove and replace the fiduciaries or other appointees who are exercising the ownership rights on behalf of the beneficial owners. These provisions mark another level of the structure of checks and balances in the company’s governance. For example, if the ownership interests are held for a particularly large family group, the trust agreement may provide a means for beneficiaries to elect a family board that will have the right to appoint and oversee the fiduciaries under the trust.

Even if beneficial owners have no authority in the governance structure, it can be helpful to organize a family advisory counsel that occasionally meets with the business’ management to receive information about the business’ performance and express concerns of family members who otherwise aren’t involved in the business. 

Parents, subsidiaries and affiliates. This system of checks and balances should be adapted to the whole structure of the family business if it involves multiple companies. It’s possible, through global owner agreements or trust ownership, to ensure that each component company in the business is consistently governed and that owners of component companies are treated fairly in fundamental transactions involving the business.  

Get it in Writing

Family-controlled businesses too often tend to neglect documentation of economic rights and understandings among family members and other insiders. The default statutory or common law rules that apply to these relationships rarely satisfy the expectations or intentions of the parties involved. Sometimes, these unwritten understandings can be given effect by moral force of the senior generation, but, often, they become the subject of disputes after business interests pass to the next generation or to parties outside the family.  

Therefore, all agreements and contracts affecting the economic rights and legal relationships of family members and other insiders with respect to the business should be documented in a writing that’s signed by the parties and contains express and appropriate provisions about how they can be amended or revoked. Examples include: 

Governing documents. Corporation and LLC charters are always reduced to writing because they must be filed with the appropriate state agency to give the company legal existence, but a charter that meets the bare minimum standards for filing may not include some provisions that must be in the charter to be enforceable. Also, it’s more difficult for the board or shareholders to unilaterally change the charter than to change the bylaws under default rules.  

Owners shouldn’t use off-the-rack charter forms or bylaws. They should, instead, consider carefully which provisions should be in each of these documents and be specific about how these documents can be changed. For example, a provision in the bylaws requiring unanimous consent of shareholders to dissolve the company may be meaningless if a simple majority of shareholders can amend the bylaws, including the liquidation provision.  

Employment agreements for family members. When family members are employed by the business, a written employment agreement can protect both the employee and the company. The agreement should be specific about the family members’ responsibilities, authority, compensation and rights upon termination. Often, such agreements, and any changes to them, require approval of independent board members. A written employment agreement reduces opportunities for abuse by a family member and his proponents and, conversely, reduces the risk of challenge or change by coalitions of other family members.  

Other insider contracts. Other contracts for goods or services between the family business and individual family members or companies should be in writing, such as leases, consulting arrangements and supply or distributorship agreements. In particular, the terms of loans from family members or guarantees of third-party debt by family members should be clearly established in an enforceable written contract. If a family lender has a security interest, that interest should be perfected. If a family member has guaranteed a third-party loan to the business, his right to recover from the borrower or other guarantors for any loss under the guarantee should be set forth in a written indemnification agreement. 

Restrict the Ownership Group

In a family-controlled business, it’s often desirable to keep ownership within the family until a formal decision is made, through appropriate governance mechanisms, to admit outside owners or investors. Buy-sell agreements with transfer restrictions, estate-planning documents using trusts to own company interests and prenuptial agreements for individual owners can all be important elements of maintaining family control of the ownership group. It’s important to prevent even a small portion of ownership interest from falling into the hands of an owner outside the approved group, because of rights that minority owners may have to review books and records of the company, bring derivative lawsuits, veto changes to governing documents, block a sale of the business and allege minority oppression—all without a corresponding fiduciary duty to the business or other owners.

With respect to estate planning, the senior generation should be realistic about whether their estate beneficiaries can all co-exist as owners of the business. If they can’t, the estate plan should focus on ways to strategically allocate estate assets to exclude company ownership from the shares of the estate passing to beneficiaries who won’t be involved in the business. Depending on the proportion of family wealth represented by business interests, this may require aggressive planning to reduce the senior generation’s federal estate tax liability or creative alternatives for payment of that liability, such as a redemption of estate interests or a loan from the business. These liquidity needs might also be met through strategic use of life insurance.

Preserve Exit Strategies

Some family members seem to thrive on conflict, but all parties are generally best served if owners can liquidate their interests when they want out, or the business can expel disgruntled owners who refuse to leave.

Avoiding the minority veto. Sometimes, the owners of a family-controlled business may be best served by liquidating the company or accepting a stock purchase offer from a third party. The company’s governing documents and owners’ agreements should contain provisions allowing the owners to proceed with such a transaction without concern that a small minority owner will be able to veto it. Provisions such as supermajority share voting for fundamental transactions and drag-along rights for stock or membership interest transfers can allow the family to exit for the full value of their interests.

Expelling the hecklers. Some minority owners are determined to find fault in everything the business’ management does. Their carping is ill-informed or based on family issues unrelated to business performance. Such malcontents can rattle management, stir up ill will among other owners and cost the business unnecessary attorneys’ and accountants’ fees. For these cases, it’s best for the governing documents and owner agreements to preserve a right of the majority to expel such owners. To discourage challenge, such provisions should allow the expelled owner to be redeemed at fair market value, determined by a specific procedure set forth in the documents. The business should maintain a plan for producing the liquidity that such a redemption might require, for example through a sinking fund, an untapped line of credit or capital contributions by other owners. 

Special exit planning. The business and its owners should plan for exits under other special circumstances as well, such as an owner’s retirement, death or disability. In such cases, the exiting owner (or his estate) may need the liquidity more than other owners. Having liquidity available in such circumstances through insurance, non-qualified retirement plans, structured redemptions or buy-outs by insiders (including, if appropriate, an employee stock ownership plan) can avoid the difficulty of having an owner who’s financially compromised.

Purchase price. To be effective in settling disputes, rather than creating them, exit provisions in governing documents and buy-sell agreements should address all the details that would be necessary in documents affecting an actual redemption or cross purchase of an owner’s interest, including payment terms, releases and indemnifications. The most important of these details, and perhaps the most difficult to address, is determination of the purchase price. The documents should be as clear as possible about how the purchase price will be determined and whether the methodology will be different for different exit events. (For example, it may be appropriate to apply a discount to the purchase price when an owner puts his interest to the company, but not when the company redeems an interest upon the owner’s death or disability.) It may help to consult a valuation professional when the documents are drafted, to construct the most appropriate valuation language for the business, given its industry and all surrounding circumstances.      

Discourage Litigation

The threat of litigation, including derivative claims, can be a potent way for minority owners to harass management into compliance with unreasonable demands. However, business owners can adopt a number of strategies to neutralize this threat.

Exculpate, indemnify and insure managers. The business’ governing documents can expressly exculpate managers, directors and officers from personal liability arising out of claims that don’t involve breaches of loyalty or willful misconduct. Under the business’ governing documents, the business also may indemnify managers, directors and officers against losses, including attorneys’ fees, which they incur as a result of such claims. Such provisions can set forth procedures by which the business can be required to advance indemnification and/or insure against such losses through directors and officers (D&O) insurance policies. Sometimes the governing documents will provide general enabling language, and then, more detailed provisions will be set out in employment agreements with executives and indemnification agreements with board members. D&O policies should be reviewed from time to time to make sure their terms are completely consistent with their purposes.  

Control the derivative power. Sometimes, the legal owner of stock or membership interests may have the right to bring a lawsuit derivatively—that is, on behalf of the company—if the board of directors refuses. Often, the board itself and the officers are the target of such derivative litigation. Senior generation owners can control who will have this right in the next generation by controlling how ownership will be held. If stock or membership interests are held in a trust, then the trust fiduciary, not the beneficiary, holds any power to pursue derivative claims. Although a trust beneficiary might pressure the trust fiduciary to pursue such claims, the trust can be drafted to reduce the beneficiary’s leverage in such matters by directing the trustee not to pursue a claim absent direction by a court or even by penalizing a beneficiary who commences litigation against the trustees.

Require Alternative Dispute Resolution 

In some cases, owners of a family-controlled business may have legitimate disputes that can’t be resolved internally. However, it’s possible to require the disputants to pursue an alternative dispute resolution (ADR) through private binding arbitration, to hold down the expense of the dispute and prevent it from being dragged into a public venue. To be effective, ADR provisions should be included in virtually all agreements signed by family members with respect to the business, including stock subscription agreements, shareholders’ agreements, LLC agreements, employment agreements and other insider contracts. (It may even be possible to require binding arbitration in a trust agreement by use of a penalty clause for beneficiaries who don’t comply.) Such provisions may require a good faith effort at mediation before the parties resort to arbitration. In any case, ADR provisions shouldn’t be treated as boilerplate, but rather, should be carefully drafted to apply in all situations anticipated and to be enforceable without court construction. Such agreements can make protracted proceedings especially unattractive by allowing (or requiring) the arbitrator to award attorneys’ fees.