Why are banks so fond of boards with independent directors? What is the big deal?
Actually, banks are interested for the same reason as minority and non-executive owners in a successful multi-generational family business. Independent directors with real fiduciary responsibility have an obligation to work in the interests of all owners; not just those running the business, not one branch of the family, but everyone whose capital is at risk – including banks.
In business school, it is called Agency Theory: the potential that managers of a business will make decisions that are better for themselves than for owners who don’t manage the business. Things like executive compensation and perquisites are often a concern for owners who don’t share in them. How can all owners be sure they aren’t paying too much to run their business? Would dividends and other distributions be greater if management didn’t spend so much on their “pet projects?”
These are the same issues that banks worry about. The Warwick Business School study I cited previously concludes that when businesses don’t have a strong corporate governance process with independent directors, banks react by imposing their own controls through more restrictive lending terms. Family owners who are not convinced their capital is being managed properly may attempt to impose their own controls by second guessing management and raising doubts with other shareholders. Sometimes their behavior becomes a strain on the cash position of the business if dissident owners want to be bought out.
At the very least, dissenting voices can disrupt family harmony.
“What real value can independent board members add to my business?”
This is a question often asked by our clients when we discuss corporate governance. It is a fair question when the owners of a successful family business are contemplating the creation of a fiduciary board of directors – why should they include non-family, non-owning, non-management, members with full voting rights? Of course, the right independent directors bring valuable, relevant business experience to your business. But, it can be argued that consultants and/or advisory board members bring that value without having to give them a vote. In other words, can we get their advice without being bound to use it in our decision-making process?
Good advice is always valuable but independent directors on a board designed to represent the interests of all the owners of a business have been shown to add much more tangible value. A study of 1,300 U.S. firms recently released by the Warwick Business School in England shows that banks loan on more favorable terms to businesses with independent directors on their boards. This study, done over a period of 13 years, shows repeatedly that as the number of independent directors on boards in these companies increased, the terms of their loan agreements with banks improved in the company’s favor.
The issue comes down to this: When there is an effective system of corporate governance in place, indicated by the presence of independent directors, banks have greater confidence in a firm’s internal controls and don’t feel they need to impose as much external control through their loan covenants.
How’s this for real value? A better relationship with your bank can yield a lower cost of capital in your business.
I often work with families that have major differences regarding the direction of the business they own but never openly discuss the varying opinions among themselves. The fear that bringing up any disagreement will be harmful to the harmony of the family, hurtful to the previous generation, or otherwise destructive to the business keeps important decisions from being made with all the information available. Limited input into major decision making processes always leaves a business vulnerable to out-of-date or short-term thinking. However, if conflicting ideas can be heard without destructive behavior, the result can actually be increased harmony because everyone has confidence that the final decision was made with all points-of-view and as much information as possible.
First, find as much in common as possible before there is a conflict. For families, this can generally be done by spending some time defining the values that have made it possible to have the great blessing of a successful business. What are the stories of grandparents and great grandparents that everyone finds inspiring and enjoys telling with regard to the success the family has enjoyed? What are the “truth sayings” that have been passed along within the family? How have these beliefs and values influenced the development of our business in the past? How can they be useful in today’s environment?
Second, people should not be forced to give up their individuality to participate in the blessings of their family business – they simply need to value the important things they have in common. When the day-to-day operating focus is on common principles that are important to everyone, differences can be accepted without the fear that “we no longer know who we are.” Grounded in the knowledge that they have a set of core beliefs in common, family members can listen to differing opinions and value all perspectives; talk about problems rather than people; seek common interests and develop “both/and” rather than “either/or” solutions as often as possible.
Yes, communication is the key but it must be respectful, caring, and carefully managed.
Family ownership is unquestionably the most frequent model of business ownership in the world after the initial founder. Yet, it is almost universally feared because of the perceived likelihood of internal conflict. Too often bright young people who grow up in the legacy of a business owning family reject the opportunity offered by their business because they are afraid of conflict with other family members.
I have encountered wonderful family-built enterprises where the parental owners sell their business out of fear that it will be the source of family conflict in the next generation. Some current generation owners attempt to create rules against next generation family members working in the very business they want to pass on as an inheritance.
Is this fear unfounded? Certainly not!
Conflict in a family is only natural and therefore, it is inevitable in a family business. Siblings in every family grow up attempting to distinguish themselves as individual members of the family unit. We don’t want parents, teachers, or friends assuming that we are just a “copy” of our brother or sister. The result is that we, as siblings, grow up emphasizing our differences and our families reinforce that behavior to assure us that we are valued for ourselves.
All good things, since it helps to produce independent and responsible adults. But, when siblings and cousins continue that behavior into their business relationships the results can be disastrous infighting and dysfunctional ownership. The challenge is to understand this behavior and accept conflict as a natural phenomenon. In other words, rather than allowing the fear of conflict to paralyze the future of a great family business we should instead embrace the reality of conflict and learn to manage it in productive ways.
Learn to accept our differences as strengths to support a growing enterprise that needs many different talents and refocus our energies on the common values that are also the legacy of our family.
This is part 2 of Dr. Baskin’s post on Continuity vs. Succession. Read part one here.
Continuity Planning differs from Succession Planning because it addresses the deeper issues of how ownership and governance issues will be handled in subsequent generations. While Succession Planning is generally about who will succeed YOU, current generation leader(s) of the business, Continuity Planning is all about how WE will go on together. As a family business transitions from first generation to second and third generations and beyond, success depends more upon a group process than a single leader.
Continuity Planning requires thoughtful preparation for the following questions:
Who will own the business in the next and succeeding generations? If the major transfer of wealth in an estate plan will be in the form of an operating business careful planning must be done to protect this engine of prosperity for the benefit of all owners. What will be the responsibilities and benefits of ownership? Whether the assets are transferred directly to members of the next generation or held in trust, those intended to benefit from this blessing must be prepared to be good stewards together.
How will the next owners make decisions together? When a generational transition benefits multiple owners (siblings or cousins) they need to be prepared to work together as owners and stewards for subsequent generations. An otherwise well-educated and business family that has relied upon the current generation to make decisions can disintegrate if they are not prepared to make decisions together. This is particularly true as families grow and all owners cannot or choose not to work in the business. The CEO must become accountable to ownership when he or she is not the sole owner.
What will guide the next owners? When parents are no longer able to provide guidance and counsel to the next generation where can this support be found? A clear understanding of the family values that made it possible for previous generations to build a successful family and business is critical. Having these values documented in a way that allows the current generation to continuously review them and apply them to their situation and time can provide a stable foundation for family harmony and business success.
Continuity Planning is also planning for good governance practices in subsequent generations. Providing decision making structures and processes that assure all owners, whether they hold an executive position in the business or not, that their interests are equally considered and their voice can be heard.
The most frequent issue that brings new clients to my practice in family business consulting is “SUCCESSION.” This is often viewed as the big question in a family business because so many are asking about it. Key non-family executives want to know who will be their next boss. Bankers want to know who will be responsible if something happens to the current leader. Customers and suppliers want to know who will be in charge in the future. Children working in the business want to know who is expected to step into mom or dad’s shoes. Other owners, both family and outside investors, want to know who will be responsible for decisions about how their capital/inheritance will be deployed.
As important as this question is, it really isn’t the biggest question for a family businesses. It is possible to do a great job of succession planning and miss the bigger point of Continuity Planning. I worked with a very successful and thoughtful family business leader who did a comprehensive job of succession planning. He involved all significant stakeholders in the decision including family, key executives, and outside advisory board members. While all four children had MBA degrees and excellent work experience, the search quickly narrowed to the two sons who worked in the business. When the next president was finally selected everyone, even the finalist not chosen, understood that the process was fair and based upon a set of objective criteria.
All went well for the new president through his first year at the helm of his family business. By the end of that year the business was booming and the factory was working double shifts trying to fill end-of-year orders. The new president had also promised his wife and four children that they could visit her parents for the Christmas holidays. As his wife pressed him for a firm date when he could leave for their holiday frustration grew because all the pressures at work made it difficult to set a date. One day his father was in the office and the new president shared his frustration. “I don’t understand your problem” was his father’s reply, “the company jet is at the airport and the pilot is on call – take it; that is what I would do.”
When the new president returned home from his holiday he had emails from his three siblings which read: “When it was dad’s company it was dad’s airplane but now it is our company and it is our airplane. (A good estate plan had gifted 80% of the shares to the four children.) And you owe us money for the private use of a corporate asset.” The new president understood, he was a CPA who knew corporate tax law. But his siblings were upset with him and his father was upset with the other children.
The real issue was that while their father had done an excellent job of succession planning, he had failed to address the deeper issues of how his children and grandchildren could own the business together and make decisions about the deployment of their jointly owned capital together? Addressing these deeper issues is what Continuity Planning is all about.
Often when working with clients to help them form or revamp a board we are faced with a list of qualifications that are strikingly similar to those of the current CEO: “a current president/CEO of a business in our industry with size similar to ours”. Of course the challenge is to find people meeting this description who are not direct competitors. It is easy to understand why an executive would want to have similar experience on her/his board. If the board understands the challenges and opportunities of a business it takes less time to inform them before a meaningful discussion.
However, when any group is composed of individuals who are too much alike Group Think can set in and diminish innovation. Group Think occurs when people are too comfortable with each other or too respectful of each other to challenge ideas. A “rubber stamp” board cannot test ideas in the crucible of critical analysis. Sometimes the very differences that cause us to spend extra time explaining an issue before we get to the solutions stage of a discussion can produce the most creative outcomes. Having intelligent, committed board members from different backgrounds can provide new ways of thinking about old problems. For example, the president of a company from a different industry whose customers, suppliers, or distribution channels are similar to yours may help you find alternatives your competitors don’t see. Different points of view help us to look at problems from a fresh perspective and can break the logjam of “we tried that before”.
OK, let’s just admit that productive people almost universally hate meetings – “what we do instead of doing something” is the frequent sentiment expressed to me. So, too often, the required meetings of corporate boards are simply “formalities” or sometimes an attorney’s creative writing exercise. I have had business owners tell me the primary reason they decided to organize as an LLC was to avoid the need for a board of directors. If board meetings are just a waste of time, why are they the center piece of any discussion of good governance in business? As with most things meetings are only as productive as the people who manage them. If the board chair manages the agenda, the discussion, and the action items well board meetings can be extremely productive.
If the board chair is thinking ahead to the next meeting well in advance the agenda and pre-meeting information can be distributed with enough lead time to allow everyone to come prepared. If the chair manages the discussion in a way that makes sure all opinions are expressed and understood but does not allow anyone to “hi-jack” the meeting for their own purpose both the quality of decisions and the satisfaction of members will improve. Rather than a time waster, good governance can be a time saver by testing ideas before they are implemented and avoiding costly mistakes.
So, if as we discussed in our last post next generation “heirs apparent” need real P&L experience how can this happen in a way that helps everyone develop confidence without putting the entire enterprise at risk?
The answer, of course, will be different depending upon the family and the business itself. But here are a couple of examples:
Some family businesses have subsidiaries where the P&L can be judged separately from the main business.
When family businesses decide to grow through M&A activity they may have the opportunity to allow a developing leader to take-charge of the P&L of a newly acquired organization for a significant period of time to prepare its operations to be better integrated into the parent company.
One great family I know found an interesting solution to what was becoming a bitter family conflict. Father and son were simply not able to work together and the tension was becoming unbearable.
The father was a “production guy” who had built great value in his business through innovation. Son was a “marketing guy” who saw that the national market in which his father had taken the company required a different approach to compete. The rest of the family believed this son was the right one to succeed his father at retirement but the father could not see that ability in his son.
When an opportunity presented itself to enter a different business in the same market as the family company the son pitched the idea to his dad. The father saw danger in integrating this new type of business into their proven business model but offered to finance a new start-up if his son would leave the family business and run the new enterprise.
The father’s motives may have been a combination of helping his son and relieving tension in the family and the company but it turned out to be a brilliant strategy. When the son’s company proved the success of the new business model over the next few years his dad was proud and began to see his skills in a different light. Today, the two companies have merged and the son has succeeded his father, “just the way dad always dreamed it should be.”
I am often struck by how difficult it is for brilliantly successful people to achieve their ultimate goal – seeing the business they worked so hard to build continue in their family. Sometimes the very person who has dreamed so many years that grandchildren and great grandchildren would be part of the enterprise that bears their family name becomes an obstacle to the dream coming true.
Some want to work until they actually die at their desk without considering the devastating impact such a cataclysmic event would have on their family and their company.
Others can’t see the necessary skills and business acumen in their children who are available to succeed them.
Both of these scenarios can sometimes benefit from adopting a form of the Nike slogan, “Just Do It”. Not to suggest recklessly delivering the keys to a Ferrari into the hands of someone with a learner’s permit. But it is equally unfair to accuse someone of reckless driving when you have never seen them behind the wheel. The ability to have the opportunity to prove your mettle in real P&L responsibilities is the crucible that will provide either the confidence for succession or reveal what needs to improve before succession occurs.
Too many apparent heirs to the leadership of their family business have never had the opportunity to develop their confidence and the confidence of others in their ability to assume real responsibility. When children are protected from the opportunity to fail neither they, their parents nor their siblings have enough data to develop the confidence necessary for successful succession.