Family Business Governance – Top 3 Lessons Learned

Family businesses permeate our economy and the business world.

According to a recent Forbes article, close to 80% of US businesses and 40% of the Fortune 500 are family-owned (a link can be found here).

Family businesses are a bit like snowflakes–everyone is unique. But they are also a bit like sausage making: You don’t necessarily want to know everything that goes on in the process.

These features of family businesses – individuality and messiness – are particularly prevalent in questions related to family business governance, since the makeup and temperament of individual families and their members can complicate business ownership.

As many readers know, corporate governance generally refers to the system of rules, shareholder rights, and oversight under which corporations are controlled and directed. Within a family-owned business, these complicating issues can be compounded by family-related questions around sensitive, and emotionally fraught issues like board representation, the ongoing and evolving role of the family in the business, and changing levels of ownership by non-family member outsiders.

Based on my own experience with family businesses, I believe there are a few rules of thumb useful for addressing questions around the governance process.

1. Beware of overconfidence – both in the managers and in the family

Humans are hard-wired for overconfidence, a fact which shows up in many academic studies. Daniel Kahneman, in his book, “Thinking Fast and Slow,” provides a good example:

For a number of years, professors at Duke University conducted a survey in which the chief financial officers of large corporations estimated the returns of the Standard & Poor’s index of the following year…the correlation between their estimates and the true value was slightly less than zero…the truly bad news is that the CFOs did not appear to know that their forecasts were worthless.
In addition to their best guess about S&P returns, the participants provided two other estimates: a value that they were 90% sure would be too high, and one that they were 90% sure would be too low…there were far too many surprises…more than 3 times higher than expected.

Managers and family alike are vulnerable to overconfidence.

Managers, whether they are family members or not, can have an inflated view of their abilities. Perhaps they seek excessive pay for poor performance, or underestimate business risks they are taking. Perhaps they pursue new business lines and “de-worsify.” Or perhaps they are “empire builders,” pursuing value-destroying acquisitions instead of returning cash to shareholders. The principal-agent problem is alive and well today, and managers have many incentives to act in ways that aren’t in the best interests of family shareholders.

Likewise, family owners often think they know best, and due to their “privileged” family ownership can be vocal and opinionated about it. In particular, they can become risk averse, seek to increase the dividend, or may limit management’s flexibility to maximize long-term value. It is often management, however, with their better flow of information and more relevant experience, that has the best insight into how to increase the value of a share.

2. Sometimes more structure ≠ better governance – consider culture

When a family has a concentrated economic interest in a business, family members can become fearful, especially when a firm grows and outsiders play a bigger role in the business. And fear sharpens the instinct to control. In times of uncertainty, families can have a tendency to think that, with governance, more is always better. “The family could get screwed. Therefore I want X, I want Y and, oh by the way, I also want Z.” Families can also view the business through a social legacy lens, which means emotions can run higher than they might with a purely economic ownership.

I have seen family members get caught up with lawyers who like to express things in extreme ways. “We have never, ever seen this [governance term] in a similar context,” or even, “this [governance term] is a death sentence for the family.” Yet on the company or management side, you hear the lawyers saying, “these are the most shareholder-friendly terms we have ever seen.” The family, fearful for their family legacy asset, focuses on all the ways the managers could possibly act in a self-interested fashion, and it begins to create wild scenarios.

While governance structures are useful, they have costs as well. Strong governance can reduce the discretion of managers, which is not always desirable. In some cases, excessive governance can set up an adversarial mindset between family owners and managers that hurts the business.

The solution? Take a deep breath. It’s easy to create a laundry list of “required” governance rights, but what is often overlooked is that public ownership models can be inappropriate in some cases and can destroy trust.

A recent article on corporate governance (a copy can be found here: http://www.gsb.stanford.edu/sites/default/files/38_Munger_0.pdf) by Stanford professors David Larcker and Brian Tayan, highlights this issue. In a quote within the article, Charlie Munger states it well:

“One solution fits all” is not the way to go. All these cultures are different. The right culture for the Mayo Clinic is different from the right culture at a Hollywood movie studio. You can’t run all these places with a cookie-cutter solution…A lot of people think if you just had more process and more compliance – checks and double-checks and so forth – you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust…Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.

This is especially true for family businesses, which have often succeeded due to family-based culture and ownership and are not well suited for a traditional public ownership corporate governance models.

3. Create formal structures for the family

Encouraging ongoing participation in governance of the family business can be a significant challenge.

Families can have a complex history and web of relationships. The family may be dispersed across geographies and generations, and have different levels of business experience, personalities, values, and views. When interactions become politically charged, or disagreements flare up, it is easy to alienate family members, especially younger ones, who may be hesitant to take part or get involved.

One way to address these challenges is through the application of thoughtful formal structures, which will involve all family members and help prepare them to be good future owners.

There are numerous traditional structures that can be useful. Formal family events, such as family assembly meetings, can help keep family involved and informed. A board of advisors can provide a forum for family members to play a role in the business, and can act as a stepping stone to corporate governance roles. A family council can interact with a corporate board, and act as a family advocate. The family can establish a constitution, which sets forth policies and a business or wealth preservation mission, and provides unifying values for the family.

These family governance structures provide the family a framework that, while focused on the family independent of the business, strengthens a connection to the business and facilitates future decision-making.

These are obviously just a few of the issues involved in the complex and well-researched discipline of family business governance, but we hope these three rules of thumb generate some useful thinking among the family business owners out there.