For a family business to provide financial security for current family members and future generations, the company must have strong governance. It starts with the initial organization (or reorganization) of a business into a corporation, partnership or LLC. This article focuses on the corporation, which is required by law to have a board of directors and officers and to observe certain other formalities. The article also looks at estate planning strategies, including having a well-designed buy-sell agreement.
A successful family business requires strong governance
When siblings George and Caroline took over the family’s furniture business after their father’s death, they viewed the company only as a means of gaining additional wealth. This single-mindedness led to a series of missteps — failing to hire competent managers, overpaying themselves and underpaying other employees, and not holding “insiders” accountable in the same manner as outsiders — that ultimately doomed the business.
The takeaway from George and Caroline’s story is that, for a family business to provide financial security for current family members and future generations, the company must have strong governance.
Begin with the business structure
Good governance starts with the initial organization (or reorganization) of a business. For the sake of simplicity, we’ll focus on governance issues in the context of a corporation, which is required by law to have a board of directors and officers and to observe certain other formalities.
Other business structures, such as partnerships and limited liability companies (LLCs), have greater flexibility in designing their management and ownership structures. But these entities can achieve strong governance with well-designed partnership or LLC operating agreements and a centralized management structure. For example, they might establish management committees that exercise powers similar to those of a corporate board.
For a corporation, the business’s articles of incorporation and bylaws lay the foundation for future governance. The organizational documents might define and limit the authority of each executive, establish a board of directors, require board approval of certain actions and create nonvoting classes of stock to provide equity to family members who aren’t active in the business but without conferring management control.
For many family businesses, governance concerns don’t arise until the business passes to the next generation. When a founder remains active in the business and isn’t ready to cede control to a board, it may be appropriate to delay implementation of certain governance practices until the founder retires or dies.
Seek an independent board
Whether it’s part of the business’s structure from the beginning or implemented when the founder leaves, an independent board offers several important benefits. Outsiders on the board provide an objective voice on management issues and owners and managers can tap their expertise on financial, operational, legal or other matters.
To establish an effective board, the business’s organizational documents should clearly specify the number of independent directors, as well as the length of their terms and the mechanism for electing them. Staggered terms help provide some continuity and stability to the board. And cumulative voting can help empower minority owners by enabling them to combine their votes to elect one or more directors.
Use estate planning strategies
Careful estate planning can ensure that a family business continues to benefit family members and that ownership of the business isn’t diluted — at least until the business is ready to accept outside investors. For example, a well-designed buy-sell agreement can prevent owners from transferring their shares outside the family, while providing the liquidity they need to exit the business. And prenuptial agreements can prevent married owners from losing a portion of their shares in a divorce.
Owners’ estate plans should use trusts or other mechanisms to restrict the ability of their heirs to transfer shares. If shares are held in trust, however, it’s important to include mechanisms for providing beneficiaries with a say in the business’s affairs — particularly if they work in the business.
Implement strong governance practices
A successful family business is an excellent means to provide financial security for the founder and his or her loved ones as well as employment opportunities for interested family members. However, the company must be run professionally to ensure its future success. Your estate planning advisor can help implement governance practices in your business, estate and succession plans.