Topics of Family Business Governance

This booklet covers the most important topics in the governance of family enterprises.

Governance is one of the buzzwords in modern management. There are many articles, commission documents, and legal stipulations to define the system of governance in public companies. In the realm of family business, there is almost complete flexibility to design one’s own concept of governance which fits in with the needs of the owners and the management. There are many concepts categorizing and specifying the various types of governance prevailing in family businesses. Here we try to work out the common features of all advising boards. To this end, we describe the essential issues which typically emerge in the discussions of a board from time to time. These are topics such as:

There are many approaches to define the essence of corporate governance. For us, the most comprehensive and plausible description is given by the French philosopher Michael Foucault: Governance as leading the leadership of the organization. Each president, CEO, top management team needs to report to someone or an institution and needs to be monitored and evaluated. This is what governance is designed for.

Both China and Germany have the legal concept of a two-tier board. Whenever in Germany one is not satisfied with the performance of a board in general, then the question arises as to whether the one-tier concept is preferable.

We have emphasized that the topics and processes of the governance work are decisive for the beneficial effects of governance. The processes take place within a certain structure which is specific for almost each and every family enterprise. The structure is deliberately designed, is defined in the by-laws, and cannot be changed easily. Thus, we have to see the processes within the context of a certain structure. Therefore the “how” and “why” of defining the structure is of the essence. Let us try to give an answer in the form of an annotated checklist.

Governance is typically associated with larger organizations. Our question here is whether governance is needed also for the lone founder in the first generation. One can counter this proposal with arguments such as: “the scope of activities is too small” and “as the founder owns all the shares, he or she will be autonomous in their decision-making, anyway.” The risk is to establish a rubber-stamp board only whose task is merely to wave through the proposals of the CEO.

The decisive instrument for steering the advisory board meeting is the agenda with its agenda items.

Governance means monitoring as well as advising. In both tasks, one needs to understand the situation and the challenges. The non-executive board members can and even should not be directly involved in the activities of the organization. And further, they meet only on a quarterly or bi-monthly basis. Thus, all the judgment they can provide is based on indirect information that is prepared for the board meetings. Indirect means that the data and their evaluation is provided by a reporting executive. He or she is the mediator between the “reality” and the picture of the reality which can be seen and interpreted by the board.

Each board has three main tasks: (a) The competence to select the executive team and to manage the contractual relationship with them; (b) Supervising the activities and monitoring the performance of the executives; and (c) Advising the executive team. Supervision is typically an evaluation in retrospect. It does not influence the supervised action anymore. Advising, however, is an influence that precedes the final decision process. It can be of specific value and is therefore of high importance.

In the overall context of governance, it is the responsibility of the full-time executive team to come up with ideas of what to do. The executives assume the responsibility for analyzing all factors which are relevant to the assessment of advantages and risks. Now, what can the contribution of the external members of a board be? This question refers to the chairperson, too, if he or she is external or no longer fully engaged in the business operations.

A board’s oversight and guidance, based on the expertise, experience, and personal qualities of its members, have always helped drive business success and survival. But now, as the COVID-19 pandemic shakes societies and economies around the globe, boards play an even more critical role. Companies that can tap their boards’ crisis mitigation skills will likely have an edge over companies whose owners do not recognize the board’s potential or cannot encourage board members to step up.

The starting point of any strategic thinking is the question. “What are the needs of my company?”—or even more focused: “Which is the need of utmost importance?” The result of the analysis is the “agenda,” the action program for the next 2–3 years entailing the gross assessment of capital investments required. Specifying the needs is the most important phase of strategizing. Otherwise one runs the risk of working with a high concentration on secondary tasks. This would mean spoiling the most valuable resource: Management time! There are just four broad categories of needs in a company which have a clear ranking of their priorities. (1) Is the company and the owner group stable? Is our financial base stable? Are the shareholders loyal to the company or are we plagued by conflicts or facing an unsolved succession phase? (2) If the company is a fairly stable organization, then the next question is about the sustainability of the whole business line or industry or our specific business model. (3) Only if this stability can be assumed, can we address the normal strategic questions. Here again we have to ask first whether the company earns enough. (4) And if the earnings are sufficient the final question is to be explored: How much growth can we accomplish and where can we find the growth opportunities? In the following section, we reflect on those basic questions.

It is a mandatory element of the monitoring function of governance to review the profitability. Not only the profitability of the whole enterprise but also of its individual business segments. This review is essential both when the overall profitability is excellent as well as when it is insufficient. Without knowing the root causes of good profitability the board would not know which key conditions need to be met in order to continue the high profitability. Thus, in good as well as in bad times, profits are of the essence. Let us review what the key issues are in such a monitoring process.

One of the issues which is included in the annual agenda of each governance process is the capital investment program. There are several reasons why capital spending is regularly reviewed in any company. First, capital investment is a major element in the financing of the company. Safeguarding the permanent financial stability is one of the overriding priorities in the governance process. Second, the direction of the future development of the enterprise is reflected in capital investment projects. There are no significant productivity improvements or no major growth initiatives without related capital spending.

Innovation is the driving force for the successful development of the family enterprise in a dynamic economy. All important aspects of the business strategy have to be “somehow” included in the agenda of the board. The question is: what can the nonexecutive board members contribute to this discussion and what should, therefore, be the details of the board agenda? We visualize the situation of a normal board with a good portion of nonexecutive board members and the duty of supervision as well as advice. It should be noted that among the German family enterprises we are finding more and more “Strategy Boards.” This strategy board is not involved in the supervision or the approval of annual reports or financial transactions. The strategy board acts parallel to the supervisory board. It deals with topics of strategic interest to the management and/or the owners of the enterprise and contributes its advice to those decision-makers.

There are many old companies who can look back on a colorful past, starting with a small craftsman’s shop, a pharmacy, or as a self-employed merchant. All of these companies have one thing in common, they all started small and have developed into a long-lasting family business. In most of the cases, the second generation started to establish organizational structures, after the pioneering innovation of the founder. We would like to explore the challenges of the second generation from a practical/action-orientated perspective. What are the development requirements of the next generation concerning the business growth in the different stages of the enterprise? In order to understand these requirements, our team has conducted comprehensive studies of the 350 biggest industrial family-owned businesses in Germany with a special focus on the transition from the first to the second generation.

We assume that each real family business owner has the vision to transfer their business to the next generation. Transferring it as a viable business and as an independent company capable of finding its own way to the future. What could prevent this vision from becoming reality is not earning less than the market leader. The risk is not posed by investing so much in good assets or in the infrastructure of a business that the Return on Capital Employed is reduced. The risk which could lead to the downfall of the company is posed by mistakes; a series of minor mistakes or one big mistake made by an already weak organization. Thus, the first priority to secure sustainability is to avoid big mistakes. We have statistics on the causes for the downfall of businesses: The top reasons are categorized as “management failure” or “lack of liquidity.” These explanations are not instructive. They are too general. Which are the root causes preceding these consequential events?

Most of the topics of governance covered in earlier chapters were related to the positive guidance of the business operations. There is however an additional, completely different, reason for governance: To avoid wrongdoing, the violation of laws, damage to stakeholders, to the civic society or to nature.

All over the world, companies prepare a budget for a new business and guess what the business activities will be like next year. Strangely enough, we tend to assume that starting a new year will not alter anything. What should change between December and January? Hardly anything! As a matter of fact, however, there are always changes imminent in the markets of any business. In this context, seasoned owners and their managers are analyzing if and when we will face an economic slowdown again. Of course, we do not know when a recession will come. But we do know that we will have a recession again as we have had in the last 150 years of industrial development. And we took it for granted that we would see the next recession by the end of 2018 or earlier. How did I know? Because every generation during the last 100 years has had the experience that there was a recession within a period of 10 years—of course with the exception of the war periods. In Europe, the end of the previous recession periods was 1984, 1994, 2002, and 2009. 2001–2002 was a very mild recession—most likely because exports to China were already helping to balance the demand. The recession of 2008–2009 was a very deep, but at the same time very short, recession, due to the substantive infusion of money by Central Banks and Governments all over the world. And 2019 the next recession just within the 10 years cycle was due, but it was 2020 that the COVID-19 crisis hit the world economy. This pandemic caused a downfall by itself. The normal recession came afterward.

In one of the preceding chapters, we covered the “financial planning” for the mature enterprise. Even there the financial planning and strategy is a function of high importance. Here, we talk about financing the young enterprise in the first half of the first generation. In this phase, financing is of utmost importance: Financing can be decisive for survival. Why? The overriding phenomenon during the first generation is growth. The founder started a small business, a very small one. It can grow and has to grow at a high rate. Otherwise, it will not be sustainable over the generations—and then there is nothing left to analyze. To be able to grow at high rates of more than 10%—up to even 20 or 30%—one needs a high growth of the equity. In a family enterprise which wants to maintain its independence, this growth of equity can only be sourced from retained earnings. And for high retained earnings, one needs high profit rates to start with. For a 20% growth rate, one should have around 15% on sales. But this is only the basis for being able to raise loans at the rate of the growth rates—year on year. No easy task. To cut a long story short: Almost each and every founder of a business is in a constant financial squeeze. Therefore, financing is a topic which has priority on the agenda of a board for a first-generation business.

We emphasize that a governance board with non-executive members of the board is a safeguarding instrument. The functions of the advisory role as well as the risk evaluation and approval are highly important when dealing with a request to launch an acquisition of another company. The non-executive members, however, have to carefully balance scrutinizing a proposal for hidden flaws against encouraging the management to pursue promising projects and accepting justifiable risks.

In some family enterprises, the question arises of whether going public could be a strategic option to support the development of the company. This is an issue that has to be dealt with by the shareholders only. However, this is a unique decision situation and the shareholders do not have any experience of their own as to the consequences of such a strategy. Therefore, the shareholders need advice. There are quite a few professional advisers on such an issue: investment bankers, lawyers, tax advisers, and others. There is hardly any professional who provides advice on the advantages of not going public. The role of the board could be to make sure that the shareholders get a full picture of the trade-offs in the prerequisites and consequences of an IPO, specifically in the long term. Such a checklist on the full picture should include the following criteria:

The calibration of the dividend policy is an issue in almost all family-owned businesses. Perhaps less so in the first generation, but more so in the second or subsequent generation. The challenge is to find reasons for distributing profits at all and if so, to define the extent of this generosity. In this endeavor, the interests of all stakeholders have to be taken into account.

Successors in a family business must often come from the ownership group and the more responsible and better trained the pool of potential successors, the better the selection will be. Responsible owners will value the family business and the family group over individual interests and support those solutions and successors selections that are most conducive to the long-term survival of the family business.

Executive development is a key task for ensuring an organization’s future. In family businesses, we sometimes see that the major topic of CEO-succession planning overshadows the issue of developing future executives in general throughout the organization. But no matter if the business is led by one sole leader alone or—as is becoming more and more common—by a team of leaders, all key positions require continuous attention. Regularly reviewing the organization chart, discussing crucial roles, as well as identifying and developing key talent are of utmost importance.

When asked to describe how German business owners and their families “organize” the succession, the first comment to be made is: The pattern has been changing over the past two generations significantly. The concepts for the transfer of ownership can only be interpreted against the background of legal regulations and cultural traditions. In the nineteenth century, one standard concept for the transfer of any businesses was: The ownership of the whole company or at least the majority of the shares was transferred to the eldest son as a matter of course. Thereby the business owners copied the will practice of many noble families. The transfer to the eldest son was a common practice among noble families for generations—however only in certain regions in the world, i.e., Northwest Europe and Japan. In these regions the power of the noble families was based on the size and productivity of the farming estates belonging to the area they ruled over. It was necessary to maintain the productivity of the farms by avoiding the split up of the land among many heirs. In other regions, different practices prevailed. In Russia and India, all sons were the heirs of land and business. In the Arabic region, all descendants had to share the assets. Also in the countries which had to assume the law of the French emperor Napoleon (Code Napoleon), it was mandatory that the assets of a family were transferred to all children in equal shares.

The board should naturally be involved in preparing the succession in the leadership of the family-owned enterprise. Either the board is the authorized institution or, in a case where the authority is withheld by the shareholder assembly, could advise this assembly on such an important decision. If a family member is qualified and willing to assume the succession then he or she will have the preference. But then the “how,” the preparatory steps, and their timing, still need to be reviewed. To this end, one should reflect on the entirety of competencies a beginner in the profession needs to acquire as an aspiring executive and owner of a family business.

In succession planning, the senior shareholders have, for various reasons, a clear preference for a qualified sibling or a team of siblings. If there is no successor in the family who seems to be qualified to manage the company, the senior will not choose him or her for two very good reasons. The overriding priority of the owner is first to safeguard the sustainability of his own life achievement, the company. If the person’s own child does not seem to support this aim, he will—as a typical entrepreneur—look for an option that solves the problem. The second reason might be even more important. Managing a business is a responsibility with enormous stress potential which requires robust health and self-confidence based on competence. Being charged with such a responsibility without the necessary resources poses a risk to physical and mental well-being. Each father or mother will try to protect their offspring from such a risk.

A professional executive needs to be searched for. Regularly the senior entrepreneur is the one who has to plan and execute such a project. In doing so, this person has to solve two issues in which he or she does not have their own experience.

In all professional vocations, it is usual that more work generates a higher income. The medical doctor, the lawyer, the architect who works more will write more letters of liquidation. However, these invoices are not—at least in Europe—linked to the specific result of the professional involvement. This is not considered necessary as it is taken for granted that the professional will work to the best of his or her ability in the interest of the client.

A family business is firstly a business which is secondly owned by a family. The destiny of the family and the destiny of the business are intertwined—for better or for worse. One has to accept the destiny, has to make the best out of it, but cannot change it by willpower. A businessman needs a lot of luck in his destiny.