Corporate Governance : Family Owned Business

What is Corporate Governance?

• Corporate governance refers to the processes, structures, policies and laws

that govern the management of a company.

• It also refers to the way the Board oversees the operations of a company and

about how board members are accountable to the company and its

shareholders.

• Companies with sound corporate governance usually perform better than other

companies. Good corporate governance results in:

• Better access to external capital

• Lower financing costs

• Higher credit ratings

• Strong investor confidence

Corporate Governance in India

Corporate governance introduced by SEBI vide special provision – Clause 49 of the listing agreement

Applicable to all listed companies

Core concepts of corporate governance—equity, transparency, faith, and accountability

Oriented to shareholders

To ensure that a company adopts ethical, fair and transparent practices across its entire value chain and in all its dealings with stakeholders and outsiders

Introduction and meaning Objective

Current industry perception

Corporate governance equated with control and compliance;

At best with reporting, transparency and ethics.

Not as a core management process benefiting all stakeholders

Highlights of Corporate Governance for listed companies

Mandatory for all listed companies

Composition of board of directors

Board procedure, Code of conduct, Audit committee, Meeting of audit

committee, The powers of

audit committee, Role and review

of audit committee, and

Disclosure requirements

BOD should have optimum combination of executive and

non-executive directors

with not less than fifty percent of the board of directors comprising of non-executive directors.

MandatoryMinimum 3

directors, 2/3rds of whom shall be independent directors

meeting should be held 4 times a year

ensure compliance of internal control system

review the financial statements

To audit committee -Basis of related

party transactionBoard disclosure

on risk management

Proceeds from IPO

Remuneration of Directors

1)M D &A, in the Annual Report should include

Industry structure & developments. Opportunities and Threats.

Segment–wise or product-wise performance.

Outlook. Risks and concerns. Internal control systems and

their adequacy. Discussion on financial

performance with respect to operational performance.

Material developments in Human Resources / Industrial Relations front, including number of people employed

2)Report on Corporate governance by the BOD in the annual report

Applicability

Scope

B O D

Audit Committee

Disclosure Reporting Requirements

Filing

To stock exchange–

File Quarterly audited/unaudited results

Clause 49 of the listing agreement

True Corporate Governance

Moving beyond investor

protection

Creating stakeholder value through

transparent, efficient and effective practices

What are family owned businesses?

• There are different definitions………

• Family owned businesses are companies …

– … where the dominant shareholder is a family member (broad view)

– … which are run by heirs of the people previously in charge, or by families that are clearly in the process of transferring control to heirs (narrow view)

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Facts & Figures

• Family Controlled businesses carry the weight of economic wealth creation in most economies.

• U.S. alone, family businesses account for 80 to 90 percent of the 18-million business enterprises in the United States, and 50 percent of the employment and GNP.

• In India family controlled business are 85 to 90 per cent of total corporate entities which contributes 75 per cent of employment, 65 per cent of GDP and 71 per cent of market capitalization.

• Rapid growth and globalization has increased risk level for family businesses to run and survive for long life

Family Businesses – A Vital Part of the Economy

• Family businesses are the backbone of many economies around the world. Their sustainability is critical to global economic growth.

• In the Middle East region, they account for 95 per cent of all private sector companies

• Almost 80% of Indian businesses are either entrepreneur driven or family-owned-and-managed. Predominantly small and medium in size, these businesses are the backbone of Indian economy with considerable contribution to GDP.

• History of Indian businesses indicates that majority of prominent business houses like Tata, Birla, Bajaj, Walchand, Modi, Thaper, Dabur et al.

Strengths of family owned businesses

• Strong set of values: Identity

• Long-term view in decision-making: Consistency

• Possibility of unconventional strategy: Flexibility

• Desire to build a business for future generations: Sustainability

• Commitment of family management to their company: Continuity

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Family Support is indispensable

Financial entanglement harms both family and business

DISADVANTAGES Personal assets at risk Company is perceived as unprofessional by

employees and others. Difficulty in attracting employees or partners

Financials are not trusted leading to lower valuation and more difficulty in funding

Difficulties in scaling

CLOSE ENTANGLEMENT

FAMILY RUN BUSINESS

Moving to Governance Culture

Family run

business

Disentangle

Build ethical

practices

Some sacrifices/Sufferings

Good business

governance

 Why Corporate Governance is Crucial for Family Firms?

• Managing Growth

• Succession Planning

• Preserving Family Harmony

• Recruitment and Promotion

• Ensuring Fairness

Organizational life-cycle of family businesses and their changing governance needs 

• Family businesses evolve and mature through three main stages in their life-cycle. As the complexity of business increases from one stage to another, so does the need for formal governance mechanisms (Ward, 2007).

STAGES

CONTROLLING OWNERSTAGE

SIBLING PARTNERSHIP STAGE

CONSORTIUM OF COUSINS

Driven by stewardship values/principles

Ownership and management may rest in many hands as children have taken over from parents. business needs are to be balanced with the needs of several families.

Diverse ownership and management and hence calls for formalized governance structures to strategize for the long-run as well as to maintain

• A typical family constitution comprises of:

Values, mission statement and vision as core value for business. Board of directors / Board of trustees. Executive management. Authority, responsibility, and relationship among the family, the

board, and the senior management. Solution in the case of conflicts. Policies regarding significant family issues such as family

members’ employment & transfer of shares, succession planning, Chairman tenure and nomination, etc.

Family Constitution

• Most family businesses don’t have a appropriate constitution

• They usually have an informal set of rules and customs that determine the rights, obligations, and expectations of family members and other governance bodies of the business.

• With the growth of family business, it becomes crucial to develop a written and formal constitution that is shared among all family members to shun the conflict among family members.

• Family governance structures and institutions require a certain degree of formalization if they are to function well.

• As families adopt policies on the family’s approach to the business and on governing the business, they will formalize these efforts with documents that will differ depending on their ownership stage.

 

ISSUES AND THEIR SOLUTIONS

OWNERSHIP AND CONTROL ISSUES

• The most important feature of family-owned enterprises is the lack of separation of ownership from control, which blurs the essential distinction between directors and managers.

• Combining these functions may lead to serious credibility problems as there is no real system of checks and balances within the corporation (i.e. between shareholders, directors and managers).

• One of the consequences of this problem is the absence of governance systems in which the duties, responsibilities, and rights of family members are clearly defined.

• According to a McKinsey & Company survey of 2002, only 15 percent of family-owned enterprises survive into the third generation.10 This problem is compounded by the fact that in most family-owned enterprises, the family 'block' has the requisite voting power to unilaterally dismiss boards or management at a moment's notice.

• Thus the concept of independent directors may not, on its own, prove useful for family- owned enterprises. Instead, there must be a change in mindset; the directors and managers of family-owned firms should be encouraged toward self-discipline and professionalism through training and education.

 

CEO DUALITY

• Same person occupying the roles of CEO and board Chair (Braun & Sharma, 2007).

• Researchers have used agency and stewardship theory perspectives to examine this issue.

• Stewardship theory advocates unity of command at the top and authoritative decision-making under the leadership of a single individual and hence CEO duality.

• Agency theory supports non-CEO duality as separation of the roles of CEO and board Chairman enables greater scrutiny of managerial behavior. Advocates of agency theory argue that managers are economically rational self-utility maximizes and hence the need for internal monitoring mechanisms to keep a close watch on their activities and to prevent them from indulging into opportunistic behavior.

• Since the CEO duality reduces the monitoring abilities of the board, it is thus advisable to have different persons occupy these two positions (Lane et al., 2006; Braun and Sharma, 2007).

SUCESSION PLANNING- ISSUE

• The issue central to succession planning is the ‘agency relationship’ in which family owners are hesitant to relinquish control of the enterprise to outside managers (i.e., their agents).

• This issue also forms the distinction between family and non-family corporations. In nonfamily entities, independent boards and good corporate governance practices create greater transparency and accountability in the interest of stakeholders, while family enterprises may face more challenges in this area.

SOLUTION

• The key to successful succession planning is professionalism and selection criteria based on merit.

• Established eligibility rules: These clearly define when and under what circumstances family members (including children, grandchildren, cousins, siblings, and other relatives) are welcome to work in the business.

• Education and experience: Educating young family members is essential for succession and is enhanced when coupled with outside work experience in similar businesses.

• Roles and responsibilities: These rules outline what happens when family members join the business, specifically determining if a family member will fill a vacant position or if one would be created for them.

• Performance evaluation: There must be a single set of job criteria for both family and non-family employees.

A merit-based system should be used for the monitoring and evaluation of all employees. A board committee on human resources should comprise both family and non-family

member in order to ensure continued evaluation on merit based criteria.

• Compensation: Salary and benefits should not be discriminatory and must consider that family members are also compensated by other means such as dividends.

• Ownership: Inequitable distribution of shares may lead to conflict amongst family members. There should be an agreed-upon system for share distribution.

BOARD

• A Board needs to take independent/unbiased decisions; they are the 'trustees' of the

shareholders, especially the minority - entrusted in providing transparent data, taking decisions in the best interest of the 'shareholder'.

• In a family business, very often, the Board consists of mostly family members - often those who are there by name, but don't understand or aren't made to understand their duties, or what the business is all about. Sometimes outside members are selected by the owner/entrepreneur as 'rubber stamps' - people who rarely disagree or question the owners thought process or decisions.

• Solution- A balanced board: A board with with equal number of (inside) executive and (Outside) non executive/independent directors brings diversity of opinion to the table, which facilitates an objective decision-making through constructive debate and dialogue on all matters of concern. For the two groups to work effectively together, each has to value the contribution of the other. 

Moody’s Survey of corporate governance in family owned businesses in India

• The survey covered 32 companies in 16 prominent family groups, covering a broad cross-section of Indian industry. Besides the top three corporate houses (the Tatas, the Birlas and the Ambanis), the survey also included companies belonging to Godrej, Vedanta, Wipro, Essar, Bharti, TVS and Muruguppa groups among others.

• Despite regulations regarding independent board directors, families retain significant control over listed companies. As such, the difficulty in ascertaining the true independence of directors is a big corporate governance challenge. 

• There are potentially negative credit implications like adaptability, leadership transition, checks and balances, transparency etc. "Also, the prospect remains of higher leverage as families try to maintain control, while implementing their often aggressive growth plans

Companies Bill, 2012 -INDEPENDENT DIRECTORS

• Companies Bill, 2012 , Schedule IV lays down Code for Independent Directors

• Role of Independent Director Safeguard the interests of all stakeholders, particularly the minority

shareholders Balance conflicting interest of the stakeholders• The Bill lays out that Rules will prescribe a minimum number of

independent directors on board. • Many of Indian companies are run like a family managed companies;

they are not used to outsiders being on their Boards and this is going to be a profound change in the way some of the closely held companies are going to be managed going forward. 

10 Rules

Don't put family members on the payroll if they're not working in the company

Don't create two classes of employees—family vs. non-family

Don’t abuse family relationships

Don't keep it a secret if your relatives are working for you

Keep Family decisions and business decisions separate

Use family councils to address family matters

Separate functions of ownership, control and management

Create family offices to clarify the boundaries between the family’s and company’s accounts

Develop the skills and knowledge of heirs so they can become responsible owners, as they can assume various roles as an owner, director or an employee

Communicate honestly and openly with employees.

Conclusion

• McKinsey's emerging market investor opinion survey of 2001 proposed that family- owned businesses are the most significant players in emerging markets, and that their presence and input must be explicitly recognized by all concerned.

• The survey further suggested that in order to implement corporate governance practices in emerging markets, it is necessary to provide greater incentives to family- owned businesses to enable them to share in the benefits of reform.

• One such incentive might be access to external equity financing.

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• For the family-owned business, good governance makes all the difference.

• Family firms with effective governance practices are more likely to do strategic planning and to do succession planning.

• On average, they grow faster and live longer.

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