Family Business Management 7-10

3 types of agency problems in family firms

1. Principal-Principal Problems (majority vs. minority owners)

2. Principal-Agent problems (owners vs. managers, often relatives)

3. Agent-Agent problems (power imbalances between different maangers)

Principal-Principal problems in family firms

when majority family owners act in their own interest at the expense of minority owners, through conflicts of vision, family feuds, and extraction of private benefits via executive compensation of tunneling

3 forms of principal-agent problems

1. Altruism overrides meritocracy and sanctions

2. Family managers pursue own interests against other owners

3. Family managers exploit information advantage (asymmetric information) at the expense of other owners

Agent-agent problems

one group of managers has more power than another, leading to undervalued decisions, unmotivated managers, and difficulty attracting and retaining talented non-family managers

Dividend fallacy

false belief that a family business must consistently distribute dividends, education among owners is crucial to avoid this and achieve professionalization of the ownership entity

5 principles of responsible ownership governance

1. promoting stability in ownership

2. designing structures for present and future

3. respecting internal communication

4. developing a shared vision

5. formalizing policies and processes

Why do firms need governance

bc of principal-principal, principal-agent, and agent-agent conflicts, asymmetric information, and limited effectiveness of traditional governance mechanisms in the family firm context

Why is the board of directors less effective in family firms?

less likely to be installed and when it is, it tends to be dominated by family members or other insiders rather than independent directors, limiting its monitoring effectiveness

Why is performance based pay less effective in family firms?

less likely to use it for family managers and there is limited willingness to offer shares to non-family managers, reducing the alignment of interests it is meant to create

Why is the threat of takeover less effective in family firms

strong ownership concentration and legacy concerns mean family firms are less vulnerable to hostile takeovers, removing an important external discipline mechanism

5 governance symptoms particular to family firms

1. favoritism/adverse selection

2. glass ceiling (top positions restricted to family only)

3. consumption of perquisites (using company money for private expenses)

4. non-financial goals overriding financial value

5. conflict among family owners over risk, dividends, growth

Active owner

comprehensive vision of family and business needs who participates constructively in ownership assemblies, challenges the status quo, and aims to preserve wealth while maintaining group cohesiveness

Obstructive owner

prioritizes personal interests over family and business needs, representing an obstacle to effective ownership governance and long term survival

intra-entrepreneurship owner

transgenerational entrepreneurship mindset who creates new economic, social and emotional value within the family business, embracing family cohesiveness and long term perspective

Passive owner

owner whose main aim is to receive dividends without working in the business

Purpose of an ownership assembly

discuss long term interests of the family business, control general progress, and agree on critical business issues - elect directors, approve transactions, define dividend policy

Shareholder agreement

private written document governing relationships among owners - defining ownership rights and responsibilities, share transfer rules, dispute resolution mechanisms, employment policy, dividend policy, succession planning

How does a shareholder agreement differ from articles of incorporation?

articles of incorporation are a public legal document formalizing the company’s creation with general governance rules. A shareholder agreement is private and deals specifically with relationships and rules among the family owners

Owner-manager/founder stage of governance

informal, driven by founder’s personal influence and mutual trust. Formal structures are costly and often unnecessary. Main challenge is managing the entrance of next generation into ownership

Main challenge in the sibling partnership stage

maintaining trust and cohesiveness among siblings, shareholder meetings, transparent communication a redefined shareholder agreement, clear employment policy and succession policy are all essential to reduce sibling rivalry

Main aim of business governance

to develop efficient cooperation between owners and managers and to create a firewall preventing family conflicts from harming business competitiveness, and business problems from affecting family well being and cohesiveness

Board of advisors

panel of experts who provide ongoing counsel and advice to a firm’s managers. Unlike a board of directors, they have no legal responsibility and give non-binding advice

Why is a board of advisors useful

family firm boards are often dominated by family members lacking arms-length independence (paper board). Outside advisors offset management shortcomings, supplement the paper board, and bring valuable business or governmental connections

Paper Board

Board dominated by family members who lack independence from management and cannot effectively monitor or challenge the top management team. Performing governance in name only

Board of directors

panel of individuals elected by shareholders to oversee management, represent owners interest, define long term vision and strategy, control management team, connect firm with its stakeholders

5 tasks of a board of directors

1. Control (oversee management and protect minority shareholders)

2. Service (advise and support strategy)

3. Network (connect firm with stakeholders)

4. Communication (ensure transparency across governance bodies)

5. Succession (support transgenerational ownership and succession planning)

What does it mean for a board’s contribution to be additive and distinctive?

Additive means the board improves decisions or reduces risks. Distinctive means no one else in the firm duplicates the board’s tasks - should not repeat the work of family or management.

2 dimensions used to classify board members

Family affiliation and Business affiliation

Quadrant I

Independent board members (no family, no business affiliation) and Owner board members who have ownership stakes but now family or business ties. Most important type of director

Quadrant III

Triple crown board members combining family, business, and ownership affiliations, and family-business board members who work in the business but not yet owners

Quadrant IV

Owner-business board members, owners who work in the firm but are not family and business board members (non-family executives whose effectiveness depends on if appointed on merit or to maintain relationships)

Decisive criterion for board membership in a family firm

Qualification and talent, not family ties. competence is the minimum requirement for any director, including family.

Why should firms avoid packing the board with family?

board grows as family expands, not all members are equipped to govern, they may expect board seats as entitlement and family issues can contaminate boardroom decision making

Recommended % of independent board members

25 - 35%. Too few reduces benefit of constructive task conflict, too many creates relational conflicts that undermine cohesion

Recommended size of board of directors

5-8, depending on ownership structure, business complexity, and current and future family size

Who should not be invited to the board

close personal friends, retired managers who may be obsolete, individuals sitting on too many boards, and competitors

Code of good corporate governance

written document developed by ownership assembly specifying board members’ rights, responsibilities, roles, internal decision-making processes, composition criteria, nomination procedures, operational rules.

How are board members evaluated

Peer evaluation, individual self-evaluation, annual group self evaluation. Results are discussed one to one between the chair and each director, with actions recorded for future reference.

What happens if a board member consistently underperforms

the chair may suggest they do not stand for re-election when their tenure ends.

3 options for board composition

1. family members only

2. outsiders only

3. mixture of family members and outsiders

Aim of family governance

to coordinate the family with the ownership and business entities in the best interest of shareholders and family, preserving the business across generations by guaranteeing family cohesion - emotional bonding necessary for long term survival

2 dimensions used to classify types of family cohesion

1. Source of cohesion (family oriented or business oriented)

2. Type of bonding (emotional oriented or financial oriented)

Family emotional cohesion

cohesion based on altruistic behavior - common story, shared actions, love that binds family, satisfying emotional and personal needs

business financial cohesion

based on selfishness and the coordination of financial and economic investments that guarantee each member’s economic needs, binding them through shared financial interests rather than emotional ties

Chief Family Officer

embrace all family members regardless of their roles in ownership, management, or the family entity - ensuring one shared vision and implementing actions that preserve family cohesiveness, esp. as the business passes across generations

Family meetings and their purpose

informal or pre-arranged events where family discusses, shares, and makes decisions about the family-business relationship. Their main aim is to maintain and develop family cohesiveness by aligning goals, recognizing needs, and setting realistic expectations

Should in-laws participate in family meetings

The most common practice is to open meetings to blood relatives over 18. No unified position on in-laws, depends on family culture and pros and cons.

4 roles of a family assembly

1. communication (informing ownership and management of decisions)

2. educational (teaching family members about being part of a business family)

3. socialization (preserving family legacy and developing transgenerational entrepreneurial spirit)

4. conflict-resolution (reducing tension before it spreads to ownership or business entities)

When does a family assembly replace family meetings

when # of family members increases and family meetings become inefficient - typically between 2nd and 3rd generations is when more formality is necessary

Family council and when it is needed

small group of family representatives (5-9 members) selected by the family assembly to handle operative and decision making tasks when assembly exceeds 15-20 members and becomes unproductive. Represents all family branches and generations

What is the family council responsible for

developing family constitution/protocol, preparing and proposing family policies (employment, succession, conflict-resolution), coordinating family-ownership-business relationships, and maintaining transparent communication with other governance bodies

Compare family meeting, assembly, and council in terms of size and formality

Family meeting: up to 7 people, low formality

Assembly: up to 15-20 people, medium formality, meets 2-3x a year

Council: 5-9 representatives, high formality, meets 3-9x a year

Uncoordinated family in terms of wealth management

form where control over family wealth stays entirely in family members hands with no coordination - no separation of family and assets. Each member has direct uncontrolled access, creating incentives to tunnel resources before relatives do

Fiduciary

Person who acts on behalf of others to manage their assets, first tier agent between the family and the second tier managers of the various assets.

Double-agency cost

when a first-tier agent (fiduciary) aligns their interests with second tier asset managers rather than the family owners, pocketing kickbacks(secret payments), acquiescing to managers(stops holding asset managers accountable), or imposing preferences against the owners interests

Embedded family office

model where the family appoints an existing trusted internal manager (CFO or accountant of the firm) to also manage the family’s personal wealth - serving two masters

Disadvantages of an embedded family office

• serving two masters creates conflicts; resources may be allocated by family-political rather than efficiency criteria

• fiduciary may be incompetent in certain tasks

• double agency costs arise

• family members may escalate demands for subsidized personal services

Single family office

distinct organizational entity acting as an intermediary between individual family members interests and the family’s assets - offering professionalized, dedicated wealth management. Typically warranted for fortunes of several hundred million dollars due to costs of 1-2 million a year.

Trust/foundation in wealth management

structure where a settlor transfers wealth to a trsutee to manage for a beneficiary according to pre-set instructions. The beneficiary gives up property rights and cannot monitor the trustee who holds actual ownership rights over the trust assets.

Wealth management trade-offs across the 4 structures

• Uncoordinated family: wealth dissolves rapidly

• Embedded family office: wealth preserved but vulnerable to family-political mismanagement

• Single family office: strong preservation but high administrative and governance costs

• Trust: maintains wealth with risk-averse management, but significant agency costs gradually deplete wealth over time

Overall objective of governance codes in family firms

To protect owners from themselves - establish checks and balances to prevent abuse of power or incompetence by owners, rather than providing one-size-fits-all-solutions

Why can’t family firms rely on governance codes designed for publicly listed companies?

because family firm governance problems differ fundamentally - shareholders are not anonymous, opportunistic directors are less common, and the key risks relate to family conflicts, altruism, and owner self interest rather than manager opportunism

Family constitution/protocol/charter

Written document that emotionally embraces family members to guide a shared vision and link the family, ownership, and business entities. It is not a legal document but a framework for maintaining trust, cohesiveness, and clear expectations across generations

4 general parts of a family constitution

1. introduction

2. family values and beliefs

3. family business principles

4. family business policies

What does the introduction of the constitution cover?

The purpose of the agreement, subject matter, its content, the parties who sign it, and the enforcement philosophy - explains why the family made the agreement and what it wants to achieve

Family values and beliefs section of constitution

the family’s guiding beliefs as a family and as a family business, ownership vision, business vision, and what they want to become as a group across future generations

Family business principles section

core issues of the family firm relationship including employment, ownership, business governance, top management succession, family governance, conduct inside and outside the business, and how the agreement can be amended

Family business policies section

specific and detailed regulations that define how principles are put into practice - the “how” of the agreement such as meritocratic entry criteria for family member wanting to join the business

3 purposes of a family protocol

1. foster the company’s successful development (succession, professional management)

2. maintain ownership unity (share transfer rules, minority protection, conflict resolution)

3. reinforce family strength (financial services for members, grooming future owners, aligning family and business interests)

benefits of a family protocol

• increases trust and mutuality

• Assures LT success

• increases transparency

• leads to professionalism and fairness

• increases verifiability

• increases commitment and cohesion

Limitations of a family protocol

• Does not solve all problems

• Existing issues must be resolved before drafting it

• Does not replace the need to address real conflicts

• has little value if family members do not speak openly

• sometimes it is better to tackle one issue at a time rather than the whole document

Ideal moment to develop a family protocol

Before conflicts arise - ideally when the business is consolidated and there are enough committed family members. It is much easier to plan for the future than to resolve present crises

5 stages of the family protocol process

1. initiation

2. formulation

3. approval

4. implementation

5. review

How long does the formulation stage take and what are the two approaches?

2-3 years.

• Slow approach discusses every issue fully in family/shareholder meetings

• Project approach uses a task force or external consultant to prepare a draft for group consideration - faster but less inclusive

Who should be involved in developing the protocol?

Ideally, 100% of family shareholders. If full participation is not achieved, majority should at minimum understand and accept the document. Consensus and unanimity are the goals.

How should votes on the family constitution be counted - per share or per person?

Usually per person, because in-laws and the next generation are important in the long term implementation of the policies established, and per share voting may exclude them.

Why is implementation of the protocol critical?

without implementation, the whole exercise is meaningless. Missing milestones signals a lack of discipline and commitment, eroding trust both within the family and between the family and those managing the business.

Why must the protocol include a review process?

family and business circumstances change over time. The review process determines whether proposed changes fill genuine gaps created by new situations or merely respond to individual personal interests

Difference between the family protocol and shareholder agreement

• protocol is an emotional and values-based document guiding family vision and cohesion, not legally bonding

• shareholder agreement is a more formal legal document governing ownership rights, share transfers, and specific governance mechanisms

Why is the process of developing the constitution as important as the document itself?

the process of discussion, negotiation, and consensus building helps family members understand their roles, obligations and responsibilities - building shared expectations and preventing future conflicts before they arise