Matters Column

Using outside directors in your family business

May 25, 2018
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Publicly traded companies have boards of directors primarily comprised of outsiders. But how many owners of family or other closely held businesses think about, much less have, outside directors for their businesses?

The presence of outside directors in a family-held business serves several purposes, with the most important being to add value and perspective for management. Creating a board of directors comprised of outsiders provides the entrepreneur or CEO with a peer group with whom she can discuss the problems and issues of the business. Typically, a high level of confidentiality is associated with outside boards, further enhancing the value of the advice provided. The kinds of questions an outside board might take up range from investment decisions — such as whether to buy a new piece of machinery, develop a new product or open a new location — to personnel matters, such as whether to terminate a long-time employee.

The presence of outside directors can improve the decision-making process that occurs in the business. Whereas family members are less likely to challenge management decisions if the business seems to be running smoothly, outsiders force management to provide a more thorough analysis and justification of their decisions and strategic plans. This permits the outside board to act as a safety net to guard against poor decisions.  

The use of an outside board can help reassure the family member shareholders who are not active in the business that the business is not being run for the personal benefit of the active family members. For example, the board might set the CEO's compensation and approve the hiring or promotion of family members.

Outside directors can be instrumental in successfully transitioning the business to the next generation. They can encourage and support the development of a succession plan, guide the plan’s creation and hold all generations accountable for keeping the plan on track. If the senior generation expects that a child will eventually lead the business, the outside board could provide guidance as to the education, experiences and positions heirs should be exposed to in preparation for taking the helm. The outside board could also drive the effort to transition a senior leader who is reluctant to give up business control.

In order for an outside board to be useful to your business, selecting appropriate directors is critical. Although a natural inclination is to appoint "trusted advisers," such as the company's lawyer or accountant, these advisers typically have limited experience with management of operating companies. Family members also are not good choices because they lack the independence that is the basis for using an outside board. Similarly, golfing buddies or close friends can be poor choices due to their unwillingness to jeopardize personal relationships by telling management what it needs to hear. The need to discuss confidential financial data also makes it inappropriate to choose people associated with your customers.

Instead, it makes sense to choose people who can bring special skills, experience or perspective to the board. For example, the former owner of a business in the same or a similar industry may be an excellent adviser on typical business challenges. If the company expects to take on outside investment in the future, perspective and experience can be gained from an individual who served as manager of a company that raised significant outside capital. If the transition to the next generation is only a few years away, the former owner of a family business that transitioned successfully could provide important guidance to both generations. Keep in mind that candidates for your board should be able to attend regular meetings and have time to prepare in advance for them.

An important concern for those considering board candidacy is liability. Because of this, the outside board often serves only as an advisory board of directors, where the outsiders have no legal authority and their actions are nonbinding in nature. When the outside board is advisory in nature, it is a good idea to define in the bylaws the nature and role of the advisory board, to make sure the advisory board does not act on matters reserved to the legal board of directors (such as electing officers, approving loans and selling stock) and to ensure the legal board is properly constituted and elected, and meets and acts on matters as required by the Business Corporation Act.

When the outsiders will serve instead as members of the legal board of directors, the company's legal counsel should review the company's articles of incorporation and bylaws to ensure the board has the maximum protection from liability. In addition, management should investigate the availability and costs of directors and officers liability insurance (D&O).

Outside directors can provide a valuable service for closely or family-held enterprises of almost any size, even the small "mom and pop" business. Properly selected and utilized, the outsiders will offer valuable perspectives and advice to the business, making it much more likely to thrive in today's competitive environment and transfer successfully to the next generation and beyond.

Mark K. Harder serves as chair of the Private Client and Family Office practice at Warner Norcross & Judd LLP. He is a fellow of the American College of Trust & Estate Counsel and focuses his practice on estate planning for high net worth individuals and families, and succession planning for family-owned and closely held businesses. Mark can be reached at (616) 396-3225 or mharder@wnj.com.

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