Corporate Governance for Private Companies – Part II

In my last post I discussed some of the ways that companies contemplating an initial public offering or a possible acquisition by a larger firm (so-called “pre-IPO/pre-acquisition companies”) can use strong corporate governance practices, particularly readiness to comply with the Sarbanes-Oxley Act of 2002 (“SOX”), as a means of demonstrating additional value to potential investors or acquisition suitors.  However, as I mentioned in that post, private companies come in all sizes and formats and the benefits of improving corporate governance are not limited to pre-IPO/pre-acquisition companies.  For example, companies with multiple stakeholders, including outside investors, commercial lenders, strategic business partners and/or governmental customers, can follow SOX requirements to demonstrate sound business practices and build credibility with all of these interested parties.  In addition, closely held businesses (i.e., companies with a small number of shareholders and no immediate plans for an IPO or exit via acquisition) can nonetheless use SOX as a roadmap for improving operational efficiencies and preparing for possible changes in long-term strategies in the future.  Finally, family-owned businesses can follow SOX recommendations pertaining to independent directors and internal controls as a way to establish an environment of fairness and transparency within the company.

This article is adapted from material in Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

There are a number of very large private companies active in the United States, and many of these companies have a broad and diverse family of stakeholders beyond the core ownership group that is actively involved in the day-to-day management of the business.  For example, private companies may have a number of outside investors, often sophisticated professionals with a healthy appetite for information regarding the operations of the company.  In addition, private companies generally have to deal with the requirements imposed by their commercial lenders, and larger companies may be dealing with a loan syndicate that includes several financial institutions that have agreed to underwrite a portion of the credit facilities available to the company.  Key business partners, including major vendors and customers, have a stake in the business continuity and financial strength of the company over an extended period of time.  Finally, certain “special interest partners,” such as government agencies that purchase goods and services from the company, may have a keen interest in the company’s internal controls.

Private companies with multiple stakeholders are well advised to focus on improving their internal controls and business processes.  Among the steps that can, and should, be taken are formalizing internal controls and governance policies; initiating regular formal audits of business processes; improving documentation and record retention procedures for common business transactions; developing codes of business conduct; and making sure that employees are trained in the latest cutting-edge compliance practices.  These steps, when taken together, will allow the company to build and maintain credibility with all of its stakeholders.  As a result, the company will likely be able to obtain better credit terms and access more business opportunities.  Moreover, the directors and officers will receive richer information regarding all aspects of the business on a timely basis, thereby improving the quality of decision making within the firm.

Turning to closely held businesses, let’s first concede that the potential benefits of investing in tools and processes based on SOX requirements are sometimes difficult for the owners of those businesses to appreciate and accept.  Most of these companies have a limited set of stakeholders and no immediate thought of expanding to seek an IPO or attracting a public company as a potential acquirer.  Nonetheless, owners of a closely held business are well advised to review SOX standards to identify ideas that can be used to manage the risks associated with the business and increase the value of their ownership stake.  The later consideration may be particularly important given that the business typically represents a substantial portion of the personal wealth of the owners.  Another element to consider is the possibility that the closely held business will shift its strategy quickly at some point in the future and become one of the other types of companies described herein.  For example, an attractive business opportunity in a new product or geographic market may lead to interest in obtaining capital from outside investors or a syndicate of institutional lenders.  In that case, the number of stakeholders, and associated scrutiny, will increase immediately.  Also, if one or more of the owners suddenly decides that he or she wants to liquidate his or her interest in the company, the owners may conclude that the best way to achieve maximum value is through a sale to a public company, which means that the firm must think and act as a “pre-acquisition” company.

Absent an immediate need for strict compliance with the requirements of SOX, closely held businesses should focus on those areas where there is value in adopting “best in class” practices.  One popular area of interest for closely held businesses is evaluating the documents and records used for common business transactions.  By standardizing procedures in this area, the company can operate more efficiently, and management can gain better access to information about those elements of the business that are most crucial from a tracking perspective.  Closely held businesses should also carefully consider adding one or more independent members to their board of directors.  In many cases, the owners are also all of the directors and senior managers of the business.  While this streamlines the communication process, it also can lead to insular thinking.  By bringing in independent experts with industry experience and other interests, the owners can obtain the benefits of a different perspective and independent directors are often sources of new business opportunities.

Finally, family-owned businesses do, of course, present special challenges, notably the need to manage family relationships at the same time as business decisions are being made.  In addition, family-owned businesses face unique problems with respect to succession planning and their ability to provide attractive opportunities for managers and employees who are not family members.  However, there are ways in which corporate governance principles can be woven into the management of a family-owned business, and studies appear to indicate that family-owned businesses that are successful in this attempt make better strategic decisions, grow faster and survive longer.

Some of the key success factors in integrating corporate governance into a family-owned business are as follows:

  • Outside directors should be added to the board of directors and the board should be given greater authority with respect to evaluating and setting company policies and strategies. Outside directors can bring a greater degree of objectivity to the business and should be more immune from the day-to-day conflict that sometime arises among family members.
  • Family members should have a clear understanding of the importance of separating family relationships from the governance and management of the company. This may be difficult; however, recruitment of key managers and other employees from outside of the family can accelerate the process and make it clear to family members that they have taken on responsibilities that extend outside of the familial group.
  • The business, working through the outside directors, should establish a clear and logical organizational structure with a clear chain of command and a decision-making process that is transparent and free of opportunities for family conflicts. If family members are to be placed in management positions, they should have the authority to make decisions without reference to their “place” within the family.  Moreover, decisions that may be made by outside managers and employees must be respected.
  • In order to reduce strife within the family and build trust among managers and employees who are not family members, the company should establish clear policies with respect to recruitment, promotion and compensation and then follow and respect those policies.

This article is adapted from material in Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.

Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business.  Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedInTwitter and Facebook.

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