IHOMSON REUlERS

CHECKPO¡NT" August 20'l7

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Game Plan for UsingOutside Directors inFamily Business

h rivate and familv-owned busi-| | n.rr., "r" i'te.årting clients.F ^, these busrnesses evolve,I their needs change in a well-known pattern. In their early years,they focus on survival; then comesan emphasis on growth, and as theymature, the worry about continu-ity sets in. The first generation own-ers are likely strong-willed entre-preneurs; the second generation ismore diverse in their skills andmotivation. They each have a

unique personality.Non-public businesses tend to

be challenged by a lack of capitalor a lack of talent. If they are ableto overcome these issues, theygrow and prosper. For the mostpart, if the bank is happy and thebusiness pays its taxes, the own-ers can do as they please. Thisindependence usually providesgreat satisfaction to the ownersand is often a driving motivationfor why they work as hard as theydo. They tend to eschew consult-ants and outsiders if they can avoid

When a family-owned business client would benefit frorn outside directors,identiTy ihe steps and timeline for a successful arrangement.

BRUCE WERNER

them.'Who else knows their busi-ness as well as they do?

But as the business grows and getsmore complex, the owners may startto sense their own limitations. Theymay seek perspective or want to hearhow others have dealt with theirpressing issues. nØhen this happens,leaders tend to look outside for help.After all, who can the owner or CEOtalk to safely regarding existentialissues? His or her job is to antici-pate the future and plan for it.

The primary benefits for a pri-vâte compâny in engaging outsidedirectors is to deal with the exis-tential issues the owners are not

able to successfully resolve them-selves. After all, even the best entre-preneurs have limitations. In thisrcgard, outside directors cân pro-vide the following key benefits:

1.. Perspectiue-provide a different point of view.

2. Exp erience-share domainexpertise.

3 . R e I ati o n s h ip s-intr o duceimportant counterparties.

4. Comp ensation-assist withcompensation plans.

5, Swcc e s s ion p lanning-assureexecutive continuity.

6. O u er sight-protect minorityinvestors and stakeholders.

7 . Conflict resolution-privateintervention.Experience suggests that own-

ers start to seek help when they dealwith decisions where they may holdconflicting thoughts. This is like-ly because they bear up to three setsof responsibilities: as owners, boardmembers, and management. Theseare different roles, with distinct

BRUCE WERNER is the managing director of KonaAdvisors LLC, and has served as an outside directoron private company boards for the last two decades.Kona Advisors LLC provides advisory services to theowners, investors, and CE0s of private and family-owned businesses. With deep experience in gover-nance, succession planning, finance, strategy andmanagement issues, Kona Advisors brings a broadperspective to developing solutions for clients. Brucecan be reached at Bruce@KonaAdvisors.com.Copyright @201 7, Bruce Werner.

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duties and priorities. In private andfamily businesses, the same peoplefrequently hold these same threeroles. If each role requires an indi-vidual to wear a hat, how does oneknow which hat to wear when?'ü/hat should someone do when theanswers conflict? A quick sum-mary of board roles and responsi-bilities is shown in Exhibit 1.

To get a better understanding ofhow roles may conflict for indi-viduals, consider using a Venn dia-gram to visually demonstrate theconflicts. To do this, draw three cir-cles on a piece of paper, such thatall three circles overlap in one area,while each pair of circles also over-laps. Next, label one circle each forOwner, Board, and Management.Then write the names of individu-als in each circle according to theirposition. This should identify howmany hats each person is wear-ing. This is the first step to identi-fy who should be making decisionsfor different issues.

The more conflict there is, themore likely the client should con-sider outside directors. If an advi-sor believes he or she should rec-ommend that a client bring inoutside directors, how should theprocess proceed?

whene t0 stantEven if the need for outside direc-tors is compelling, inertia is a pow-erful force. Just because there is aclear and substantial need does notmean it will be met. The best way toovercome inertia is with education.

Understand the marketplace. A.s

with many products and services,there is a market for individualswho serve as professional directors.In addition to the directors, thereare consultants, search firms, andtrade associations that supportdirectors. This is a highly frag-mented marketplace, with diverseofferings and price points.

EXHIBIT IBoard Roles and Responsib¡l¡t¡es

GroupOwnershÍp

FrequencyAnnual

Key lssues and MandateWhat business are we in?Who represents my interests?How is the business funded?What results do I expect?

Board Quarterly Elected by the ownersHire & fire managementApproves budgetsMajor strategy decisionsOversight & accountability

Management Daily

Each of these market participantspositions itself for commercial suc-cess, has atargetclient profile, pro-motes its competitive advantage,and has a pricing model. Exhibit 2presents some guidelines deducedfrom observation. Understandingthe marketplace puts an individualin a position to ask critical ques-tions. These questions need to beasked of, and answered by the con-trolling ownership parties. Venturecapital or private equity portfoliocompanies are in a different mar-ketplace than what is described here.

llellne tne boand's mandateFor clients considering their initialboard, it may be best to start bywriting a board charter. A boardcharter is different from an entity'sby-laws or operating agreement.The charter explains the reason theboard exists, what it is expected toaccomplish, and how it shouldfunction. A typical charter wouldcover these topics:r Purpose and scope.¡ Structure (e.g., number

of seats, term of office,

Report to the boardRuns the business

committees, and nominatingprocesses).

. Meeting schedules and timecommitments.

¡ Directo¡ qualifications.¡ Director duties and responsi-

bilities.¡ Compensation, expenses, indem-

nifications, and insurance.. Board and director perform-

ance evaluations.Public company boards are driv-

en by regulatory and exchangerequirements. Private companiesmay craft their board charters morespecifically to their needs. Boardsof family-owned companies areoften driven by the soft issues thattest a family's interpersonal rela-tionships. Succession planning,compensation, and individual per-formance are usually high priori-ties for discussion. Financial acu-men and accountability tend tofollow in priority.

Whether the board is advisoryor fiduciar¡ the directors shouldrccognize that they likely still bearliability. Owners should be awareof risks they are asking an outsiderto accept. Family-owned business-

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EXt-ilBtT 2Board lndustry Market View: Tfpical Scenarios

CompanyRevenue

Flduclary

Advlsory StyleRecrultlng

Method CompensatlonCommlttee

WorkTlme

Commitment'or Talent

Sourclng

< $20M Advisory lnlormal Networking Friends, family

$20M - $50M Advisory Semi-formal Mix Friends,consultanls

$s0M -$150M Both Mix Consultants,recruiters

$150M - $500M Fiduciary Formal Traditional Consultants,recruiters

Mix

Gratis orday-rate

Gratisor day-râte

Annualrate with

expenses$20,000 -$50,000per year

Annualrate w¡th

expenses$25,000 -$75,000per year

No A few days per year

Unlikely 4-6daysperyear

Mix 4 - 10 days per year

Yes I - '16 days per year

n Depends oncommittees

Nofes:I For private and family-owned businesses.z Excludes starþups, venture capital, and private equity backed entities.

es tend to be looking for advice,and may feel more comfortablewith strangers not having a legalvote on key issues. Some familybusinesses start with a board ofadvisors and later evaluate if theyshould transition to a fiduciaryboard over time.

Some private companies take theopposite view They demand fidu-ciary responsibility so that the out-siders have "skin in the game" tohold their attention. As an exam-ple, a 95-year-old family businessformed a fiduciary board becausethe next generation wanted to ownthe business, but not run the busi-ness. Members of the next gener-ation were active professionals liv-ing in distant pârts of the country.The current leadership understoodthat they needed outside fiduciar-ies to hold future professional man-agers accountable to the family. Sig-nificant wealth was involved, and

the current leaders did not want toleave it to chance that their heirscould handle that responsibilitywithout assistance. This is essen-tially the same reason public com-panies have outside directors.

When considering the size of theboard and committees, the analy-sis needs to go deeper. Considerthese questions:¡ SØhat are the performance

deliverables and how issuccess measured ?

¡ \X/hat skills, experiences, andrelationships does the boardneed to perform well? Mostnew boards are designed witheach seat slotted to a specificskill set. Common slotsinclude specific expertise inmarketing, sales, e-commerce,finance, and industry or regu-latory expertise. Especiallywhen succession is an issue,some boards will have a seat

slotted for a director withexpertise in family succession.

The on-boarding process re-quires forethought. Good practicesinclude site visits, key employeeinterviews, financial reviews, andcorporate history and culture tuto-rials. Seeing the company's prod-uct in use is a high priority.

it is important to consider if theclient needs facilitation in thisprocess. If so, who is best suited tohelp? A large body of knowledgeis available to help with planninga new board. Also, an active con-sulting industry caters to this need.The National Association of Cor-porate Directors is the trade asso-ciation that focuses on public com-pany boards and has an extensivelibrary to draw upon. The PrivateDirectors Association services onlyprivate and family-owned busi-nesses, and may be a better resourcefor non-public companies.

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Once the planning is done andthe client has committed to pro-ceed, a communications plan needsto be considered to address theseconcerns:o Are all owners involved in the

decision to proceed? If not,when do they find out?

o '$(/hat about spouses of familyexecutives?

r '!Øhen and how are keyemployees involved?The interview process attracts

the attention of management andemployees: Ilho are these strangersand what are they doing here? Howwill it af.fect my job? The natureand timing of communicationsshould be planned in advance,because the owners will want tomanage the message and minimizegossipy chatter.

C0n$ldon ths G0st/[cneflt ana¡yslsBecause bringing in outside direc-tors is a sensitive topic for someclients, it is worthwhile to under-stand the costs and benefits beforemaking a recommendation. Thetypical concerns are (L) money,(2) time, (3) interpersonal dynam-ics, and (4) interference with thebusiness and ownership.

níhat does this mean to a busi-ness looking to bring in three out-side directors? Common practiceis to hire a consultant to facilitatethis process. The cost to hire a con-sultant, form the board, and oper-ate it for one year, assuming fouron-site meetings plus travel, maybe $100,000 to $250,000 depend-ing on a variety of assumptions.Those costs will get attention. Thencompare this cost with the bene-fits of having a high-performingboard rather than current businessoperations. Relevant factorsinclude the following:r Does the client have a succes-

sion plan?

Are the business owners ableto resolve conflict successful-ly?Does their compensation sys-tem drive performance?Do they have a culture ofaccountability?

If the answer to any of thosequestions is "nor" what is the costof those consequences? Is the clientlikely to fix those issues withoutoutside intervention? While man-aging this expense is easier at alarg-er company, smaller companies canfind ways to initiate a board withless expense.

The time commitment to recruitand run an effective board is alsosignificant. Assume the consultantwill solicit resumes, run phoneinterviews, and bring forwardten finalists for three seats. Eachfinalist is likely to have a one-hour phone interview with anowner, maybe five finalists havea full-day on-site interview, andthen there may be a one-hour callwith three or four of the final-ists. The next step is to have inter-nal meetings to evaluate and selectcandidates.

This summarizes the time spentfacing candidates. To get a sense ofthe total time required, use the con-sultant's rule of thumb-double thetime facing the client to get the totalwork time required.

This quickly stârts to look likean additional three to six weeksof effort to get the board seated.The board work itself could be one

to three weeks of work, spread overayear. The chairperson will devotemore effort to managing offline dis-cussions, in addition to preparingfor and running the meetings.

Lastl¡ and most importantly howdoes introducing outsiders changethe interpersonal dynamics of theowners and key executives? Howdoes this impact how they do theirjobs today? How well will they worktogether? The purpose of bringingin outside directors is to effect sub-stantial change on existential issues.This is where an understanding ofthe client's personality and businessculture is critical.

There is the risk of perceivedwinners and losers. Some ownersand executives will want advocatesto help their cause; others may feelthreatened. If the outsiders do theirjob, they will quickly identify sen-sitive issues and force them to beconstructively addressed. One com-mon reason for an outside board isto help hold the insiders account-able, for their own benefit.

Knowing the clients' persona[i-ties is central to a cost/benefitanalysis. They should be fully com-mitted to the process before start-ing. Clients are more likely toaccept the time commitment andexpense when they rcalize they needa solution and have no other \Mayto deal with the issue.

Êottlng Gommltmsntand cnsatlng n0msntumOwners and executives already havefull-time jobs and busy lives, andthis can be viewed as just "one morething to do." So the fact they mayagree with the need to take actiondoes not mean it will happen.

!íorking through the cost/ben-efit analysis with the client is like-ly the major decision-making stepin the process. Owners may acceptthe results intellectuall¡ but untilthey demonstrate action, they have

a

a

a

Experiencesuggests thatc¡urners start toseek help rârhenthey deal ur¡thdecisions rñrherethey may holdconfl¡ctingthoughts.

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not fully committed to creating andseating an effective board.

Starting a board should be seenas a one- to three-year effort. Likeany investment, money and effortare expended in the beginning, buttime is needed for the investmentto mature and return both princi-pal and profit. New boards needtime to become effective. Newboard members need to build rela-tionships between themselves, own-ers, and management. If they worktogether only four-plus days peryeâr, not much time is availableto build good working relation-ships. By design, boards grapplewith existentiâl issues, whichshould not be snap decisions. Somedecisions will take years to bearfruit. If the board is dealing withcultural change, it may take evenlonger to know if the right decisionwas made.

The recruiting process will like-ly take three to six months, if wellmanaged. Once candidates arecommitted, the on-boardingprocess should be short and intense,to get them up to speed. Gooddirectors are bright, articulate,questioning, and eager to absorbnew information. They accept theposition to have an impact, and thatrequires them to be knowledgeableand empowered.

Thus, a client who is interestedin stârting a board should expect

to spend six to 12 months of effortbefore holding the first formalboard meeting. This reinforces thelogic that the client needs to becommitted to the endeavor beforestarting.

As with all talent, director andboard performance managementare required once the board is seat-ed. líhat if a wrong person wâschosen, or circumstances changeafter the board is seated? Severaltools are available to help with bothdirector and board performance. Ahealthy board has a collegial envi-ronment, where difficult or divi-sive issues can be discussed can-didly. Performance is no different.As with most investments, theyneed to be attended to for bestresults.

GoncluslonDetermining whether to recom-mend that a client form a boardwith outside directors is not a sim-ple matter. In assessing what isin the client's best interests, the

attorney needs to take a broadview to understand the implica-tions.

There is a marketplace for out-side directors, as well as an âctivemarket for the various support serv-ices that the industry uses. Know-ing the basics of the industr¡ andhow the service providers operate,is an important step in assessing theimpact outside directors may haveon a client.

Companies start and maintainboards with independent directorsto deal with their most importantissues. Boards need to be effectivebecause they are expensive, con-sume substantial executive time,and affect the most sensitive mat-ters. Choosing to avoid outsidedirectors is one wây to bury diffi-cult or unpleasant topics, but theissues do not go away.

Achieving a high performingboard with outside directors in aprivate company is not a simplematter. It is likely the result of athoughtful needs assessment, acarefully crafted board mandate,meticulous recruiting and on board-ing, and an unrelenting focus ondirector and board performance.This is a well-traveled path. Likemost other subjects in business,good results depend on exempla-ry planning, in addition to carefulexecution. I

One commcrnreasl'n fr¡r anouts¡de boardis to help holtlthe insi¡lersaecoutrtable, fortlreir crvun l¡enefit.

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