February 13, 2008

Picture this: After years of working harmoniously with the next generation to grow a family-owned business, the senior executive decides to step down. What was expected to be a smooth transition suddenly becomes a battle of wills between competing interests and competing generations. Smoldering disagreements over ownership, compensation and management of the company quickly spark into full flame. Sides are taken. Suits and countersuits are filed. Before the smoke clears, family relationships have been stretched thin (if not sundered completely) and time and resources that could have been dedicated to the business have been diverted toward resolving an unnecessary and emotionally charged dispute. While the battle that ensues may ultimately be resolved, the damage to family relationships can be beyond repair.

Unfortunately, this hypothetical scenario occurs all too frequently within privately held and family-owned businesses. Succession issues often trigger such conflicts, but other major events—including significant transactions, major capital expenditures, the negotiation of compensation agreements and key policy decisions—can bring long-buried divisions to the surface.

Of course, differences of opinion are an integral and often valuable part of doing business. Contrasting points of view can lead to creative solutions that result in better products, services and processes. However, problems can arise when the very ideals upon which a company is based—a singular vision, the desire for independence and control, and the intent to keep assets within a family or small group of investors—become roadblocks to the resolution of these disagreements and to business growth.

It may be time for privately held and family-owned businesses to consider whether electing an independent member to their board of directors would be wise to help manage conflicts and provide impartial guidance.

Benefits of an Independent Board Member

An independent director can offer a company a number of distinct benefits, services and business advantages:

Independence. Stakeholders in a business rarely act without bias. Even when driven by what they believe are the best interests of the company, their opinions are informed by personal agendas and value systems. An independent board member can take a fresh, objective look at business challenges and opportunities, and offer advice that synthesizes the perspectives of all parties while enabling the company to pursue short- and long-term business objectives.

Negotiating compensation and other executive agreements. Determining appropriate executive compensation, benefits and other perquisites is always a challenge. This is especially true when family members hold leadership positions in a business. Experienced independent directors can help work with outside consultants to create a suitable compensation package and otherwise address the concerns of relatives who do not participate directly in day-to-day operations but may own an equity interest in the company. As an objective third party, an independent director can also help identify potential candidates to fill positions open to non-family members and help ensure that these individuals receive a fair compensation package.

Credibility. Since the collapse of Enron and other accounting scandals, corporate accountability and transparency have taken on increased importance in the eyes of investors. While Sarbanes-Oxley applies to public companies only, many institutional and private-equity investors, as well as lenders, are seeking similar assurances that non-public companies are also meeting proper accounting and fiduciary standards. If, for example, a privately held business is seeking outside investment, a board of directors with an independent member can help demonstrate the commitment of leadership to operate the company with the highest levels of integrity and objectivity.

Resolving competing interests. An independent director can also help negotiate solutions to the competing interests of family members or minority and majority shareholders. This can be especially helpful when it comes to succession planning. As was the case in our opening example, the gap between what a retiring CEO believes is best for the company and the opinions of other family members can be quite large. By helping negotiate an effective succession plan, an independent director can contribute to the long-term viability of the business. Likewise, if disagreements arise among family members after the founder of a company retires, having had an independent board member involved in the pre-retirement discussions may help reassure family members and resolve disputes before they end up in litigation.

Concerns about Electing an Independent Board Member

Of course, it is important to raise a few questions about the value an independent board member offers to privately held and family-owned companies:

How "independent" is an independent board member? An independent director doesn't just appear out of the blue, ready to go to work. Instead, he or she must be selected by someone within the company. The nominating party—whether an owner, executive or both—is likely to choose a director whose point of view and background favor his or her own agenda. One solution to this dilemma may be to shift the focus of the selection process from "independence" to "balance." For example, if two individuals share ownership of a company, each party could nominate one third party to select the potential director, and the independent director ultimately chosen would be determined by the two selecting parties.

What if majority shareholders don't want an independent director? If the majority shareholders do not agree to the election of an independent board member, the initiative could die on the vine. What's more, the fight over whether or not to bring on an independent director could itself cause some of the very problems that the action is intended to prevent. Therefore, for those parties interested in electing an independent board member, their first step must be to achieve consensus on the issue among themselves and other owners.

Will having an independent board member cost more than it's worth? An independent director does not work free of charge and must be compensated for his or her services. Likewise, the director may insist on directors and officers liability insurance in order to protect against any financial risks associated with board service. This expense should be weighed against the expected advantages of having an independent board member.

Does electing an independent director mean losing control? Executives of privately held and family-owned companies are often concerned that an independent board member will block decisions or prevent owners from acting with the degree of independence to which they are accustomed. For many, the desire to "call their own shots" was one of the primary reasons they created their companies in the first place. However, in the case of limited liability companies and limited partnerships, these concerns can be allayed if the operating/partnership agreement provides for a board of directors with advisory powers only.

Will the independent board member know the business well enough to perform adequately? In many cases, board members may end up serving the equivalent of only a couple of weeks per year. Given this limited exposure to the workings of the company, there may be legitimate concerns about the ability of independent directors to provide truly useful guidance. And if their primary source of information is the executive leadership of the company, their opinions may be biased by the very individuals they are expected to advise. Of course, these concerns are not unique to privately held and family-owned businesses—the same questions are often asked of the boards of publicly owned companies. In order to assuage these concerns, board nominations should be made with an eye toward the backgrounds and experience of potential members. The more familiar the individual is with the company, the industry and the marketplace, the more useful guidance he or she will be likely to provide.

In sum, privately held and family-owned businesses face many of the same challenges that confront their publicly held counterparts. Since an appropriately structured board of directors can be of great service to a company, it makes sense that any business should weigh carefully the option to elect an independent director.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.