All Articles Finance Modern Money Corporate governance and privately held companies, part 2

Corporate governance and privately held companies, part 2

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Modern Money

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, 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 road map for improving operational efficiencies and preparing for possible changes in long-term strategies. 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.

Companies with multiple stakeholders

Of the large private companies active in the U.S., many have a broad and diverse family of stakeholders beyond the core ownership group 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 underwriting 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. Finally, certain “special interest partners,” such as government agencies that purchase goods and services, may have a keen interest in the company’s internal controls.

Private companies with multiple stakeholders are well advised to focus on improving internal controls and business processes. Among the steps that can, and should, be taken:

  • 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;
  • Making sure that employees are trained in cutting-edge compliance practices.

These steps, when taken together, will allow the company to build and maintain credibility with all 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.

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 for managing risks associated with the business and increasing the value of their ownership stake. The latter consideration may be particularly important given that the business typically represents a substantial portion of the owners’ personal wealth.

Another element to consider is the possibility that the closely held business will shift its strategy quickly at some point 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, 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 also comprise the directors and senior managers. 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.

Family-owned businesses

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 doing so 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 insulated from the day-to-day conflict that can arise 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 logical organizational structure with a clear chain of command and a decision-making process that is transparent and free of opportunities for family conflict. 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.

  • 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.

Alan S. Gutterman is the founder and principal of Gutterman Law & Business. He has three decades of experience as a partner and senior counsel with internationally recognized law firms counseling small and large business enterprises in the areas of general corporate and securities matters, venture capital, mergers and acquisitions, international law and transactions, strategic business alliances, technology transfers and intellectual property. His publications are available on the Thomson Reuters Legal Solutions site and additional information on his publications and activities can be found at