The constitution solution to governance clutter

Most family businesses don’t last beyond the third generation. Researchers have found that only 13 per cent make it through (Clearing the third generation hurdle, April 18). Why is that? Because as a family business grows, there will be tensions as more stakeholders and more family members with an interest in the enterprise move into the picture. The business, as it grows, will be demanding more financial and management commitments from its owners.

Family issues rather than business issues determine generational change in every family business. This is why every family business needs a constitution, a roadmap setting out the family’s vision and values.

Significantly, few family businesses bother establishing a constitution. That might explain why many don’t last the distance. A KPMG/Family Business Australia survey has found that four out of five did not have one. These findings are consistent with similar surveys in 2005, 2006 and 2007. Experience would suggest that they will run into problems later for failing to effectively plan ahead.

Family constitutions are not enforceable in law. What they do instead is create a moral obligation among family members as it relates to the business.  Binding them together morally ensures a greater commitment to preserving the family legacy.

Nor will they circumvent conflict. All they do is provide a mechanism to resolve and manage these conflicts and focus everyone on the key issues that are being ignored.

Family constitutions could circumvent some of the most common mistakes of family businesses: lack of succession planning, unclear family hiring practices, poor lines of communication that see stakeholders kept out of the loop, unfair compensation where family members are compensated differently from non-family members, family time and issues getting confused with stuff that belongs in the business and out of date ownership structures.

Ideally, what the family constitution should do is ensure these matters are discussed before they happen. It would short-circuit them as potentially divisive issues.

If family constitutions are ever put in place, it usually happens when there is a changing of the guard, when the founder passes it on to their children, comprising other branches of the family. As this can be unplanned if, for example, the founder dies or becomes ill, it is better to have the document in place earlier on.

Unlike a shareholders agreement, a family constitution covers more than just the people who have shares in the business. All family members, or their representatives, are participating in the process.

Every family, like every business, is different so the constitution would vary from family business to family business. But there are some key rules.

At the very least, the family constitution needs to document the mission, values and principles of the business and outline the key strategic objectives including the long and short term goals. It also needs to set out the process for resolving conflicts about the business between family members and spell out their rights. How should communication be organised? A family council? Regular meetings? Does that encompass the next generation. If there is a family council, how is that nominated? What is the composition? What are the rules of conduct? Who chairs the family meetings? How does the decision making process actually work? What matters are decided by a majority vote? Where does it require a unanimous decision?

The constitution also needs to state the process for dealing with family and non-family employees and the hiring and compensation of family members. Should family members be renumerated above, at, or below market rates? Should all family members be compensated at the same rate, regardless of their contribution to the business?  What education and previous work experience do they need?

Some companies, for example, require family members to have worked for another organisation for several years before they can join. Are in-laws welcome to join the company? What is the process in respect to loans? If a family member wants to start a new business, is there a procedure for the family to chip in with equity capital? Are there procedures for estate planning? What are the rights and obligations of shareholders? What about non-family ownership? Are ownership privileges affected by critical milestones such as marriage, birth, death, divorce, or termination of employment? Should key employees who are non-family members hold shares?  Are there restrictions on the sale or transfer of shares?  When shares controlling the company, that is to say shares with voting rights, are made available, should these be extended only to family members who are active  and employed in the business or should they be extended to those who are passive and not employed in the enterprise? Is there a recommended retirement age for directors and managers? Are there processes in place for the buying out of family shareholders?  What are the rules for nominating, training and assessing incoming managers?  

Again, the rules will vary from family to family. But framing a family constitution requires some hard decisions. Who will be involved in developing it? Will it be a business first process, led by the CEO, or a family first process led by for example a family council. Will it be done by a committee?

It’s important to give the process time. Family constitutions can take as long as 18 months to develop. Rolling it out might not be easy as people will have to get used to referring to the document. And ideally, it would need to be reviewed and updated every three to five years. In a sense, the work only begins once the family constitution is in place. But then continuity of any business is like that.