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Creating or updating the family businesses governance is one of the key prerogatives of a family owner. Experience shows that an early start helps. Sometimes, family business founders and owners may not be comfortable with the idea that on their retirement, their children might not be able or willing to run the business that they founded. This is a critical issue, especially for a country like India, where 70% to 80% of businesses with a turnover of more than $1 billion are run by families.

This article, second in the series, is a part of the McKinsey Leadership Institute’s series on family-owned businesses and elaborates on the role a family business founder plays in creating sustainable corporate and family governance. The article discusses three fundamental dimensions which the owner must shape. The first is to plan for stable ownership, for instance by constraining shareholding rights, and by creating exit mechanisms for family shareholders. The second is to ensure inclusive and action-oriented decision-making, for which the business can leverage a variety of governance bodies. The last one is to manage the roles of family members in the business, which requires striking a balance between management and shareholding roles.

In India, GMR group is an example of early governance and succession planning. Group chairman and founder G.M. Rao started preparing a detailed succession plan when he was just 60. He also developed a family constitution which prescribed the process to manage differences among family members, provided a family code of conduct, and stipulated rules for family members’ entry in the business. It also introduced the concept of a “deadlock trustee," a person who resolves any disagreements between the next-gen successors when deciding the next chairman.

STABLE OWNERSHIP

Ownership rules are important governance models of a family business. The founder or owner is responsible for two of the most important functions, i.e., ensuring there are no ownership conflicts and that ownership does not get transferred out of the family without everyone’s consent. This is possible when the founder or owner charts out clear succession criteria along with the timing of succession, defining restrictions to rights of ownership, and laying down exit mechanisms for family members.

Clear succession criteria and timing

Although an equal distribution of shares is the default option in most families, sometimes unequal distribution may be the right solution. In certain family cultures, it is acceptable to transfer shares to male heirs. However, to avoid misunderstandings and frustration, this rule could be communicated to family members in advance. In other families, where the owner prefers to allocate discrete portions of the business to next generation owners, there is the advantage of neutralizing differences or governance difficulties, since each family member has the freedom to run his or her business independently.

Whatever the model, owners need to define the criteria to prepare the family members for the new set-up. In the well-known Al-Muhaidib family from the Middle East, for instance, the actual transfer of shares is being carried out gradually in order to enable the third-generation members to prepare themselves mentally for becoming owners of the group. Their family council has already transferred 20% of the shares to the third generation.

Marico Ltd has divided the succession strategy into two parts: defining a process for a “drop-dead" successor, and developing internal talent. The CEO, who is a family member, has appointed the individual who would take his place in the event of an emergency. However, this individual would hold the reins only for the short-term, defined here as six months. It would then be the board’s responsibility to let this individual continue in the role or identify a permanent successor, either from the internal talent pool or from outside. The company has implemented this process for the entire top management and considers it a strong succession strategy.

Restrictions to rights of ownership

Most long-standing family institutions have a customized ownership structure that simplifies the rules of the game and maximizes stability in ownership.

On the one hand, the owner could put the shares in a trust, which means that the next generation will not be owners but a shareholder’s agreement could ensure stability in ownership and governance by restricting shareholder rights.

When a trust is created, the next generation family members are bound by the deed of trust, which might prohibit them from pledging, transferring, or selling shares and can limit dividends. This approach promotes the idea of stewardship, that there are no real “owners," but that each generation “borrows" the company from future generations, with the obligation to strengthen it for the future. This is the model followed by the Tata family.

Restricting shareholders’ rights through a shareholders agreement could promote stability in ownership. For instance, in an agreement signed in 1810 by Mayer Amschel Rothschild and his two elder sons, the sons renounced their right to sell their shares of the family business. The family’s shareholders agreement has been updated periodically ever since, enabling the perpetuation of the business over seven generations.

Exit mechanisms

Due to various reasons, family shareholders may become frustrated and look for an option to move out. Many owners, therefore, create exit mechanisms. This can be done through a system of family buy-out or penalties.

The family buy-out mechanism creates an obligation for the exiting shareholder to propose his or her shares first to the remaining family shareholders. There was an instance where, in a business with more than 150 family shareholders, the owner created an internal market whereby a family member willing to sell his or her shares had to offer them first to his or her immediate relatives, then to the remaining family members, and finally to the family trust.

Exit mechanisms might also include a penalty. One model could be to ensure that outsiders who acquire shares do not have any voting rights. Another model could be to impose a discount on the shares’ selling price. A well-known American family allows buying of shares only at half of book value, with the first right of refusal to family relatives. This agreement has enabled the company to remain in the hands of a small and stable group of family owners.

INCLUSIVE AND ACTION-ORIENTED DECISION-MAKING

The first step to create an inclusive and action-oriented decision-making process is to set up the right governance bodies and their mandates. The second is to design rules for decision-making to maintain a balance between inclusiveness and action. Some owners even bring in external governing or executive board members for an objective and expertise-driven view.

Governance bodies

Building strong governance bodies is a necessity, especially when several family members are involved. Some of the governance bodies include: shareholders’ assembly, family assembly, shareholders’ council, holding board, family council, investment office, and foundation. The shareholders’ assembly convenes all the shareholders and elects a more restricted shareholders’ council, in charge of nominating the CEO and taking major decisions. Similarly, the family assembly convenes all family members even if they are not shareholders—for instance, spouses—and its role is to enable broad participation by the family and sharing important information with them. A family council usually comprises select senior family members who have the power to take major decisions such as carrying out changes in the shareholding agreement.

The Burman family council reviews the strategy of Dabur India Ltd, for example. A structured meeting is held every quarter where various independent business ventures are discussed. The council’s role is to look into the broader business strategy and vision of Dabur India. Also, in the group, the positions of chairman and vice-chairman have, historically, been held by members of the family. Further, neither of them draw salaries; their income is only from dividends. These two roles are also rotated within the four branches of the Burmans by the family council. There are never more than four family nominees on the 12-member board at any given point in time. There are also instances of radically different models. A Latin American family has a holding whose chairman is one of the siblings. He is also chairman of the business, and is therefore, de facto the only interface between the business and family members.

Once the governance bodies are in place, the owner must define appropriate decision-making mechanisms. Some owners institute a system that requires the shareholders or family council to take into account data-backed analyses or inputs from key executives in the company before making a decision.

Bringing in external board members

Creating an effective board of directors, who have the relevant knowledge and experience, can be a powerful tool for enabling objective and rich decision making in a family business. This is especially true in periods of generational transitions. Effective boards have two major characteristics—a pool of talented people with deep expertize in both industry and functional areas and board members that invest significant amounts of time in engaging closely on strategic and organizational issues. In India, the Marico group prides itself on its set of highly experienced board members who also act as mentors to the CEO and senior management team.

ROLES OF FAMILY MEMBERS

“You cannot expect a family to consistently produce talented entrepreneurs generation after generation," said a well-known entrepreneur. “Our role as founder and parent towards our children is to train shareholders, not business managers," said another famous business founder.

In order to ensure that their businesses continuously remain successful, owners and governing bodies need to define clear criteria for selecting family members as executives or even as CEOs or chairmen of the businesses. In other words, they need to ensure that the appointment is based on the individual’s qualities and qualifications to be successful in the particular role rather than as part of any “entitlement" coming from being a part of the owner’s family. An extremely successful family owned business follows exactly the same processes of evaluation, promotion and compensation for family members as it does for its employees. This also ensures that the organization looks up to and accepts the family member as an integral and indispensable part of the business. In India, we have seen that the Bajaj family, the Kirloskar family and the Agarwals and Goenkas of the Emami group have managed this transition from one generation to the other by slowly grooming the next generation into effective leaders of today.

A critical role of a family member is to be a shareholder who creates value for the business. A quote from Sulaiman Abdulkadir Al-Muhaidib, chairman of the eponymous group, explains this well: “Being a shareholder is different; it is a much bigger thing than being a manager. Shareholders tend to have a longer-term point of view; they need dividends, not just income. They see the business as a whole, where an executive concentrates on a specific business unit".

As family businesses get transferred from generation to generation, several family members need to jointly govern what was previously in the hands of one person. A stable ownership foundation, inclusive and action-oriented decision making processes and, lastly, clarity on the role of family members, whether to manage, or to play the role of a chairman who gets professional managers, or indeed continue to be a pure owner in the form of a good shareholder, will all help in sustaining the business for generations to come.

This is a part of McKinsey Leadership Institute’s series of articles on family-owned businesses.

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