Do outside directors add value to private family businesses?

The best performing board I’ve been on is one I’m on now, a family owned company, with four outside directors, two family shareholders and the CEO.

(Jim McHugh---Director at Southworth International Group, Inc. and Kennebec Technologies, Inc.)

Family businesses tend to be reluctant to recruit outside directors given their particular culture. Their long-term focus and significant emotional attachment of the owning family to the firm could often collide with the outsiders’ perspectives. However, today many private family businesses are adding outside directors to their boards. So why would a private family company want to recruit an outside member on their boards?

Family businesses are increasingly aware of the risks they face. Many of them fail to transfer the business to the second generation, and most of them do not survive beyond two generations. Poor operational management, lack of governance standards, family conflicts and a conservative attitude to risk-taking are just a few reasons they break down.

Contributions of outside directors to family businesses

Today the practice of including outside directors in private family businesses is widely recommended by corporate governance codes for private firms (e.g., Code Buysse in Belgium; Corporate Governance Guidance and Principles for Unlisted Companies in the UK; Guidelines for improving Corporate Governance of unlisted companies in Finland). The proponents argue that outside directors bring new knowledge and networks, provide unbiased advice, and assure the credibility of the company.

Notwithstanding the potential contribution of outside directors, not every family business benefits from appointing outside directors. In their study of private family firms, Cabrera-Suárez and Martín-Santana find that the presence of outside directors even hinders the firm’s profitability. This raises the question of when or under which conditions outside directors add value to private family businesses. According to Forbes and Milliken, boards are decision-making groups, and they are more effective when group members (directors) interact with each other to perform the directorship role. Cristina Bettinelli, in her study of 90 Italian family businesses find that boards are more effective when the goals of outside and inside directors are aligned, when a CEO is willing to listen to the board, and when outside directors are actively engaged with boards’ activities.

The need for family business-specific information

Apart from being actively engaged, outside directors need firm-specific information to do their jobs properly. Without firm-specific information, outside directors can neither question the actions of the management nor give valuable advice.

Yet private family businesses are largely left alone with respect to information disclosure. Unlike publicly listed businesses which are under pressure by activist shareholders, private family businesses are flexible in disclosing firm-specific information to public.

Are private family firms willing to share firm-specific information with outside directors? Several corporate governance scandals in family companies, from Parmalat in Italy, Takata Corp. in Japan, to The News Corporation in the U.S., suggest that sharing information is not automatic.

The biggest issue with many private family businesses is that adding outside directors leads them towards greater secrecy: owning families prefer to maintain control; to protect their privacy and do not like to expose their conflicts to outsiders. For these reasons, they have difficulties trusting outside directors.

A recent research work[1] at the EDHEC Family Business Center investigates how outside directors could add value in private family businesses. Survey data from 421 private family businesses in Belgium have been collected. The results show that private family firms disclose less information when outside directors are present, in comparison to private nonfamily firms. This leads us to question the wisdom of including outside directors on the board of private family businesses, as recommended by corporate governance codes.

Interestingly, around 25% of private family firms in our survey answered that they never disclosed nonfinancial information (e.g., information about strategy, product markets, internal process and innovation) to the board. Only financial information is disclosed to the board as it is required by law. So in these firms, boards are just rubber stamps set up to fulfil the legal requirement. In fact, the appointment of outside directors in these firms is just to make sure “house in order”.

Meanwhile how do family shareholders acquire information and discuss strategic issues with managers? They do it informally. Discussions in the kitchen or at Christmas parties are examples of occasions where they are informed.

Despite the insufficient information disclosure in many private family businesses, managers of the most successful businesses in the survey make an open, honest attitude and conscious effort to inform the board.

Taken together, for family-controlled firms wanting to take advantage of outsider directors’ expertise, merely appointing them on the board without providing them firm-specific information is not effective. Controlling families should have a trusting view and are willing to share information.

As private family businesses gain more attention, there is a need to have a structured governance system aimed at engaging outside directors to exchange ideas with management, express different viewpoints, and build trust among directors and managers. An overall commitment from owning families towards using the board actively in strategic decision-making is the prerequisite for good corporate governance.

Cited references

Bettinelli, C. (2011). Boards of directors in family firms: An exploratory study of structure and group process. Family Business Review, 24: 151-169.

Cabrera-Suárez, M. K. and Martin-Santana, J. D. (2015). Board composition and performance in Spanish non-listed family firms: The influence of type of directors and CEO duality. BRQ Business Research Quarterly, 18, 213-229.

Forbes, D.P. & Milliken, F.J. (1999). Cognition and corporate governance: Understanding boards of directors as strategic decision-making groups. Academy of Management Review, 24: 489-505.