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A Better Partnership

Publications

May 2003
19
May 19, 2003

Using Outside Directors in Family Businesses

If the public was not aware of it before last year's scandals involving major publicly owned corporations, by now everyone knows that publicly traded companies have boards of directors comprised with significant numbers of outsiders. But how many owners of family or other closely held businesses think about, much less have, outside directors for their businesses?

Generally speaking, the presence of outside directors in a family held business serves only one meaningful purpose: to add value and perspective to management. They do so in several ways. As many entrepreneurs or chief executive officers of family held businesses will agree, it's lonely at the top. Creating a board of directors comprised of outsiders provides the entrepreneur or CEO with a peer group with whom she can discuss the problems and issues of the business. Typically a high level of confidentiality is associated with outside boards, further enhancing the value of the advice provided. The kinds of questions an outside board might take up range from investment decisions such as whether to buy a new piece of machinery or develop a new product, to personnel matters such as whether to terminate a long-time employee who is no longer functioning at the level required or to name a child as the eventual successor to the leadership position in the business.

The presence of outside directors changes the decision making process that occurs in the business. The mere existence of the outside directors as the last stop in the decision making process forces management to more thoroughly analyze and better justify their decisions in a way they might if they were not forced to explain their plans to the outsiders. This permits the outside board to act as a safety net to guard against poor decisions.

If you have a family held business in which some family member shareholders are not active in the business, the use of an outside board can help reassure the inactive family members that the business is not being run for the personal benefit of the active family members. For example, the board might set the CEO's compensation and approve promotions of family members.

After making the decision to utilize an outside board of directors, the most critical decision is going to be the selection of the directors themselves. Although a natural inclination might be to appoint "trusted advisors," such as the company's lawyer or accountant, this is usually not advisable. Most lawyers or accountants have only limited experience with management of operating companies. Family members also are not good choices because they often lack the independence that is the basis for using an outside board in the first place. Similarly, golfing buddies or close friends also can be poor choices due to an unwillingness to jeopardize close personal relationships. Persons associated with customers can offer crucial insight, but problems can arise due to the need to discuss and share confidential financial data that is inappropriate to put in the hands of a customer.

The best choices for the board of directors are those persons who can bring special skills, experience or perspective to the board. For example, the former owner of a business in the same or a similar industry may be an excellent choice because he can advise on how to surmount the challenges presented. If the company is a candidate to one day "go public" or take on outside investment, an individual who has served as an officer or upper level manager of a public company or in a private company that raised significant outside capital from a venture capitalist can offer perspective and experience. If the human resources or financial management areas are weak, persons with special skills in these disciplines might be valuable additions to the board.

When selecting directors, be sure your expectations are clear and make sure the persons selected are able and willing to fulfill the commitment. Candidates should be prepared to attend regular meetings and also to prepare in advance for them. One way to ensure they take the role seriously is to provide adequate compensation. Fees of $1,000 to $3,000 per quarter for attendance at a quarterly board meeting are not uncommon.

Finally, the matter of liability is going to be important to the candidates for an outside board. Because of liability concerns, often the outside board serves only as an Advisory Board of Directors. When configured in this manner, the outsiders have no legal authority and their actions are nonbinding in nature only. When the outside board is advisory in nature, it is a good idea to define in the Bylaws the nature and role of the Advisory Board, to make sure that the Advisory Board does not act on matters reserved to the legal Board of Directors (such as electing officers, approving loans and selling stock, for example), and to ensure that the legal board is properly constituted and elected and meets and acts on matters as required by the Business Corporation Act.

Where the outsiders are going to serve as members of the legal board of directors required by the Business Corporation Act, the company's legal counsel should review the company's Articles of Incorporation and Bylaws to ensure that the board has the maximum protection from liability. In addition, management should investigate the availability and costs of procuring directors and officers liability insurance.

Outside directors can serve a valuable role for closely or family held enterprises of almost any size, even the small "mom and pop" business. Properly selected and utilized, the outsiders will offer valuable perspective and advice to the business, making it much more likely to thrive and prosper in today's difficult competitive environment.

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Mark K. Harder is a partner with Warner Norcross & Judd LLP and focuses his practice on the general representation of family and closely held businesses and their owners, including general business, estate and succession planning and real estate law. Mark may be reached in the Holland office at 616.396.3225. Warner Norcross & Judd is a full-service law firm with offices in Grand Rapids, Metro Detroit, Holland and Muskegon. Because each business situation is different, this information is intended for general information purposes only and is not intended to provide legal advice.

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