This article has been written by Rajesh Kumar Handuja pursuing an Executive Certificate Course in Corporate Governance for Directors and CXOs from Skill Arbitrage and edited by Shashwat Kaushik.
This article has been published by Shashwat Kaushik.
Table of Contents
What is corporate governance
As the management principle states – everything we do needs controls in place and needs to be monitored for implementation of the controls, even if everything is going right. If there are no controls, then there are high chances of failure.
When it comes to managing businesses, whether family owned or otherwise, there is an absolute necessity to implement controls – which will keep the businesses doing the right thing and keep the stakeholders’ interests, as well as the society in general, safe.
A well structured control mechanism, applied to businesses in general, is called corporate governance. The corporate governance mechanism encompasses all the rules, norms and procedures that regulate and control business operations. The management, including the board of directors, auditors, shareholders and other stakeholders, are responsible for ensuring that the businesses are run and managed properly. Their role is crucial in steering the corporate structure so that businesses achieve their objectives and also ensure transparency and accountability at all levels. They need to ensure that the relevant provisions of corporate governance are appropriately embedded in the governance procedures, e.g. Articles and Memorandum of association, etc. Instituting robust governance mechanisms will uphold confidence among employees, customers and investors and also ensure the seamless operation of the business.
Over the years, there have been a number of instances of business failures significantly impacting employees, customers, investors, shareholders (large and small) and society in general (for example, if any employee loses their job due to mismanagement, it is not only the employee who suffers but the family of the employee is also severely impacted). Many of these failures are actually attributed to fraud, mismanagement or a lack of proper governance mechanisms. In order to ensure quality governance in corporate setups, the Confederation of Indian Industry, Securities and Exchange Board of India and Ministry of Corporate Affairs, as well as other regulators, have issued a number of guidelines with the larger intent to prevent fraudulent practices and to protect stakeholders. Some of these controls are listed below:
- Independent Directors on the board of directors;
- Formation of Corporate Social Responsibility, Audit, Remuneration and Nomination Committees;
- Serious Fraud Investigation Office; and
- Women directors on board of directors to ensure diversity.
Need for corporate governance in family owned businesses
Family businesses form a major part of India’s economy and hence play a vital role in India’s growth. While many family owned businesses range from very small to very large,. These family owned businesses are no exception when it comes to having corporate governance in place. These businesses need a well structured corporate governance, like any other business entity. There is an absolute need for these businesses to be disciplined and properly governed. Lack of proper governance will certainly have an adverse impact on the national economy. There is a need to have strong governance measures in such businesses to prevent tension between family members as well as to provide strong competition to other players in the global economic markets. In family-run businesses, there is often a high degree of interdependence between family members, which can lead to conflict and tension. Strong governance measures can help to prevent this by ensuring that there is a clear separation of roles and responsibilities and by providing a framework for resolving disputes. In addition, strong governance measures can help to ensure that the business is run in a professional and efficient manner, which can give it a competitive advantage in the global economic markets.
Major challenges in family owned businesses
Major challenges in family owned businesses are:
- Most of the key managerial positions are held by family members, thereby vesting the decision making power within the family. However, there are also some potential drawbacks to having family members in key managerial positions. These include:
- Conflicts of interest: When family members are in charge, there is a greater risk of conflicts of interest. For example, family members may make decisions that benefit themselves at the expense of the company.
- Lack of diversity: Family-run businesses often lack diversity in their leadership. This can lead to a narrow range of perspectives and a lack of innovation.
- Difficulty in succession planning: When the founder of a family-run business retires or passes away, it can be difficult to find a qualified family member to take over. This can lead to instability and a decline in the company’s performance.
- Non family members may only occupy senior positions but with very little opportunity for decision making/ influencing the decisions made by family members.
- Slight instability/ rivalry or difference of opinion could adversely affect the business and lead to positioning the business in a negative light in the market and to prospective investors. For example, it could lead to:
- Decreased productivity and efficiency, as employees may be distracted by conflict or uncertainty.
- Increased turnover, as employees may leave the company to avoid the negative work environment.
- Damage to the company’s reputation, as customers may be less likely to do business with a company that is seen as unstable or contentious.
- Difficulty attracting new investors, as potential investors may be wary of investing in a company that is not stable or that is seen as having a negative work culture.
- There is a greater risk of nepotism than providing a fair chance to others (outside family) to be in key positions. Nepotism is the practice of favouring relatives or friends, especially in hiring or promotion, without regard to their qualifications. This can lead to a number of problems, including:
- Incompetent or unqualified people are being hired or promoted.
- A lack of diversity in the workplace.
- A decrease in morale and productivity.
- A loss of trust in the organisation.
- Businesses are driven more by emotions than by professional practices and procedures. This is because emotions can cloud judgement and lead to decisions that are not in the best interests of the company. For example, a business owner who is feeling stressed or anxious may make impulsive decisions that they would not normally make. They may also be more likely to take risks that could end up costing the company money. Professional practices and procedures, on the other hand, are designed to help businesses make decisions in a rational and objective manner. They provide a framework for decision-making that can help reduce the influence of emotions.
- The head of family is not competent enough to run the business and, subsequently, could lead to inappropriate transfer of power within the family as the family grows.
- Unawareness of policymakers of the specificities of family businesses and their economic and social contribution.
- Lack of a proper succession plan and businesses being transferred to incompetent successors.
Provision for corporate governance in family owned companies under Companies Act, 2013
As mentioned earlier, the family owned businesses are expected to follow and adhere to an equivalent corporate governance mechanism as any other non-family owned company or group of companies. The corporate governance mechanism is essential for running any business successfully and ethically. In fact, it is more important to have a well structured corporate governance mechanism for family owned businesses in view of the challenge, as brought out earlier in this document. Institutioning standard accounting processes, preparation and disclosure of the financial statements – demonstrating transparency in all its transactions as well as accountability towards shareholders and other stakeholders—will strengthen the organisation. Some of the other important measures are appointing independent directors, ensuring an accountable and transparent board of directors, conducting regular board meetings, having whistleblower policies, etc.
A family protocol should be commonly used in family business as a set of rules that define the internal policies on which the family members agree to work during the life of the company. The report of the European Commission on Family Businesses referred to the Family Protocol as the Family Constitution and defined it as:
“A statement of the principles that outline the family commitment to the core values, vision, and mission of the business. The constitution also defines the roles, compositions, and powers of key governance bodies of the business: family members/shareholders, management, and board of directors. In addition, the family constitution defines the relationships among the governance bodies and how family members can meaningfully participate in the governance of their business. (European Commission, 2009)”
Key points for continued success of family owned businesses
The family owned businesses must focus on the following key points to have continued success in the long run and greater confidence among shareholders and stakeholders:
A clear distinction between business, emotions and family relations
The head of the family (and potentially the head of business) is accountable to ensure that all the family members involved in running the business have a well defined role and responsibility. Businesses do not run only on emotions and relationships. Each member is expected to perform his/ her role appropriately and it is important that each member has a clear understanding of the expectations from them. This clarity will help not only to prevent internal clashes and conflict but also to help businesses thrive and compete at the global level with other businesses.
Define leadership roles
A succession plan is vital for any business activity in order to be prepared for the future, whether it is a planned transition or a role acquisition due to exigencies. A well structured succession plan consists of the skill/ competency gaps and a roadmap to bridge them. The person likely to succeed the incumbent gets a good opportunity to learn the secrets as well as a proper handoff. It also helps to remove any confusion about whether there is natural succession (e.g., from father to elder son and so on…) or a well-planned, out of the box succession. It also helps shareholders and other stakeholders express their interests, objections, etc. and keep business communication clear and transparent.
Principles of democracy
In order to run a business with disciplined business practises, it is absolutely necessary to appoint democratically selected directors on the board of directors in family run family owned businesses. It is an important aspect of building confidence since most of the key positions are generally governed by favouritism and nepotism. It is important to make the governance practises public as much as possible to emphasise family’s resolve to run the businesses ethically as well as professionally.
Separation of family protocol vs company by-laws
It is highly important to have distinct boundaries for family protocols and company by-laws because both of these operating guidelines have distinct characteristics and should not conflict with each other. The family protocol is an agreement of honour in the family fellowship designed by family members (with or without external guidance) and harmonises family interest with business interest. On the other hand, the company by-laws are a public document controlled by laws that is generally designed and elaborated by lawyers who have expertise in defining the company bylaws and focus only on the business interests to regulate the company’s whole structure. The family assemblies should not interfere or double up with the general meetings of the business, as the family assemblies are generally held to handle family matters and general meetings are held to handle business topics.
As is evident from the discussion in this paper, corporate governance is an absolute necessity in family run businesses to protect the rights of family members and shareholders (current and future), to treat family members equally, and to maintain the power balance. It also protects the rights and interests of third parties (stakeholders other than family members) to promote active cooperation between them and society in general by creating more jobs and wealth. The ultimate goal is to keep the business competitive and flourishing. The family owned businesses face a unique set of challenges as compared to other companies due to the very nature of their control. To build confidence among external stakeholders, it is necessary to have a well structured governance mechanism and businesses need to demonstrate that established controls are practised.