Obamacare Rules Pose Challenges for S Corp Owners
The decisions facing business families can be gut wrenching – and the implications of these decisions can be huge both for the future of the family and also of the business: “Who should the next CEO be – my daughter or my son?” “Should we buy our cousin out of the business?” “Can non-family directors be trusted to make key decisions for our business?”
To help our clients, we use a simple analogy for how and where strong family businesses make decisions. Just as we separate the bedroom from the kitchen in our homes, successful family businesses build out and furnish four rooms: the owner room, the board room, the management room, and the family room.
Discrete decisions are made in each room: management directs operations; the board monitors the performance of the business and hires/fires the CEO; owners set the high-level ownership goals for the business and elect the board; and families build unity and develop family talent – to name just a few of the most basic decisions made in each room.
Well-run family business systems funnel decisions to the appropriate room, and family members and others play different roles and behave differently in each room.
The source of decision-making power also varies across the rooms. In the owner room, power is based on who controls the shares, either directly or through trusts. In the board room, directors influence one another in a peer-to-peer setting. CEOs run organizations that are hierarchical and generally make decisions based on financial returns. Families usually operate by consensus and make decisions based on their impact on legacy and stewardship.
The four-room model helps set decision boundaries. A non-family CEO, for example, stays in the management room and doesn’t tell the scion of the business family where to go to college. Similarly, executives make many daily decisions on how to implement the business strategy but do not decide the dividend policy. That’s up to the owners. For their part, family members can’t just walk into any room; there has to be a process for channeling family wants and needs to the appropriate rooms.
The four rooms are not randomly configured; there’s a clear hierarchy. Management answers to a board that ultimately answers to the owner group. The family room is not perched atop of the other rooms, as the other rooms don’t report to the family. Rather, the family room runs adjacent to them to symbolize family unity, which is so important for maintaining decisiveness across the full family enterprise and for developing the talent of family members who, if qualified, can move into other rooms. The family room is also important in that it provides a forum for addressing the family conflicts and stresses that can spill into the other rooms.
In our work using the four-room model, we have found that family businesses face three reoccurring, fundamental challenges in decision-making. Let’s take a look at each of these in turn.
Family A* lived in one room. They conducted business around the lunch table. The nine siblings, who equally owned the business and served in key leadership roles, ate together every day. The executive dining room became the de facto board room, owner room, management room, and family room. At one sitting, it was typical of the siblings to go from talking about the minutiae of daily business (setting prices at the retail stores that the family owned), to how the siblings should invest their multi-million dollars of jointly owned liquid assets, to where to spend their Christmas vacations.
These were genial discussions that rarely led to decision-making – one of the greatest challenges (and dangers) facing any family business. The conversations tended to go round and round despite the need to take action on a business portfolio that was on the decline. What was going on? First, the informal setting fostered wonderful dialogue, but rarely led to actual decisions. Even when actions were agreed on, there was little follow-up to see whether they had been implemented. More importantly, decision-making defaulted towards consensus based on the equality of their ownership, despite some having greater expertise in certain areas than other siblings did.
Many family businesses have this very informal way of exchanging information; they are often unaware that structure can dramatically improve the quality and effectiveness of their decisions. The lack of awareness is typically historical. A one-room family business is like a massive loft in which a bachelor might live – a converted warehouse that combines the den, bathroom, bedroom, and kitchen into a single space. Were he to marry and have children, our bachelor would need a larger house with walls dividing the rooms; there would have to be a separate kitchen, dining room, living room, and bedroom. So, too, as the family business grows from a founder-owned and operated entity to a larger family system, it must evolve towards a more sophisticated structure.
We helped Family A to see the need for structure, and they separated their family business system into the four rooms. We worked with them to create Executive Committees for their core businesses, each reporting to a separate board. An Owner Council was established to make decisions about how to allocate capital across their businesses, and a Family Council to prepare some of the 30 members of the next generation to step into leadership and management roles one day, if suitable. The nine siblings no longer occupied every room together, and people were brought in from the outside — in particular, into the management and the board rooms — to make the decision-making process more effective.
Although it took the siblings time to adapt to the structure of the four rooms, doing so has allowed them to make some tough choices about their business, as well as to find the mix of roles that best suits their talents and interests. They still eat lunch together every day, and clearly enjoy one another’s company, but now they come together primarily to catch up on their nephews and nieces, to plan vacations, and to stay connected as siblings.
Family B was in many ways a showcase family business. They had world-class family governance led by a textbook family council; in fact, we have never seen a finer one. They had a rock-star board room, with a mixture of family and non-family members. The directors met regularly and effectively oversaw the business, which was well functioning and profitable. Dividends were strong, even as the business was growing.
But there was one overarching problem – the owner room was missing. The owners had by choice given their proxy to the directors. They held shareholder meetings once a year as required by law, but these were perfunctory. The proxy effectively allowed the board to elect itself.
Eventually there was a majority of outside members on the board, and the influence of family owners began to wane. The family council was outstanding at organizing annual family meetings and developing the next generation, but they could not provide a cohesive perspective on key owner issues and decisions.
In its role overseeing management, the board kept asking: “What do the owners want?” “Do they want to grow the business?” “Do they want liquidity?” Without an owner room, the board had no way to have this conversation directly with the owners. In the absence of this perspective, the board members charted the course that they thought made the most sense. It took several years for the family owners to realize that the path they were on was not the one that they wanted, but they lacked the venue to act on that concern.
Having a family business with no owner room is like owning a mansion without a kitchen: no matter how beautiful the estate may be, the home is not functional. Yet in our experience, the owner room is the room that is most frequently missing in a family-owned business, at least in the US.
In part, the explanation lies in the fact that US business schools have lots to teach executives about best practices for boards and management in publicly-traded companies, lessons that can be transferred to family- owned businesses. But private ownership is generally ignored in academe – and in practice. Advisors who dedicate themselves exclusively to family firms have focused on the family part of the family business system for the last 30 years.
While good family business governance is necessary, it is not sufficient.
If there is no owner room, the family’s connection with the business gets lost. When owners become passive over time, they lose control of the business to the proxy who makes their decisions for them. On the other hand, we know of quite a few prominent European families that have owner rooms but no family rooms. In these cases, money becomes the overriding concern. Voting rights determine how decisions are made — even when family members are discussing the budget for the next family gathering.
That was not the problem for Family B, who needed to create a functioning owner room. To do so, the family first had to do something that felt uncomfortable. They had to establish a venue where family members were not all equal, where owners would participate, but spouses and in-laws would not – i.e., an Owner Council. The owners then augmented their knowledge of the business before electing representatives who would be authorized by the full owner group to define their vision for the business and actively select the board. It took time, but today the family has recovered control over their business, with the owners now serving the critical function that had been missing.
Family C had a board room where an under-performing non-family CEO/chairman dominated a set of fairly disengaged and inexperienced family board members. When the board met, the CEO/chairman ran the show, sharing what information he chose as relevant. Questions from the family directors were addressed with a confusing level of detail that they couldn’t understand. The owners said that they felt “stupid” during board meetings.
While the company was clearly under-performing its peer set, the CEO/chairman ensured that he had a non- performance based, very lucrative compensation package. The owners, on the other hand, were told that dividends were unlikely for at least a couple of years. Clearly, the right people were not in the board room.
Getting the right people in the board room, however, is no easy task. It often provokes anxiety to bring independent directors into a closely-held private business. Unless they are just rubber-stamping the decisions of majority holders, independent directors wield a lot of power. They learn the secrets of the business and are, indeed, outsiders. The level of trust required to share information with outsiders is extremely high. But when it works well, a good board serves as a buffer and a bridge between the owners and the business. As a colleague puts it: “The board is the arbitrator of fairness.” Indeed, by solving problems in as unbiased a way as possible, a highly effective board can help stabilize the family business across generations.
Cleaning up a board room usually involves balancing the number of directors who are owners with outside, independent directors. Over time these board rooms often shift to a majority of independent directors, but this transition typically takes many years. Best practice is for non-owning executives, other than the CEO, to be excluded from the board, while family members are restricted to those who are deeply knowledgeable of, and committed to, the business, rather than to those who are there to “protect” their ownership stake.
With this in mind, we helped Family C do two things: elect a set of strong, independent members to its board and move some discussions and decisions from the board room into the owner room, where the family owners could discuss their concerns and make ownership decisions outside the direct influence of the CEO/Chairman. (We also recommended an outside director be named Chairman, but the CEO’s contract prohibited that action. Some messes stay messy – or are postponed for later.)
The four-room analogy is a simple but dynamic way of rethinking decision-making in family businesses that can be transformative. As a CEO client summed up the transition to the four rooms: “I’ve become 50% more efficient. When my second brother, who no longer works in the business, comes into my office now and complains about some executive decision that I’ve made, I say, ‘Jack, are you talking to me as an owner? This issue is not in your bailiwick. This is the management room.’ Now I have one conversation at a time – and sometimes more conversations than I ever thought were necessary – and I am making a lot more progress.”
This is the eureka moment that is the reoccurring theme in our work.
*Some of the identifying details in this article have been changed to protect client confidentiality.
First Published: 8 Sep, 2015. Harvard Business Review