by Donald J. Jonovic, Ph.D.
Owners of closely held companies, by experience, inclination, necessity, and, often, personality, tend to focus on the short term. Most available waking hours are absorbed by immediate problems, sudden opportunities, annual profits and cash flows. Fortunately, a successful business can, in fact, be built this way. It happens every day.
Unfortunately, this focus on immediate challenges and rewards is definitely not the way to build the shareholder value of that successful business for the long-term.
Consider how this outlook affects transition. Few would doubt that a smooth ownership and management transition in a family firm can enhance the value of that firm to shareholders and potential buyers. Even so, in companies with a short-term focus, transition (when it’s thought about at all) is seen as an “event” in some distant future: “We’ll get to it when the problem arises.” This is wrong. Companies don’t suddenly decide to have a transition any more than a woman suddenly decides to give birth. Transition is a process. It is a way of going about things.
Similar statements could be made about developing management, building unified shareholder vision, even maintaining a sound buy/sell agreement. Each enhances the long-term value of the firm. Each is a process rather than event. Each withers in businesses with a short-term focus.
I refer to development of these “processes” in a successful family business as “professionalization” of that business. In practice, this translates to assuring long-term growth of shareholder value through a longer-range focus on the key factors supporting business value: shareholder harmony, effective management, and efficient internal communication.
Further, since taking this longer view is generally a foreign experience to most successful business owners and their managers, a new telescopic lens must be attached to the operating periscope: the right help or effective outside review.
Effective Outside Review
Most business owners resist the idea of forming a functioning board of outside directors. The main sources of their reluctance are desire to maintain their independence a sense of uniqueness (“Outsiders could never understand this business.”), a strong culture of secrecy, and a deep distrust of formalized “bureaucracy.”
I don’t argue with these sentiments, except, perhaps, the penchant for secrecy. While I understand the motivation, I’ve seen the negative results of the hermetic seals that encapsulate so many business owners and families in business. Instead of protecting them from outside interference, it tends to doom them to atrophy, depriving them of the very dynamism and flexibility for which entrepreneurship is praised.
Thus, even accepting the reality that most closely held companies aren’t ready for an outside board, we can’t sit back and allow them to proceed with no help at all.
As argued in a previous article (“What Most Businesses Need Before an Outside Board,” Family Business: Winter, 1993), the first step toward professionalizing and increasing shareholder value for most business owners is creation of an advisory board. This is an informal body composed of key management, key shareholders, and key advisors to the business. Their charter is simple in concept, but often technically difficult in application: help the shareholders and management focus on the following three components of professionalization:
Professionalizing a successful closely held business begins with professionalizing the ownership (This doesn’t mean sending shareholders to leadership school or fitting them for three-piece suits. It means managing their roles and relationships for maximum effectiveness).
This can be a useful and obvious place for the advisory board to start, usually through creating or updating the shareholder buy/sell agreement. The process necessarily focuses on all the key questions of transition. Does the agreement deal with the future of the business as well as tax issues? Is a cross-purchase (surviving shareholders buying out the interest of deceased owners) still sensible now that children are involved? Should non-working heirs share in ownership? Should the value of the business be revised annually? If not, how often? What kind of business valuation formula, if any, should be used? Should a periodic professional valuation be performed?
If a future sale is anticipated, there are additional considerations. A potential acquirer walking into a morass of quarreling shareholders won’t have much interest. A carefully thought through buy/sell can help here, too, thus increasing shareholder value by increasing market value of the business. For example, to help keep a minority group from blocking a sale, the buy/sell could provide for sale without 100 percent agreement. Or it might even determine ahead of time what would constitute a valid purchase offer.
Most important, shareholder agreements tend to focus on share value, which is both central to shareholder harmony and the paradigm measure of both shareholder value and long-term business health. Business value should be a focus of the advisory board, reviewed at least annually right along with the balance sheet and operating statements.
The quality of management is the bedrock of shareholder value. If you doubt this, apply the “wallpaper test” to your management team: Would your team be retained by a new buyer? If your answer was “no,” you probably wouldn’thave a buyer. Without an effective management team, the company’s value to a potential buyer is significantly decreased. On the other hand, a working, functioning team with a positive and identifiable impact on the bottom line can neutralize one of the most troubling negatives in the value of a closely held company–dependence on “The Boss.”
The effectiveness of the management team can be enhanced by identifying goals and establishing objectives–obvious value levers, clearly, but too seldom found in the toolbox of closely held companies. Developing an ongoing, formalized process of performance evaluation–a process of review, constructive critique, and quantitative measurement of performance–is essential to professionalization, but, like the shareholder agreement, is often beyond the skill set of internal management. Again, this is an important area where an advisory board can offer essential help and expertise.
Consider, for example, the miasma of compensation. In closely held companies, compensation is seldom rational, but it must be. Professional advisors, working together with shareholders and key management, can help build a professionalized (responsive, sensible and workable) compensation system.
Whether compensation is an effective motivator is debatable, but, for companies wanting to professionalize, there’s no doubt that it can provide an effective means of focusing and redirecting management toward the goal of increasing shareholder value. Advisors can help business owners develop bonus systems clearly tied to performance (not only the individual’s but the company’s). They can help explore options, including some form of equity bonus. Phantom stock plans, for example, while not providing actual ownership participation, tie management effort to the bottom line and offer ownership–like reward.
These are complex issues, but they are not new to the planet Earth. Competent advisors can bring experience and depth of knowledge to unique situations. They can also help keep the long term focus that business owners tend to neglect.
Efficient Internal Communication
Understanding different points of view is particularly important in the closely held company because the key concept of “shareholder value” has as many meanings as there are shareholders. Internal communication must be structured to manage the effects of this richness of opinion.
In a closely held or family business, each individual owner can and usually does take a variety of roles: shareholder, director, manager, and that unique role each plays as an individual. When people speak to each other from different perspectives, communication pathways inevitably get clogged.
For example, Brother Joe, half-owner and warehouse manager, may be speaking as a manager when he wants to invest in increased warehouse space to improve order response time. His “shareholder value” is defined as business growth. Brother Tom, half-owner and potential retiree, may be thinking as a shareholder wanting to improve his ROI by limiting capital improvements and increasing dividends. His “shareholder value” is optimizing personal cash flow.
Formalizing the communication process is essential to eliminating such misunderstandings. Specifically, it’s helpful to set up formalized meetings to separate the various levels of decision-making. In practice, this usually means scheduling shareholder meetings, advisory board meetings, and management meetings, regularly and at appropriate intervals.
- Shareholder Meetings.Shareholders and professional advisors meet annually or semi-annually to wrestle with shareholder value objectives: return on investment, growth in value and management of risk.
- Advisory Board Meetings.Broad, strategic issues like compensation structure, capital investment, and long-range plans are saved for advisory board meetings, which are held somewhat more frequently–perhaps quarterly–and include key managers, owners, and advisors.
- Management Meetings. At regular meetings, strictly operational issues are addressed. Only managers and, as needed, professional advisors are involved.
Yes, it is somewhat bureaucratic, but without such a formal structure, it is difficult to safeguard against the ever-present danger that one person speaking as a manager and another speaking as a shareholder might come to verbal, emotional, even legal “blows.” Through “professionalizing” internal communication, this most common and widely discussed problem in family businesses–owner or family conflict–can be the one that’s most easily managed.
The fundamental objective of business ownership is the building of shareholder value, however that’s defined in a specific business–as increasing cash flow, expanding profits, building equity, or adding to market value. Entrepreneurs and founders do a good job building value for themselves and their partners by combining talent and energy with the leverage of a short-term, reactive focus.
The more successful a business becomes, however, the less it responds to this operational myopia. Threats loom ever greater, but farther in the future and harder to see. Solutions take more time to implement, and more time to show results. Internal skills and knowledge get engulfed by a rising tide of complexity. Shareholder value stagnates or drops.
Professionalization corrects this myopia. It’s a process of building abilities to see more distant threats. It’s a means of ensuring that problem solving begins early and is relentlessly pursued. It’s a commitment to widening the base of knowledge and expertise available to the organization.
Ultimately, professionalization is a commitment to building the ownership, the organization, and the advisors together into a powerful “solving engine” that automatically scans in ever-widening circles for ways to protect and build shareholder value in the long term.
Donald J. Jonovic, Ph.D., President of Cleveland’s Family Business Management Services, is an advisor to family businesses. He serves on many boards, and is an adjunct assistant professor at Case Western Reserve University.