Legal Strategies for Smooth Family Business Succession

“What keeps these patriarchs awake at night is succession to the next generation”, said Kevin Herbert, HSBC’s co-head for private banking in north Asia, as he spoke to the Financial Times in March this year about Asian tycoons and family businesses. Family business leaders have good reason to worry. Only a third of all family businesses survive the transition from one generation to the next. Indeed, the number of businesses that have been in the same family for more than 200 years could be as few as 46 worldwide.

In recent years, American business school professors have been studying family businesses. The case studies on family business successions published by Professor John L. Ward of Northwestern University and Professor William T. O’Hara of Bryant University are particularly instructive. Based on an analysis of these case studies, this article discusses the major challenges of succession and the governance structures that lawyers could devise for family businesses to smooth the succession process.

The Three Stages of Succession

Succession is a long-term process that starts before, and stretches beyond, the actual handover of the business. It is also one of the most emotionally-charged business decisions for any family business. Having a good governance structure goes a long way towards managing this lengthy and emotional process.

Succession can be divided into the following three stages:

  1. selecting an heir;
  2. handing over the business; and
  3. keeping the peace within the family after the handover.

Each stage brings its own challenges, which are outlined below.

Selecting the Heir

It seems only natural that an incumbent CEO would want to pass the family business to his or her children, but selecting one child over another to manage the company can be difficult. This is why the selection process is likely to be the most emotional and sensitive aspect of the succession process. Actual or apparent favouritism leads to family disputes that may ultimately shatter the family and the family business.

Fairness is key to the selection process. From its early days, a family business should establish an employment policy that sets out the qualifications expected of its CEO. The qualifications should be as objective as possible, for example formal education requirements, language requirements, and experience requirements both outside and within the family business (eg, having held a senior executive position for a certain duration). The employment policy should also specify performance targets and subject candidates to regular performance reviews.

By setting out the qualifications and performance targets in an employment policy, the selection process becomes more transparent. Transparency promotes fairness and meritocracy, both of which are important values for any successful business. The successor chosen in accordance with the employment policy is likely to command more respect from others, which in turn, helps to maintain stability during the later stages of the succession process.

Having an employment policy also helps the business to nurture talent within the family. The policy provides clear goals for ambitious family members, thereby encouraging them to develop the necessary competency from an early age.

However, family businesses should prepare for the worst. Unexpected events can create a vacuum in the line of succession. Family companies should prepare themselves for this risk by retaining external talent. In addition to bringing new ideas, external talent can ensure the continued success of the company where there is a lack of interest or talent within the family. They can also help the company to survive unexpected events such as the sudden illness or death of an heir or family member, who holds a senior position. In order to retain external talent, the company should consciously create promotion opportunities for them, such as setting a limit to the number of top positions held by family members so that outside talent can aspire to rise to the highest ranks.

The Handover

Many aging CEOs are reluctant to retire. Since they have invested so much time, effort and capital in their businesses, they may be unwilling to hand their businesses over to their successors. This reluctance to retire creates risks for the business. First, it causes tension between the two generations, which may adversely affect the management of the company. Secondly, talented next generation family members may be deterred from joining the family business if they know that one day they might need to wrestle control from their parents. Thirdly, a reluctant CEO is less likely to plan well for the transition between the two generations. The successor may, therefore, find himself ill-prepared and hastily ushered into the commander seat only when the incumbent CEO is unable to manage the business any further.

The obvious response to this challenge is to impose a mandatory retirement age in the CEO’s employment contract and the firm-wide employment policy. The retirement age should be agreed upon at an early stage (ie, before retirement becomes an imminent and emotional issue).

It is equally important to address the emotional aspect of retirement. The retiring CEO should be reassured that retirement does not necessarily mean that he or she is cut off from the family business. He or she may still be a member of the board or be retained as a consultant of the company. These arrangements can help the retiring CEO ease into retirement, smooth the transition process and also benefit the company as the retiring CEO continues to contribute his or her knowledge and experience to the business.

Keeping the Peace

Family companies are strengthened by family solidarity and weakened, if not wrecked, by family feuds. Therefore, managing the “family” aspect of the company is just as important as managing its “corporate” aspect.

Family feuds are most likely to occur during the succession process, but their risk of occurring does not end with the handover. As the business is passed on through the generations, the ownership of the business may be dispersed across an increasingly large number of family members, which increases the risk of family disputes regarding the management of the company.

It is inevitable for family members, at some point, to have diverging interests and needs. While some members may wish to hold on to their shares in the company, others may wish to sell their shares and pursue other interests. It is in the company’s interest to concentrate ownership in the hands of shareholders who share common interests and goals; otherwise the company may be embroiled in negative publicity and court proceedings by disgruntled family shareholders. Therefore, the company should establish a mechanism by which family members can easily trade their shares within the family. For example, family members could enter into an agreement whereby they give one another a pre-emptive right if one member sells his shares; if no family member wishes to purchase those shares, the shares will then be repurchased by the company. To truly facilitate exit of ownership, the shares must also be valued at a fair price.

Another common area of tension is between managing and non-managing family members. In most cases, only a handful of family members will hold senior positions in the company. The non-managing family members (who may or may not be shareholders of the company) may suspect that they are not being fairly treated by the managing family members, or that the managing family members are diverting value from the company to themselves. Such suspicion provides fertile ground for breeding distrust and disputes.

There are three approaches to solving this problem. The first focuses on objectivity and due process. The family business should develop policies to govern sensitive areas, such as the employment, remuneration and dismissal of family members as employees of the company. These policies should set out the decision-making process and the factors that the decision-maker should and should not take into consideration, thereby establishing a more rational structure for determining potentially emotional issues. Ideally, all family members should be involved in formulating the policies, so that the policies have more legitimacy. Mechanisms should be put in place to allow for periodic review of the policies so that they reflect changes in the family’s needs and concerns. The company could also establish independent committees to consider and decide upon these sensitive matters.

The second approach focuses on communication and transparency. Successful family companies put in place structures that facilitate information sharing and communication between family members. For example, the company could mandate disclosures relating to key areas where managing family members are in positions or situations that create conflicts of interest, such as compensation, perks and benefits, and external business opportunities. Families may also organise regular family meetings to strengthen family ties and to identify concerns before they escalate into problems.

The third approach focuses on dispute resolution. The company could establish procedures that facilitate rational and structured discussions of contentious or sensitive matters. Further, if the company has a board of directors, the majority of which are independent professionals not affiliated with any family member, then the board could have a crucial role as a mediator between the family members who are merely shareholders and those who are also senior executives. In case of a deadlock, the board may be empowered to end the stalemate by deciding the matter once and for all.

Conclusion

Succession can be a bumpy ride for family businesses, mainly because it is fraught with emotional tensions. Such emotional tensions can be eased by governance mechanisms that facilitate objectivity, transparency and communication, thereby providing a rational structure to the succession process. The mechanisms considered in this article not only have the potential to smooth the succession process, but also may enable family businesses to emerge stronger from the process. 

Jurisdictions: 

Mayer Brown JSM, Associate

Xin Fang holds a First-Class Honours Master’s Degree in Corporate Law from the University of Cambridge. She has worked at Mayer Brown JSM since 2010, focusing on international mergers and acquisitions, joint ventures and private equity transactions.