Governance of the Business Entity

The corporate governance model is the most effective business governance model because of the recognition of the interest of the three discrete groups, ownership, management, and policy. Moreover, the control adjustments available between the groups allows fine-tuning for a particular business needing a certain mix of boundary definition and control. In entities such as limited liability companies, where there is no formal policy-making group provided for in the typical entity creation, a provision for such a group can be added to the legal documentation of the entity.

The bylaws of a corporation and the statutes of the state of incorporation control the relationship between the board of directors and the president of a corporation. Typically, the shareholders (owners) elect the directors on the board. In addition to setting business policy, the board of directors appoints the officers of the corporation including the president. The board of directors sets compensation for and reviews the executives it appoints, including the president. In a closely held corporation, the shareholders, directors and executive officers are often the same people. Some states have statutory provisions which allow simplification of the typical corporate structure in the case of a closely held corporation. Many owner-managed businesses use limited liability companies or other business entities where the roles of owner, executive and employee are not so sharply defined. It is not unusual for the ownership, management, and policy roles to be confused and duties (especially review of the president or CEO) overlooked.

To make the best decision-making process in the business planning process, a small group of diversely informed individuals should aggregate their judgments and provide that wisdom to the decision-makers charged with determining and setting forth the policy. This group should be formed to include the elements of diversity, independence, and decentralization. In a corporation generally this group will involve the board of directors, sometimes supplemented by a board of advisors. But in a closely-held business or a limited liability company or other entity, the ownership and policy-making roles will not be with separate individuals and the boundaries of ownership, management, and policy may not be defined. In these situations advisory boards with members outside the business may help keep the proper perspective in the policy or planning process. Advisory positions may be informal and usually will not involve the liability of a director’s position on a board of directors.

The business planning process may be viewed as a series of decisions. These decisions are best made when the decision-makers have the input of policy group members exhibiting diversity, independence, and decentralization and articulating written judgments concerning planning problems. A collection of these written judgments will constitute a plan. The plan will be executed by the executive officers of the business.

Choice of Business Entity

There are a number of variables that will suggest appropriate entity selection. Three factors are most considered: limited liability, governance (including control and compensation), and tax treatment.

The primary factor is limited liability. An individual should not do business unless it is through a limited liability entity. Limited liability protects the business owner from the claims of outside creditors of the entity and also protects from the liability that could accrue to an owner from the actions of another owner. Generally the choice of limited liability entities is between a corporation and a limited liability company (“LLC”).

The next factor is governance. With respect to the number of owners, recent court decisions suggest that a single owner of an LLC will not have as much liability protection as the single owner of a corporation. Moreover, the governance and compensation issues are different between an LLC and a corporation. For example, in a corporation each owner would vote shares of stock on ownership issues (electing a board of directors and officers) and typically an owner would exercise one vote as a director on the board of directors (setting compensation) and receive compensation as an officer (employee) of the corporation. With a limited liability company, the member is not an employee of the company and profits of the company are allocated to the capital accounts of the owners (members) in the proportion of their capital contributions. A member will not have control unless the member is designated a manager by the member or members contributing the most capital. The number of owners and the amount they invest will influence control and compensation issues of the entity.

Tax treatment generally involves three choices: corporate (“C corporation”), S corporation, and LLC. A C corporation is taxed as a separate taxpayer on the money it earns (filing a form 1120). Money in a corporation can be transferred to a shareholder in three ways: compensation (salary and bonus), dividends, and loans. Often the warning is given that the C corporation shareholder will incur “double taxation.” While this can happen, well-run C corporations are able to utilize the deduction for wages and bonuses, along with other benefits regarding fringe benefits and retirement planning to reduce or eliminate this effect. The shareholder of an S corporation is liable for tax on the income of the S corporation but the S corporation does not have to pay tax (filing an informational form 1120S with a K-1 to the form 1040 of the shareholder). Since much of the profit of the S corporation can come to the shareholder as a dividend without additional tax, advisors frequently recommend that S corporations pay small salaries to shareholders who are employees to limit amounts paid to withholding and government trust accounts. The owner (member) of an LLC receives in the member’s capital account an amount from LLC earnings in proportion to the balance of that owner’s capital account to all other owner’s capital accounts. (An LLC files a partnership form 1065 with a K-1 to the manager’s form 1040.) This entire amount will be subject to self employment taxes. S corporations and LLCs can “pass through” losses incurred by the entities to the extent of basis (the money invested).

Entity selection involves a complex decision tree. Do a thorough analysis involving all the owners with accounting and legal advice before the selection is made.

Status of Owner-Managed Businesses

A closely-held business is a business owned by its managers and is also called an owner-managed business. Family relationships are involved with owner-managed businesses. Depending on how you define family business (multi-generational involvement in both ownership and management, for instance), family businesses are owner managed businesses.

Seven out of ten new employer firms last at least two years, and about half survive five years. More specifically, according to Census data, 69 percent of new employer establishments born to new firms survive at least two years, and 51 percent survive five or more years. See the Small Business Administration findings (http://www.sba.gov/advocacy/7495/8430).

Owner-managed businesses represent the majority of all businesses in the United States. Owner-managed businesses create most of the nation’s new jobs, employ about half of the nation’s private sector work force, and provide half of the nation’s non-farm, private real gross domestic product (GDP), as well as a significant share of innovations. The Small Business Economy – A Report to the President – 2008 (http://archive.sba.gov/advo/research/sb_econ2009.pdf). This report provides a perspective on the status of owner-managed businesses:

1. Challenges of the Economic Environment. In the last few years, owner-managed businesses faced difficult challenges in the extremely distressed financial environment. The credit freeze in the short-term funding market had a devastating effect on the economy and small firms. Although interest rates paid by business owners followed a pattern similar to movements in the prime rate, which declined throughout the year, most business owners faced a less accommodating credit market, especially in the second half of 2008. Lenders exhibited widening rate spreads and tightening terms of small business lending. By late 2008, the normal production of goods and services had virtually stalled.

2. Lost Jobs. More than half of the 763,000 jobs lost in the first two quarters of 2008 were lost in owner-managed businesses.

3. Continuing Challenges. Businesses face concerns about the cost and availability of health insurance, attracting a quality work force, meeting global competition, regulation, taxes, and government procurement opportunities.

Another resource is the American Family Business Survey (http://massmutual.com/mmfg/pdf/afbs.pdf). In the summer of 2007, the American Family Business Survey surveyed family-owned businesses to gauge strengths, challenges and changes since the previous study, which took place in 2002. The study was interpreted by Kennesaw State University and underwritten by Massachusetts Mutual Life Insurance Company (MassMutual) and the Family Firm Institute. The findings are summarized under the following topics:

1. Optimism. Even amid a housing market crisis and generally depressed business conditions, family business owners express general optimism. Only 26.5 percent of the respondents expect no change or a decrease in revenues next year. The vast majority of respondents are optimistic about the future; 22.3 percent expect increases in revenue of more than 11 percent and 51.3 percent of respondents expect an increase in sales revenues of up to 10 percent.

2. Urgent Issues. While they are performing and growing well, family businesses face some significant challenges. Perhaps first among these is the issue of succession. Within 10 years, 40.3 percent of business owners expect to retire, creating a significant transition. Of these, fewer than half (45.5 percent) of those expecting to retire in five years and fewer than a third (29 percent) of those expecting to retire between six and 11 years have selected a successor. Of those who have selected a successor, the successor’s median age is about 18 years younger than the current chief executive. Co-CEOs, as in previous years, are being considered at a similar rate (42.2 percent). Many have less certainty about retirement, which is also a tremendous risk. Almost a third (30.5%) have no plans to retire, ever; and nearly another third (29.2%) report that retirement is more than 11 years away. Since the median age of the current leaders is 51, this means that many people plan to die in office. Further exacerbating the substantial succession risk is the fact that nearly a third (31.4 percent) have no estate plan beyond a will. This is worse than the 2002 survey, in which only 19 percent had no estate plan beyond a will. Likewise, in 2002, 68 percent had a good understanding of estate taxes that could be due, whereas in 2007 this number deteriorated to only 53.5 percent having a good understanding.

Other urgent issues identified by respondents as being their most important challenges include, in order:

• Labor costs
• Health care costs Finding qualified employees
• Foreign competition
• Labor union demands
• Domestic competition
• Oil prices
• Availability of credit from lenders
• Estate taxes

3. Gender of Leaders. 24 percent of the businesses surveyed have a female CEO or President. In 2002 that number was only 10 percent (which was already double 1997 numbers). As a result, within the past decade there has been an almost five-fold increase in the number of women leaders in family businesses since 1997. The trend of female leadership of family businesses should continue as 31.3 percent of firms indicate they may have a female successor. And the prevalence of women in leadership positions carries through the organization even when moving down the organization chart. Nearly 60 percent of all firms have women in top management team positions. On average, the family businesses in our sample each employ nearly five family members, of which 60 percent are men and 40 percent are women.

4. Ethical Behavior and Social Responsibility. Family exerts a strong impact on the business; 83 percent state their families have a high influence on the business and 91 percent indicate that the owning family’s values are emphasized in the business. 57 percent of the respondents answered that being a family business affected their firms’ ethical behavior. Family firms have not made the investment in the kind of written code that is more common in larger firms. Over one third of firms have a written code of ethical behavior, but most of these family businesses (60 percent) believe that their ethical standards are more stringent than those of competing firms. The respondents also report ethical standards are discussed often or always at meetings with lower- and mid-level employees (54 percent), in discussions with customers (48 percent), in meetings with executives (45 percent) and suppliers (38 percent), and during board meetings (36.5 percent). The firms in the sample are deeply embedded in their local communities, more than two-thirds (67.2 percent) of respondents said their businesses contributed significantly to their family’s identity in their communities.

5. Professionalism. Slightly more than one third of the firms (36.6 percent) have a written strategic plan. Similarly, a bit less than one third (31.1 percent) use a formal process to establish a strategic plan. 20 percent had or do have a non-family CEO (a large increase from 14 percent in 2002). The use of other types of formal planning:

• 37.4 percent have buy-sell agreements or other arrangements defining who can own stock and how it is transferred;

• 64 percent have regular formal valuations of the worth of the business;

• One third have an active board of directors and over half (50.9 percent) rate their contribution as outstanding;

• Over half (55.4 percent) have formal family meetings at least once a year; and

• Almost half of all firms (45.2 percent) have a full-time employee responsible for human resource management matters such as recruiting, performance.

6. Family Unity. The families here are unified; 87 percent say family members share values. When it comes to the unity of the owning family in business matters such as strategy, ownership, and management, 82.9 percent of the respondents answered that they were completely or very unified as an ownership group.

The status of owner-managed businesses in the face of difficult economic circumstances is problematic. Owner-managed businesses project the common human frailties of unrealistic optimism and denial. Too few use a decision-making process based on accurate and realistic information. Too few incorporate good decision-making into the creation of strategic planning to better deal with the inevitable challenges. Too many owners are in denial about their inevitable separation from the business, leaving the business – the other owners and its employees – in jeopardy. While the survey indicates families believe they have unity, experience indicates that unity, if present, is not a constant. Without ownership agreements providing conflict resolution, the stability of the business is fragile.  Only one in two owner-managed business will be in business in five years. For most owner-managed businesses, the ongoing viability and success of the business is in doubt.