February 2015

In This Issue

Why private equity-backed companies need independent directors, Developing an independent family business board, and the Private Company Governance Summit 2015

eNews Date: 
Wed, Feb 04, 2015

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Featured Articles

Case Study: Developing an Independent Family Business Board

Best practice for any family business seeking to transition to the next generation is establishing good governance that is appropriate for the particular circumstances of the family and its enterprise. But, practically speaking, how does this evolve? Consider the following case of a family-owned manufacturing firm and the factors that led the founder to invest in the development of an independent board.

The family had just finished a six month family business consulting engagement and now had a basic management and ownership succession plan in place. In addition, a family bank was set up to manage a vacation property, help avoid family conflict over money, and as a resource for entrepreneurial family members not in the family business. Satisfied with the work done to date, the founder asked, ‘What’s next?’

State of the business

The family business in this case is complex, with over 500 employees and several international offices. It is a C-Corp, and several employees own a small amount of stock. The company was founded on the strength of the founder’s proprietary technology and had grown rapidly in its 25-year history. Although senior leadership had accomplished a great deal in bringing a start-up from an idea to a $150 million operation, they understood that the next growth phase exceeded their direct experience.

The company had a technology advisory board that consisted of a group of key technical leaders within the company, select outsiders from academia, and others with expertise in investment banking and intellectual property. There was also a statutory board of directors that met on occasion to review tax and ownership matters.

To meet future challenges it was clear that the next phase of work would need to focus on corporate governance. Accordingly, Andrew, the company’s founder and CEO, was asked to consider building a formal, independent board of directors. His initial reaction was: ‘Why would I spend time and money creating a board that I would have to report to, and who would decide my salary?’

Andrew’s reaction was not atypical for private company leaders who are unfamiliar with controlled-company boards. To help Andrew better understand why an independent board made sense at this point in the company’s evolution, several reasons were presented.

Reason one: succession planning

Andrew and his wife had 4 children who were to be next generation owners and, potentially, employed at the company. The eldest, Margaret, now 35 years old, was already on a leadership track at the company and was being groomed as a potential future CEO. Upon succession, or in the event something happened to Andrew, Margaret would be the trustee of the controlling interest in the company. Unlike the current situation, where the founder, chief executive and majority shareholder are one person, Margaret’s role would be quite complicated.

In addition to her fiduciary obligation to beneficiaries, her role as a future board member (i.e. chairman) would require her to consider all shareholders, including shareholding employees. She would also have a vested interest in her own employment with the company, as well as the possibility that her siblings might also work at the company. Navigating such a complex landscape with so many potential conflicts of interest would be difficult. Margaret would benefit greatly from independent board members who could more objectively consider the ownership interests of all shareholders and, potentially, the employment interests of family members. Moreover, an independent board might be necessary to help Margaret manage the inherent conflicts of interests that might exist in her dual fiduciary role of Trustee and Director.

Most importantly, from the business’ perspective, if Margaret did succeed her father, she would be a first-time CEO and would benefit greatly from the counsel of seasoned business leaders and industry experts who could help her direct the company’s path going forward.

Such a board takes time to build and beginning that process now, while Margaret is in a subordinate role, would enable the board to help mentor and guide Margaret’s development into the leader that would someday enjoy that board’s confidence. Margaret would also have the opportunity to develop personal rapport with the board members and perhaps even have some influence in the selection process. As such, the board would be her board, as well as her father’s.

Reason two: business necessity

None of the existing managers had led a business from $150M million to $1 billion (the company’s goal), and they were aware that this required different skill sets. Too often such senior leaders either do not realize this, or realize their limitations and hold the company back from growth to protect their own positions. This group, however, embraced the idea of independent governance. They understood the need for the strategic guidance, accountability and structure that an independent board would bring. They also understood that an independent board would continuously evaluate the senior management team and guide the CEO/Founder in identifying leadership gaps and management needs, going forward.

It was apparent that organic growth was nearing its limit. Future growth was expected to come from the acquisition of new products and services, strategic alliances with larger companies, and investment in new technologies. These initiatives would require both expertise and, possibly, access to additional capital. An independent board could provide the experience needed to advance prospective alliances and provide lenders and investors with an additional level of confidence.

Additionally, if certain technology developments proved successful, a public offering might be a way to fund the significant growth such new technology might demand. Similarly, some acquisition strategies being discussed might make more sense within the context of a public offering. Regardless, any initiative to raise money in the capital markets would require an independent board. It would make more sense for the current owner to create an independent board with which the company could go public, rather than having one imposed upon it by its investment banking team.

Reason three: control

Because the CEO/Founder owned a controlling interest in the company, there would be no loss of control. However, a proper independent board would expect to have significant influence despite the lack of formal control. A CEO who routinely does not listen to his or her board will eventually lose independent directors. A CEO who has a reputation of losing directors will soon find be unable to attract good directors. Therein lies the power of a good director. Yet, there would be some comfort for the owner that ultimately he still calls the shots and is in full control.

The green light

Andrew asked for the preparation of pro-forma board documentation and policies for review. Among these initiatives were board mission/vision statements, director compensation & indemnity, director independence criteria, committee structure and charters, company prospectus and director contracts. The founding documents of the firm (bylaws, shareholder agreements, etc.) were also reviewed and modified to include components necessary for an independent board.

The costs of directors’ salary and D&O insurance were considered, as well as the costs of meetings and time involved. It was apparent that this would be a significant financial and time commitment for the company. Since an independent board is not mandatory, it was clear that the board would have to create value far in excess of its costs to be sustainable.

A timetable of one year was set to have the first independent board meeting with a minimum of two independent directors. Andrew would be chair and lead director. The COO and CTO would each sit on the board, and In-house Counsel would serve as secretary to the board. Margaret, the heir-apparent, would serve as Board Facilitator. She would be responsible for communicating with board members before and after each board meeting to ensure that all directors had needed information and to see if they had comments or suggestions for the proposed meeting agenda. She was invited to participate as a non-voting attendee at all board meetings.

The first independent board member

Selecting the first board member is probably the most difficult and the most important challenge for family businesses developing independent governance. The first board member would be signing on for the purpose of building the board—not merely serving on the board. He or she would be mentoring the CEO in good governance practice and would also be pivotal in attracting additional members. In addition to having the business experience needed, this first director also needed to understand and appreciate the value of family ownership and private control.

As Seneca wrote: ‘Luck happens when preparation meets opportunity.’ The company was able to attract the CEO of publicly-traded family business in a related industry as its first independent board member. This industry leader had taken his family business public and knew full well the advantages of staying privately controlled. He also appreciated the unique level of commitment and passion that family members often have for their business. His personal rapport with both Andrew and Margaret developed rapidly.

Now that the independent board had a ‘face’, the process gained the traction. Soon thereafter, the second director was engaged and the first meeting was kicked-off.

It has now been three years since that first independent board meeting. The company has grown and the board has expanded to a three independent directors. The value of this board has proven indispensable in its guidance on leadership issues, as well as several business challenges and opportunities that faced the company

The board has also been a significant development opportunity for Margaret, the heir-apparent, and has given her father the piece of mind that reliable governance brings.

Doug Baumoel is the Founder of Continuity, LLC. Doug brings an extensive background in family business operations and executive management to his work with clients. He served as a second-generation executive in his own family’s business and has held key executive positions in other family and non-family businesses. He started businesses in both the US and Europe, and lived overseas for six years while founding and managing the European offices of his family’s business. Doug earned his MBA from the Wharton School and a BS from Cornell University.

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Private Equity-backed Company Boards Need Independent Directors

Without at least one disinterested director (and better to have two), the legal risks can be high.

Many companies that are controlled by a single stockholder or affiliated stockholder nonetheless have significant minority investors.  This is particularly common in private equity-backed companies where the lead private equity fund may have partnered with another fund that takes a secondary position, and where the management team typically also has an equity stake.  In addition, the PE funds may have provided debt, including subordinated debt, to the portfolio company in different amounts and with different rights.  And, in every instance, the lead PE fund will be providing, for a fee, management or consulting services to the company.  In all cases, representatives of the lead PE fund will be directors of the company.

Of course, it is not remarkable that owners and their representatives wear multiple hats with private equity-backed companies as well as in other businesses. But, without careful advance planning, multiple roles can create complex challenges for the controlling owner and its representatives on the board of directors.  Absent advance planning, these directors may be biting off more than they can chew if troubled times arrive.  Recruiting truly independent directors to the board is the best way to avoid such problems.

Directors have fiduciary duties that they owe to the company and its shareholders.  The core fiduciary duties are the duties of loyalty and care.  The duty of care requires that directors, when they make a decision, to reasonably inform themselves of all material information reasonably available before making the decision.  Directors must critically assess the information to evaluate the business decision at hand.  The duty of loyalty requires that directors put the interests of the shareholders and the company ahead of their personal interests.  

Directors of a corporation who are alleged to have breached their duty of care are generally protected from personal liability by the business judgment rule.  The business judgment rule is a very strong presumption in Delaware corporate law, as well as that of most other States, that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation.  Under the business judgment rule, courts give significant deference to decisions made by the board of directors, and will not challenge a board’s decision unless the plaintiff can show that the directors failed to satisfy one of their fiduciary duties.  Moreover, when the business judgment rule applies, directors will be personally liable for breach of the duty of care only where they are found to have been grossly negligent.  Thus, unless the directors are conflicted or lack independence relative to the decision (i.e., a breach of the duty of loyalty), do not act in good faith, or reach their decision by a grossly negligence process, directors’ decisions generally will be respected by courts, and directors will not be personally liable for their business decisions.

Conflict of interest

However, this strong presumption in favor of deference to the board vanishes if it is alleged that the directors were subject to a conflict of interest that implicates the duty of loyalty.  Conflicts of interest arise for a director where the director is obligated to another party or has divided loyalties, or the director is considering a transaction where he will receive a benefit that is not shared by the company’s stockholders as a whole.  Conflicts of interest can develop in any number of ways, such as when the board of directors is considering a round of financing that will dilute some stockholders at the expense of others, when contemplating a sale of the company (including deciding to whom to sell the company and for how much), deciding whether to enter into an agreement or significant transaction, or deciding whether to indemnify other directors in a shareholder litigation.


In these situations, the business judgment rule will not apply, as courts are skeptical that directors in these situations can fulfill their obligation to act in the best interest of all of the corporation’s stockholders.  Instead, the courts apply the test of “entire fairness.”


The description of the “entire fairness” doctrine in the case of Weinberger v. U.O.P., Inc. remains the best articulation of the standard:

The concept of fairness has two basic aspects: fair dealing and fair price.  The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.  The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including all relevant factors….However, the test for fairness is not a bifurcated one as between fair dealing and price.  All aspects of the issue must be examined as a whole since the question is one of entire fairness.

Under the “entire fairness” doctrine, the fairness of the process that is used to review and approve a conflict-of-interest transaction can protect the directors from subsequent challenge.  The most effective way to do this is to exclude any conflicted directors from the decision-making process and instead delegate the decision to a special committee comprised solely of disinterested directors.  In fact, the appointment of a special committee to consider an interested transaction is typically the most important factor that can demonstrate a fair process.  Whenever a PE fund or other controlling stockholder populates a board of directors, it should give careful consideration to when, and whether, disinterested directors may be called upon.  If there are not disinterested directors to be found, the board may have to demonstrate the substantive fairness, to all the stockholders, of a challenged transaction.  This burden can be extremely difficult, and at a trial, expensive to satisfy, especially when contrasted with simply engaging one or two truly disinterested directors to sit on the board.  And, it generally is not easy after a serious conflict arises to recruit individuals to act as independent directors in the face of what may become a contentious dispute.  Moreover, even the choice of such late-coming directors can itself be challenged as an effort by the controlling stockholders to “stack the deck” in its favor.


PE funds often appoint their employees to the board of directors of their portfolio companies.  These directors will be unlikely to be considered as independent if a conflict arises between the PE fund and the corporation or other stockholders.  Some PE funds also use as directors their “operating partners,” who nominally are unaffiliated with the PE fund.  However, courts may still find the interests of such a director and the PE fund too closely aligned, particular if there has been a long-term professional relationship between the two parties or if it can be shown that the designee had expectations of being recommended for other board seats or receiving other work from the PE fund.

Defining the disinterested director

To determine whether the directors approving the transaction were disinterested and independent (and therefore, whether the fair process of the “entire fairness” standard is satisfied), courts conduct a director-by-director analysis.  The courts consider the overall circumstances affecting each director to determine if he had interests that conflicted with those of the common stockholders or the company and whether such conflicting interests were of such importance as to have made it likely that the director could be influenced by the conflicting interests.  The circumstances and factors that courts take into consideration are legion.  Many conflicts are obvious, such as when the director is employed by, or receives significant compensation from, one party to the transaction.  Examples of other factors courts consider include: 

• Whether the director (or a related entity) holds a material amount of preferred stock or debt so that the director may be tempted to make a decision to benefit the interests of those holders over the common stockholders;

• Whether the director will receive employment by the company or another interested party after the transaction, and what compensation that director will receive for such employment;

• Whether the director will receive a payout through a management incentive plan or liquidation payment;

• Whether the director had significant past relationships with any other director, controlling stockholder or interested party; and

• Whether the director received any benefit from any other director, controlling stockholder or interested party, such as advancement in their career or a seat on the board of another company.

In order to avoid having to demonstrate the substantive fairness of a challenged transaction, engaging a truly independent director can be a fairly inexpensive insurance policy against future challenges.  Assuming that a controlling stockholder is willing to put one (or preferably two) independent directors on the board, the “entire fairness” standard will require that these directors constitute a special committee to review the conflicted matter.  A board should consider the following steps when creating this special committee.

1. Establish A Clear Mandate.  The special committee must have a clear mandate regarding its powers and responsibilities.  Moreover, the committee must have the ability to reject any transaction.  The establishment of a special committee that is authorized only to make recommendations to the board will be seen as undercutting the committee’s effectiveness, and therefore its efficacy in establishing a fair process.  Of course, this raises the possibility that the independent directors might disagree with the controlling stockholder, but in that circumstance, the transaction, if challenged without the benefit of any independent director review, would likely be difficult to justify as entirely fair.

2. Guard Against Undue Influence of Interested Parties.  Interested parties, such as management or controlling stockholders, clearly have important roles in any significant transaction, particularly a sale of control.  However, it is important to put in place procedures to prevent them from having undue influence on the transaction.  These procedures should be reasonably tailored to the specific situation at hand and applied thoughtfully; otherwise, a court may well view them as having been adopted for the sake of form and deem the entire process to be tainted by the absence of effective constraints on the influence of the conflicted parties.  In addition, interested parties should disclose to the special committee all material facts concerning the transaction to enable an informed decision by the committee.

3. Retain Knowledgeable, Independent Advisers.  The special committee must be able to engage its own legal and financial advisers (i.e. separate from those engaged by the company) who are independent of (and not beholden to) the interested parties and do not otherwise have potential conflicts of interest to provide independent advice regarding the fairness of a transaction.

4. Maintain Accurate Record-Keeping.  Critical decisions made by the board and special committees—including the specific factors taken into account in making those decisions—should be recorded in the minutes prepared for the meetings.  The record should be prepared contemporaneously and reflect a careful, deliverable and reasonable decision-making process whenever important decisions are made.

While there is no perfect solution to handling conflicts, particularly when facing troubles such as a liquidity crisis or other challenges, many difficulties can be avoided if the board has included at least one director who reasonably would be considered to be independent from the controlling stockholders. Too often this is not done, or is done too late in the day, when the decision to bring on a new director is itself subject to challenge on the basis that the controlling stockholder chose that director because it knew he would be sympathetic to the controlling stockholder’s positions. Thoughtful boards will make every effort to avoid these problems by anticipating them. Indeed, the independent directors can often bring valuable insights and perspectives that would justify their participation in any event.


Doug Raymond is a partner in the law firm Drinker Biddle Reath LLP.  He works extensively on matters of corporate governance for both public and private companies. He advises boards of directors and special board committees across a range of challenges from conflicts of interest and changes in control, to corporate investigations and risk management assessment.  Emily Klinicki, an associate with firm, assisted in the writing of this article.

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Other Perspectives

Private Company Optimism the Highest in Nearly a Decade

Three-fifths of private companies plan to add fulltime equivalent employees in the coming year, but net hiring continues to shrink, reports PwC US’s latest Private CompanyTrendsetter Barometer®. Despite the most optimistic outlook for the US economy since 2006, employment growth at private companies remains modest due to difficulty in finding qualified workers, among other factors.

  Trendsetter companies surveyed in the fourth quarter expect their fulltime equivalent employment to inch up by 1.6 percent in 2015 – below 2014’s overall increase of 1.7 percent –even though these companies report economic confidence, stronger revenue forecasts, and significant gains in profitability over the past 12 months.

  Fully one-third of survey respondents said they were unable to fill open positions over the past year, but if they had, their yearly fulltime equivalent hiring might have reached 2.6 percent in 2014 instead of 1.7 percent. Technology and engineering professionals are most in demand. Blue collar workers are less sought after, with many of them having been out of the workforce since the recession and needing new skills to reenter it now.

  Spending Holds Steady, Even with Misgivings about World Economy

  Despite hiring challenges, 2014 proved a good year for private companies, particularly with respect to domestic activity. Revenues forecasts climbed, capital spending held strong, and profitability reached its highest level in nearly a decade.

  In fact, when asked about the US economy, 73 percent of Trendsetter companies described it as growing – the largest share in years, and double that of about two years ago. This may owe in part, to the fall of energy prices, which has led to reduced cost pressure and more disposable income for many consumers.

  However, the gap between private companies’ increasingly positive view of the economy and their misgivings about the global economy continues to widen. This past quarter, only 31 percent described the world economy as expanding. Weakness abroad means increased pressure on exporters, requiring US companies that sell internationally to keep an eye on evolving conditions in foreign economies.

  Growth Opportunities for the Year Ahead

  But private-company growth prospects remain buoyant with five-of-six Trendsetter executives (83 percent) forecasting positive growth in 2015. Moreover, former impediments to growth hit new lows: fewer companies expressed concerns about foreign competition, regulatory pressures, energy prices, and the strength of the dollar than last quarter.

  One clear danger persists: the steady increase in the number of companies that worry about finding qualified workers. Thirty-seven percent are now voicing this concern, up nearly 10 points from a year ago and at its highest since the first quarter of 2008, when 40 percent of companies fretted about the skills gap.

  Additional Survey Findings

  • On average, private companies are looking forward to 9.2 percent revenue growth in the next 12 months – the highest rate since early 2012.

  • Almost two-thirds of private company leaders said, before year-end 2014, they would hit or exceed their full-year revenue targets, and another one-quarter said they would catch up to their sales targets by mid-2015.


  • On average, companies are budgeting 2.76 percent in hourly wage increases for the next year, compared with 2.69 percent during the fourth quarter of 2013.

From Bored to Ballistic: The Bell Curve of Board Behaviors

The constant, meddling actions of a controlling, outside investor/board member in the day-to-day affairs of a company can have a direct, negative impact on the organization’s performance.

A while back I was retained to help develop a new strategic plan for the management team and the Board of Directors of an angel-backed technology company. Soon after I started the project, the CEO told me that a significant angel investor/board member (Moneyman) called either she or the CFO every day at 4:45 for an update on the company. Every day, not kidding…

Was Moneyman, “Just checkin’ in…?”

Was he simply showing enthusiasm, expressing interest, acting curious, proffering sage advice, coaching the senior team and being ‘hands on’? He wasn’t calling to coach or offer operating advice. Moneyman was meddling. To read the whole article, click here.

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