Family constitutions – how to prevent problems before they happen

June 2010 by Leila Golchin, Associate, Swaab

Successful development of a family constitution can help to ensure the prosperity and longevity of a family business

What is a family constitution?

A family constitution encapsulates the values, beliefs and objectives of the family and defines the relationship of the family to the business.

Running a family business is hard enough without the additional pressures of worrying about the outcome of generational change. A family constitution can assist with ensuring business matters and family affairs are aligned and will help your family deal with generational changes constructively.

Also known as a family creed, family charter or family agreement, a family constitution is a document which supports the family business. It sets out the values and principles that underlie the conduct of the business, defines the strategic objectives of the business and sets out the way in which the family makes decisions affecting the ownership and management of the business.

A family constitution should provide a mechanism by which conflict can be successfully managed and resolved. The act of creating a constitution forces the family to consider important issues about the future of the family business that might otherwise be ignored.

It is increasingly recognised that family issues rather than business issues determine the outcome of generational change in family businesses.

Why do you need a family constitution?

Family to business mechanisms, such as a constitution or family council, provide a formal link between business matters and family affairs. The advantage of a formal governance mechanism is that it facilitates communication between the family, the owners and the business managers.

As the family business evolves and successive generations enter the business, several changes occur. First, the number of individuals with an ownership interest in the business increases. Secondly, the expectations of these individuals begin to diverge. Thirdly, as the business expands, it makes increasing financial and management demands on its owners.

A family constitution helps the family deal with these changes constructively. It requires the family to think about important decisions before they have to be made and to agree on important family and business goals. Shared values and common goals bind the business owners and sharpen their business focus. A family constitution should articulate these shared goals and vision.

A family constitution will assist the family council, which effectively acts like a board of directors for family matters, in managing the family business.

What is in a family constitution?

Just as each family business is unique, so each family constitution will need to reflect the unique characteristics of both the business and the family to which it relates. Nevertheless certain matters are commonly covered in family constitutions:

  • Strategic business objectives reflecting agreed family values for the business
  • The process for hiring, assessing and remunerating family members employed in the business
  • The rules for nominating, training, assessing and appointing management successors
  • Processes for nominating and assessing individuals for appointment to the family company s board of directors and/or the family council (if one exists)
  • The composition and rules of conduct for a family council
  • Communication and disclosure policies between the company and the family
  • The process for resolving conflicts about the business between members of the family
  • Communication and disclosure policies for family members not working within the business
  • The rights and obligations of shareholders in the family company
  • Recommended or compulsory retirement age for family directors and managers
  • Processes for buying out family shareholders in the business
  • Succession policy
  • Policies concerning external, non-family ownership and management of the business
  • Procedures for amendments to the family constitution

A family constitution should be able to accommodate growth and change in the family business. For example, the business might reach a point where external management and independent, external representation on the board are considered desirable.

Another possibility is that growth in the business creates financial demands that can only be satisfied through access to external capital, either in the form of equity or debt. The family has to make several trade-offs here involving its appetite for risk (debt) and the extent to which it wants to maximise family ownership and control (external equity).

When should we adopt a family constitution?

It is never too early to adopt a family constitution. Ideally a family constitution should be drafted well ahead of any potential transitions. In practice however, a family constitution is most likely to be adopted or revised at the time of generational change within the business. It can often be considered when the business is about to be passed on from the founder to his or her children. Two or more branches of the family can find themselves in charge of the business and unsure of where to go next. The transition from the second to third generation can further increase both the number of owners and the diversity of their ambitions for the business.

Generational change can be unplanned, typically as the result of the unexpected death or disablement of the existing proprietor. This is a good reason to prepare the constitution well ahead of any expected transition. Formulating a family constitution will take time and may require a number of family meetings. Even if there is no agreement on all matters, it will form a good basis for the family to work from when issues arise.

Guiding principles

Before drafting the constitution itself, the family should agree on some general guiding principles. For example:

  • What comes first, the family or the business?
  • Is ongoing family ownership and management in the best interests of the business? For example, can the business future capital requirements be satisfied under continuing family ownership?
  • Is continuing ownership of the business likely to create tensions and divisions within the family?

Constructing a family constitution is rarely a straightforward exercise. It can be an emotional and stressful experience for all concerned, but the successful development of a family constitution often results in better communication and greater harmony within the family which can help to ensure the prosperity and longevity of the business.

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