FAMILY BUSINESS SOLUTIONSYOUR GUIDE TO A FAMILY CONSTITUTION

Contents

Your guide to a Family Constitution. 1

1. Your existing Family Constitution. 2

2. Creating a formal Family Constitution. 4

3. Ownership issues. 6

4. The Family part of the Constitution. 10

5. Your Family Constitution. 12

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and assumptions in the hope that everything will continue to work, or to invest in gettinga few things written down.

Here we explain the formal FamilyConstitution. We hope it will help yourfamily to decide whether having one willallow you to achieve the balance you wantbetween being a successful enterprise and a successful family.

Family Business and Family Enterprise

We are often asked what we mean by theterm “family business”. Our definition is anoperating business in which members of thesame family have most of the power. Thiscould be one nuclear family (parents andkids), a multi-generational family (add ingrandparents) or a network of families (alarge extended family or clan).

Often all the ownership is concentrated in the same family but in reality a family willhave power to do most things they want ifthey control more than half the ownership.

Many business families diversify their interestsinto other assets and activities that they sharetogether, such as financial investments, land,property, farms, philanthropy, leisure assets(holiday home, boat etc), new ventures andso forth1. We’d describe this as a “familyenterprise” and we believe that strategiesthat seek to optimise all forms of a family’swealth need to include practical advice onhow each of these assets and activities can be well organised.

The idea of a Family Constitution is relevantto a family business and a family enterprise,but to avoid endless repetition we mainly usethe term family enterprise to include a familybusiness. We hope this clarifies the matter.

“Family Constitution” might sound a bitformal and “not for us”, but in fact yourfamily will already have an unwritten versionof a “family constitution”. It is thecombination of assumptions, understandingsand expectations that exist in every familyabout “how we do things around here”.

The problem is that over time a family and their enterprise usually become morecomplex; the family grows, ownershipfragments as it passes down through thegenerations and the family enterprisechanges, which sometimes involvesdiversifying into other assets and activities.It then becomes risky for the future health,wealth and happiness of the family and their enterprise to be based entirely on aninformal constitution. The key decision that needs to be taken is whether topersevere with informal understandings

YOUR GUIDE TO A FAMILY CONSTITUTION

Successful family enterprises are different in many ways, but they have at least one thing in common; they are well organised. Their success is achieved through thoughtfulplanning, and part of this organised approach often involves creating a Family Constitution.

1. One client with an investment in a football club wondered which heading applied; investment, leisure asset or philanthropy!

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The informal Constitution reflects thefamily’s beliefs and attitudes in relationto a wide variety of important matters,such as:

• Wealth

• Leisure

• Gender

• Education

• Family harmony

• Privacy

• Work

• Work-life balance

• Fairness

• Relationships and marriage

• Individual expression

• Philanthropy

The obvious risk with a Constitution basedentirely on understandings, assumptionsand expectations is that it can result inmisunderstandings, mistaken assumptionsand unfulfilled expectations. It is easy tothink of examples.

“I assumed you’d want to work in ourfamily enterprise.”

“I thought my spouse would get a job inthe family enterprise.”

“I’d expected to become the next managingdirector“ or “the majority owner.”

“I thought everyone would receive anequal share of the family enterprise.”

And, frequently, the answer from arelative is, “really, why did you thinkthat?” Often these misunderstandingsoccur between generations who,unsurprisingly, have different ideas aboutwealth, work-life balance and so on, andthese disagreements can easily result inharmful conflict.

Complex issues abound when the interestsand ambitions of a family overlap with theneeds of their enterprise. For example, in afamily business the decisions that are bestfor the business might cause disharmonyin the family, or what makes for acontented family life might cause ructionsin the business.

The good news is that many of thechallenges that enterprising families faceare predictable and the predictable canalways be planned for.

If families and other important stakeholderswant to know who will be the next owners or how family members get a job in thefamily enterprise or how wealth will bedistributed fairly, they can either wait for theissue to become a hot topic and hope it willbe resolved (based on understandings etc) orthey can plan for what they want to happen.

Families who like to plan for their futuresrather than leave matters to chance prefer a written Family Constitution to the informal,unwritten version. They also tend to be verypractical people who assume that there willbe different views and opinions on importantissues like succession, ownership and soforth, and they take the view that it is betterto debate these issues calmly in advance ofthe need, rather than waiting for somethingto blow up.

“Clogs to Clogs” and other clichés

Another way of making the case for a writtenFamily Constitution is to address head-on one of the clichés about family businessesthat is often expressed as “clogs to clogs” or“shirtsleeves to shirtsleeves” in 3 generations.

Or as one of our clients rather robustly putit, “the first generation starts the business,the second generation builds it up andthen the third or fourth generations justp*** it against the wall.”

1. YOUR EXISTING FAMILY CONSTITUTION

It might not occur to a family that they already have an informal Family Constitution. But the fact is that in every family there will be a mixture of understandings, assumptionsand expectations that underpin how the family makes important decisions, or, put anotherway, “it is how we do things around here”.

Statistics are often quoted about how fewfamily enterprises survive to the 3rd generation.Rather than putting this low survival rate downto the ‘clogs to clogs’ cliché, we like to thinkthat there is a better explanation.

In every family enterprise there are anumber of people with an important stake,who make demands for resources that areinevitably limited in some respects. There is only so much time, money, love andopportunity to share around in a familyenterprise to meet the demands of theenterprise itself, the owners, the family, the board and employees, outside investors,customers and creditors.

The informal type of Family Constitutionemerges as a way of coping with all these demands. It is the family’s way ofbalancing the different interests, and thistends to lead to an expectation thateveryone with a stake in the enterprise willunderstand and adhere to the informalnorms and expectations that have evolved as “the way we do things around here.”

However, while the balance of interests at anytime in a family enterprise may appear stable,it is never static; things never stay the same.

As already mentioned, the needs ofindividuals and the enterprise are constantlygrowing and changing so every familyenterprise is always in a state of flux.

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The response to these changes in familyenterprises is often to try to adapt byabsorbing as many changes as possiblewithout radically altering the informal FamilyConstitution. This is often accompanied by phrases like “if it ain’t broke….” and “that’s how we’ve always done it.”

This strategy of adapting to change,without making any major changes,appeals to families who are in businesstogether because, like most of us, theydon’t like change because it always feelsrisky. However, the informal Constitutionthat worked for a nuclear family is lesslikely to serve the interests of a group ofsiblings (and spouses and grandchildren)who become involved in, or attached to,the family enterprise, and it is really goingto struggle by the time the enterprisepasses to a generation of cousins.

In order to keep up, the Family Constitutionhas to be changed, which means morethan just adapting or tweaking the informalversion. If this is not done, what worked for the first generation doesn’t work for the 3rd generation and the accumulation of misunderstandings and unfulfilledexpectations combine and contribute to the demise of the family enterprise. Hence “clogs to clogs”.

Clichés can contain elements of truth, even wisdom, but in this case “clogs toclogs” is not because family enterprises are poorly run or because enterprisingfamilies are dysfunctional. It’s because the Family Constitution is not updated to keep abreast of developments.

In place of the cliché, the truism that should be broadcast is that success needscareful planning. Don’t leave matters tochance and don’t just hope that an informalConstitution will adapt naturally to fitchanging circumstances. The practicalalternative to hoping for the best is to stepup to the challenge of creating a bespoke,written Family Constitution.

These questions might sound obvious; butthe tricky part is that the reasons why afamily want to stay connected through afamily enterprise often change over time.It cannot be assumed that whatever droveone generation will necessarily persuadethe next generation to devote part of theirlives to the family enterprise.

For example, founders are often motivatedby the entrepreneurial dream of being in control of building a new venture andcreating a legacy to pass to the nextgeneration. But the next generation face a different challenge.

Are they committed to preserving andextending this legacy? Do they have a sharedunderstanding of what it is? Does it mean as much to them as it did to the founders?Does the family want the family enterprise to continue because it provides them withcareer opportunities, or a good investment,or because it is their name above the door, or because they feel responsible to the otherstakeholders, or because it is good fun orbecause it is a bit of each of these and someother things besides?

A very important point about understandingthe shared purpose in a family enterprise isthat it is usually a combination of financialand emotional reasons.

This is one of the things that makesfamily enterprises different from othertypes of business.

In non-family enterprises, it is assumed that the sole purpose is increasingshareholder value for the current owners. In contrast, the reasons why a family wantto be in business together might be amixture of the following:

• Providing the desired level of financialsecurity for a growing family.

• Achieving a lifestyle.

• Creating, preserving and/or extending a legacy of family ownership to pass to the next generation.

• Pride in a brand (especially if it’s thefamily name) or a reputation for being a family enterprise.

• Providing career opportunities for familymembers.

• Attachment to a particular industry,product or geographical area.

• Keeping a growing family in touch witheach other as they get on with theirown lives and grow up and grow apart.

• Putting something back throughphilanthropy.

This is not a tick list and every family has to articulate their own version of a shared purpose.

But when the family understand why theyare in business together, there is no doubtthat this can be a great strength. The “glue”binds them together and makes them willingto stick with the family enterprise throughthick and thin.

Equally, the absence of a clear sharedpurpose poses significant risks and dangers.Without it, as time unfolds, there will just not be enough “glue” to bond the familymembers to each other and to their collectiveinvestment. In the absence of “glue”, thingstend to fall apart. And when this happens, it often results in the family’s wealth andtheir personal relationships being wasted in needless conflict.

When families end up in conflict, it usuallyinvolves family members who have differentideas about what they want from theirfamily enterprise. One might want tomaximise the return on investment whileanother wants to preserve and extend a legacy to pass to the next generation of family owners. There is ample scope for conflict here but the real problem is perhaps that these family membersshould never have been joined together in a family enterprise in the first place.

2. CREATING A FORMAL FAMILY CONSTITUTION

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The best way to start creating a formal Family Constitution is by clarifying, “Why the family want to be in business together?” “What is this all about?” “What is the “glue” that bonds us to each other and to our shared investment in the family enterprise?” “What returns are we looking for?”

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Articulating and writing down the sharedpurpose, and putting it at the front of thewritten Family Constitution, makes it fareasier for individual family members todecide whether a role in the familyenterprise will either help them achieve what they want for their lives or constrainthem and thwart their own ambitions. The standard against which family membersshould be encouraged to measure theirenthusiasm for the shared purpose isultimately very practical; is it “good enough”for me to want to be part of the familyenterprise, in whatever role(s) I choose;owner, executive, leader or family member.

The standard of “good enough” is, frankly,as good as it can be in the real world, and if it cannot be achieved in the eyes of some, then the practical question thatneeds answered is how to let familymembers who do not want to be in thefamily enterprise exit gracefully, and allowothers, who have a sufficiently strong senseof shared purpose, move forward together.If structures are created that bind peopleinto a family enterprise against their will,the feelings of reluctance, disappointmentand even coercion will leak out eventually,usually with troublesome consequences.

Return on investment

There is a fundamental difference betweenowners who expect their investment toproduce a market rate of return (we’ll callthem Value-Out owners) and those whoattribute importance to returns that are not based on immediate financial reward(Custodians).

The commitment of a Value-Out owner will depend on receiving satisfactoryfinancial returns. If these are not achievedthen, like any other rational investor, he orshe will want to be able to sell their sharesand redeploy their investment in order tosecure a better return.

The Custodian, on the other hand, is likelyto accept trade-offs between financialgains and other types of “return”;

such as the opportunity to create or maintaina legacy of family ownership to pass on tothe next generation of the family.

The Value-Out owner and the Custodianmight rub along together when the familyenterprise is doing well enough to satisfytheir different desires, but if – or shouldthat be when – things get tough, thedifferences between them will be far moredifficult to resolve. One might say, “it’s timeto sell” while the other thinks “that’s notwhat this is all about”.

One type of owner is not a better personthan the other; the point is to decide whichtype of owner you want in your familyenterprise. Many families mix a bit of bothbut usually have a tendency more to onetype of ownership than the other.

The key is to make it clear what owners canexpect, which makes it important to write it down and sort out the detailed rules thatreflect the family’s agreed attitude in relationto ownership.

For example, every family enterprise needscontrols over how ownership shares can besold. Value-Out owners will expect to havean opportunity to cash-in when they want or to sell if they are offered a premium price,for example, by a competitor.

This would not appeal to the Custodian whowill be concerned about securing the longer-term benefits of family ownership and,consequently, would assume that there will be a limited opportunity to sell, even in goodtimes, and that the potential purchasers will belimited to other owners and family members.

3. OWNERSHIP ISSUES

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A Family Constitution should clarify who can own part of the family enterprise andthe roles and responsibilities of those owners. The following should help a family to work out their answer to these deceptively simple questions.

ONE TYPE OF OWNER IS NOT A BETTER PERSON THAN THEOTHER; THE POINT IS TO DECIDE WHICH TYPE OF OWNERYOU WANT IN YOUR FAMILY ENTERPRISE.

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Bloodline or spouses?

Some families limit ownership to bloodlinedescendants of a founder, while others wantspouses and partners to be included asowners. Those in favour of spouses andpartners being allowed to become ownerswill view their inclusion as strengthening theownership group through introducing somediversity. It will also help to maintain the“glue” among a growing family asownership passes down the generations.Since spouses and partners will be parents of the next generation of owners, they willbe more likely to convey a positive messageabout the importance of the family enterpriseif they are owners, than they would if theywere excluded from ownership.

Those in favour of restricting ownership tobloodline would highlight the benefits ofmanaging a smaller group of owners andargue that the bloodline descendants of afounder are more likely to have a sharedunderstanding of ownership than peoplewho marry into the family. They would alsodraw attention to the adverse consequencesif some family members transferredownership to spouses while others decidednot to do so. Another concern might bewhat would happen to ownership in theevent of matrimonial breakdown.

Are shares “matrimonial property”?2

We are often asked this question byfamilies who are concerned about whatwill happen to shares in the familyenterprise or family business in the eventof marital breakdown.

“Matrimonial property”, which a divorcecourt will look at with a view to equalisingbetween spouses, consists of everythingof value acquired individually or jointlyduring the marriage to the date when co-habitation ceases.

There are important exceptions to this,including gifts and inheritances, so anyshares that are handed down by onegeneration to the next do not becomematrimonial property, although subsequentchanges to the shareholding may meanthat the shares become matrimonialproperty.

If you don’t want shares to be treated as matrimonial property then you should:

• Acquire them before marriage ratherthan afterwards.

• Inherit shares rather than buy them.

• Receive them by way of gift fromsomeone other than your spouse.

2. Our text is based on our understanding of Scottish Law. In England & Wales and Northern Ireland, different rules apply to matrimonial property.

• Not change the shareholding during the marriage (before separation), or ifthe shareholding is to be changed (forexample, a company re-organisation/buy-back), make sure that there is aseparate ‘post-nup’ in place (see below).

If the shares are sold during marriage,make sure that there is a separate ‘post-nup’ in place and put the sale proceedsinto a separate account in the name of theseller and not an account in joint names of the spouses.

It is vital to keep the ‘paper-trail’ showingwhere the money came from. This moneymay still be regarded as matrimonialproperty by the courts, but there is agreater chance of avoiding the moneybeing treated as matrimonial property ifit can be clearly shown that it came fromthe sale of the shares.

However the following is worth noting.In the event of separation or divorce theremight still be scope for argument overwhether the value of the shares should be taken into account in negotiating afinancial settlement, as any award made bya court must be reasonable having regardto all the resources of the parties.

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Pre-nups and Post-nups

This stands for pre-nuptial and post-nuptialagreements. In Scotland, the general rule is that a pre-nuptial agreement is bindingand can, on divorce, oust the jurisdictionof the courts in relation to future financialprovision. If you want to enter into a pre-nuptial agreement, it’s better done well inadvance of marriage to avoid the claimthat someone was railroaded into signingat the last moment.

Post-nups are very useful. They can allowthe necessary contractual documentation to be updated when circumstances in thefamily and business change and so preventdifficulties at a later stage if a coupleseparate. This can allow for much greaterflexibility when undertaking businessreorganisations, especially if this mightresult in shares that are not “matrimonialproperty” before the reorganisation,becoming such afterwards.

3. OWNERSHIP ISSUES

Working and non-working owners

Some families strongly believe that ownersmust work in the family enterprise andthat if they choose another career, they will not be entitled to a share of ownership.The attraction of working owners is believedto be that it will avoid conflict betweenworking and non-working owners, andespecially resentment among the workingowners that their efforts are profitingthose who could not be bothered to helpthe family enterprise by the sweat of their brows.

However, others might take the view thatrestricting ownership to working ownerscan have unintended consequences. Familymembers who decide to pursue othercareers and are cut out of ownership mayfeel they are also being cut off from thefamily, especially if the family enterpriserepresents a significant portion of thefamily’s overall wealth.

Alternatively, they might decide to take acareer in the family enterprise in order toqualify for ownership but feel they are beingbound by “golden handcuffs” and resentthe fact that they were forced to give up on their own career aspirations in order tobecome an owner in the family enterprise.

In truth, working and non-working ownerscan collaborate successfully provided therules (in a written Family Constitution) areclear; for example by having a dividendpolicy for all owners and a remunerationpolicy for working owners that, together,make clear who gets what from the familyenterprise. It would also be worth clarifyingif any decisions need to be made by workingand non-working owners together, ratherthan just by the working owners, forexample, decisions that involve a significantrisk to the family’s wealth or reputation.

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4. THE FAMILY PART OF THE CONSTITUTION

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ensure that the Family Constitution includesan agreed procedure to help resolve theseconflicts and keep the family enterprise ashealthy as possible.

A Family Assembly can play an important rolein educating and informing the wider family,including the next generation, about thestructures that affect their lives, for example,technical structures such as family trusts,which will outlive their creators. On a broadereducational front, the Family Assembly oftenhelps to increase the family’s awareness ofbusiness practices, which can be useful tofamily members whether or not they pursuea career in the family enterprise.

Family Council

The constitution of the Family Assembly will also need to specify how it will beadministered, how often the Assembly willmeet, what formality is required to conveneand run the meetings and how any formaldecisions are to be taken.

Sometimes it is helpful to appoint or elect a separate group with responsibility forrunning the Assembly and being the maingovernance link between the wider familyand other parts of the enterprise, such as the board of directors. This separate group iscalled the Family Council and the illustrationshows how important a role it can perform in overall governance

However, it is essential to understand that if the “glue” that binds the family togetheris not maintained and, instead, is allowedto dilute, over generations there eventuallywill come a point where it is not strongenough to hold the family enterprisetogether. Hence the social value of theFamily Assembly should never beunderestimated.

The formal role of a Family Assembly isoften to formulate and comment on familypolicies that affect current and futuregenerations of the family and not just theexisting owners. This could apply to thefamily’s philanthropic activities or aspects of their relationship with the enterprise, for example, in relation to employment and remuneration of family members or the exploitation of the family’s reputation in marketing and PR.

Another Family Assembly policy may be anagreed procedure on how conflict amongfamily members or between the family andthe enterprise should be resolved. Whenthere are many interests (individuals, familybranches, various business and otherinterests etc) interacting and competing forthe finite resources that a family enterprisecan provide, there inevitably will bemoments when the anxiety that thiscompetition causes spills over into conflict.

That’s just part of the reality of a familyenterprise, so it is pragmatic and wise to

Where there are a relatively small number of family members with an interest in thefamily enterprise, important discussionsconcerning the family can usually take placespontaneously – “around the kitchen table”– whenever needed. But as a family grows,this type of informal governance needs to bereplaced by more thoughtful structures, likea Family Assembly. The rules about the roleof the Family Assembly should be set out inthe Family Constitution.

Family Assembly

The Family Assembly is a forum where theinterests and concerns of the family can beaddressed. Because it is a flexible structurethat can be adapted to suit the needs ofdifferent families, it is very important todefine clear goals and tasks for the FamilyAssembly. Otherwise there will beambiguity about its role and it will bedifficult to evaluate whether or not theFamily Assembly has been successful.

The goals could be social, formal andeducational. As a family grows and thedemographics become more complex, aFamily Assembly can generate the type ofsocial interaction that will help to createand sustain the “glue”. The importance of this tends to be better appreciated byfamilies than advisers, who tend to devaluethe importance of establishing a social rolefor the Family Assembly.

Family issues always affect a family enterprise and it is pointless to try to treat a familyand their enterprise as if they were entirely separate entities. As the family grows andbecomes more complex, the governance of the family becomes important.

Family Assembly

Appoints/Elects

Information/Communication

Family BusinessPolicies

Annual FamilyMeeting

Family BusinessEducation

Family Council

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Section 1: Our Shared Purpose

• A statement of why we arein business together.

Section 2: Ownership Governance

• The role of owners – Value-Out or Custodians.

• Bloodline or spouses.

• Working or non-workingowners.

• Return oninvestment/dividend policy.

• Transferring ownership.

• Decisions reserved forowners (including howthese are made).

Section 3: Family Governance

• The role of familymembers.

• Family Assembly and FamilyCouncil.

• Family policies (e.g.employment andremuneration of familymembers; philanthropy;education of nextgeneration; PR).

The other parts of the Family Constitutionwill depend on the type of assets that arepart of the family enterprise. For example,if the family owns a business then theconstitution should cover things like:

• Role of the board.

• Composition of the board.

• Selecting and appraising boardmembers.

• The role of non-executive directors.

• Communication between the board andthe owners and wider family.

• Remuneration and incentives.

• Decisions reserved for the board.

• The responsibilities of any boardcommittees.

If the family enterprise involves differentassets and activities (property, investments,philanthropy etc.), the Constitution shouldclarify the relationship between the familyand each of these activities. If the familyinvests the time and effort in clarifying thebalance of power between the owners, thewider family and the company, partnership,charitable trust or whatever, there is far lessscope for the type of conflict that canotherwise afflict a family.

5. YOUR FAMILY CONSTITUTION

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The Final Words

We were recently asked by a client to sumup in a few words what an enterprisingfamily should do if they wanted to continueto build wealth across generations. Weweren’t even being offered the opportunityof getting everything onto one side of A4paper but, responding to the challenge, werepeated what was said at the beginning;“get organised”. Two words thatprogressive family enterprises interpret bycreating their own Family Constitution.

In this edition of Business and Life we’ve highlighted the following sections of your Family Constitution.

More information from Ken McCracken:kmccracken@familybusinesssolutions.co.ukorSusan Hoyle:shoyle@familybusinesssolutions.co.uk

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Published by Family Business Solutions Ltd302 St Vincent St Glasgow G2 5RZTel: 0141 222 2820Fax: 0141 204 2326.

Family Business Solutions Limited (FBS) is a limited company registered

in Scotland with registered number SC199202.

The information contained in this newsletter is for general guidance

only and represents our understanding of relevant practice as at February

2010. FBS cannot be held responsible for any action taken, or any

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