Institutionalization is to family-owned businesses what getting ready to raise a first series “A” is for a startup: A rite of passage that also says a hell of a lot about the health of your business. Last week, we took a deep dive into a recent study (pdf) by PricewaterhouseCoopers (PwC) on what family businesses need to do to thrive post-pandemic. We found that family businesses with medium-term strategic plans fared best during covid, but that a significant number of them don’t have the governance structures and basic paperwork — like shareholder agreements — to formalize the positions of family members in the business. In too many cases, those gaps will come back to haunt them in the years ahead.
To be ready for What’s Next, PwC joins a chorus of lenders, development finance institutions and advisors who are beating a drum that plays just one beat: Institutionalization. That’s fancy-speak for touchstones including the separation of ownership from management, hiring independent board members, succession planning, and creating a reporting framework that ensures management communicates to the board everything from strategy to results. Naturally enough, digitalisation should be at the heart of strategic plans.
In part two of a three-part series, we check in this week with senior folks at international financial institutions that help family businesses institutionalize. It’s not an easy road, it will result in some tough choices (and maybe a clash or two) — but the product on the other side is an investable business. Don’t care to raise investment? Cool. But consider this: An investable business is, by definition, one that would survive your absence — opening the door to retirement (or at least stepping back a step) one day.
And institutionalization isn’t only for family-owned companies: Every bootstrapped business will have to go through it one day.
“Institutionalization is the main enabler for growth,” principal equity lead for Egypt and the Southern Mediterranean at the European Bank for Reconstruction and Development (EBRD) Hassan Massoud tells us. It doesn’t just build a more robust business able to survive challenges: Institutionalization gives companies access to capital that allow them to grow faster, unconstrained by family finances, as well as access to expertise. It also makes it easier to find and retain top talent and forces a business to properly structure the ownership and intrafamily finances.
Just as every company is different, so too will be its priorities when it comes time to institutionalize, says Amira Agag, MENA corporate governance officer at the International Finance Corporation (IFC). Family businesses tend to have similar “constellations” of problems, but institutionalization starts with a diagnosis phase unique to your business. The IFC provides tools, consultation, and training that focus on the corporate governance challenges that family businesses face. The EBRD’s Massoud agrees, saying there’s no one-size-fits-all approach to becoming a corporation: Every company starts from a different point and has different goals.
The biggest challenge in corporatizing family businesses tends to be the unwillingness of members to bring in a professional board and outside management. Bringing on professional directors or senior managers is tough for family members used to (a) unchecked authority, (b) not being questioned, and (c) being able to dip into corporate coffers as if it’s the petty cashbox at the corner store. At some stage, the business will grow to a point where family members need outside skills and experience to manage the additional complexity and take the business to the next level, Agag says.
STEP 1- A good starting point is to look at the roles and responsibilities of any family members who work in the business. Who has what decision-making power? To whom are they accountable? Sorting that out can be a significant challenge if you’ve faced (or currently face) pressure to hire unskilled or inexperienced family members. A good institutionalization process can help attract the right caliber of family members to work in the business, according to Massoud — and identify paths to upgrade skills at the same time.
STEP 2- Make the (often gut-wrenching) decision to establish a professional board to separate ownership / governance from management. This will ideally involve separating the roles and responsibilities of “chairman” from “CEO” — and force you to bring in independent directors who should have skills that (a) your company needs and (b) that are not on offer from family members. In a situation like this, a management team can focus on operations, while the owner dedicates himself or herself to business strategy and managing risk, Agag suggests.
That process begins with identifying who has what stakes today — and who will be inheriting in the next generation. Look at who is best-suited to join a board (which provides oversight) and then who has the skills to be a member of a management team, Massoud tells us. After that, companies can identify their challenges and move towards solving them, he adds. This will put solid governance structures and foundations in place, Agag says.
Nomination to the board should be a structured competitive process, Agag says. This includes selecting members who can challenge and contribute to the development of strategy. Boards will be involved in overseeing management performance, creating institutionalized board policies and operations, and serving as a steady hand for the company. Members should be highly experienced outsiders who can offer the firm fresh perspectives. This eliminates the “rubber stamping” or duplication of skills, as Agag puts it.
What skills should you look for in an outside board member? One option is to choose someone with experience in a segment, country or industry in which the company isn’t active, but into which it wants to expand, Massoud says. He also says families should look for people who have been through similar challenges in the past. This person does not necessarily have to be in the same industry, but should have been intimately involved in an institutionalization path before, he adds.
STEP 3- Succession planning is also important, as the family grows and potential senior management candidates from the family become available. “We have seen many family businesses delay succession planning until the last minute, putting the company at risk,” Agag tells us. If left unaddressed, these issues can leave the company significantly exposed, she adds. The biggest challenge is in getting the older/current generation to acknowledge that the next generation has the ability to take over. Gaining external work experience to prove themselves is one solution to this, Agag says.
Yes, Junior is going to make mistakes, Mrs or Mr Founder — or (perfidy) not make the same decision you would have. But the business survived your learning on the job, didn’t it?
Institutionalization is a great way to attract future generations, but prior experience is advisable. “From our experience, we have noticed that future generations are ready to join and lead their family business when good governance is introduced,” Agag tells us. But the IFC always advises the next generation of family business leaders to gain work experience outside their company, as well as to work within different parts of their family business to be better prepared.
And remember: The process of implementing governance is an ongoing journey, Agag says. The system needs to be embedded into the business culture and keep moving.
For investors, bad governance practices, structures, and informality can be a serious issue. Investors look for a company that is sustainable and has growth potential, Agag says. Successful family firms exhibit sustainable levels of growth and commitment that are a direct result of being well governed. Family-owned firms also inspire a level of commitment that other companies can find difficult to achieve, Agag says.
And each step in the process speaks to a certain type of investor. “Every step of the institutionalization process has a certain type of investor that understands how to manage its risks, ranging from seed, to VC, to SME PE, to growth equity, to buyout equity — all the way to public market investors,” Massoud says.
WHAT’S NEXT in this story? In the third and final installment next week, we’ll look at bold-name case studies of how businesses institutionalized and attracted the outside expertise and capital they needed to get to the next stage of their journey.
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