Governance counseling for closely-held businesses and private companies with multiple stakeholders

August 27, 2013

5274Most of the commentary on governance counseling for privately-held businesses focuses on ways that companies contemplating an initial public offering or a possible acquisition by a larger firm (so-called “pre-IPO/pre-acquisition companies”) can use strong corporate governance practices, particularly readiness to comply with the Sarbanes-Oxley Act of 2002 (“SOX”), as a means of demonstrating additional value to potential investors or acquisition suitors.  However, private companies come in all sizes and formats and the benefits of improving corporate governance are not limited to pre-IPO/pre-acquisition companies.  Most of our readers don’t have the opportunity, or the desire, to represent pre-IPO/pre-acquisition companies; however, law firms of all sizes typically get a steady share of work from other types of privately-held companies that can choose to selectively adopt and follow SOX requirements to demonstrate sound business practices, build credibility, improve operational efficiencies and prepare for possible changes in long-term strategies in the future.

There are a number of very large private companies active in the United States, and many of these companies have a broad and diverse family of stakeholders beyond the core ownership group that is actively involved in the day-to-day management of the business.  For example, private companies may have a number of outside investors, often sophisticated professionals with a healthy appetite for information regarding the operations of the company.  In addition, private companies generally have to deal with the requirements imposed by their commercial lenders, and larger companies may be dealing with a loan syndicate that includes several financial institutions that have agreed to underwrite a portion of the credit facilities available to the company.  Key business partners, including major vendors and customers, have a stake in the business continuity and financial strength of the company over an extended period of time.  Finally, certain “special interest partners,” such as government agencies that purchase goods and services from the company, may have a keen interest in the company’s internal controls.

Private companies with multiple stakeholders are well advised to focus on improving their internal controls and business processes.  Among the steps that can, and should, be taken are formalizing internal controls and governance policies; initiating regular formal audits of business processes; improving documentation and record retention procedures for common business transactions; developing codes of business conduct; and making sure that employees are trained in the latest cutting-edge compliance practices.  These steps, when taken together, will allow the company to build and maintain credibility with all of its stakeholders.  As a result, the company will likely be able to obtain better credit terms and access more business opportunities.  Moreover, the directors and officers will receive richer information regarding all aspects of the business on a timely basis, thereby improving the quality of decision making within the firm.

Turning to closely held businesses, let’s first concede that the potential benefits of investing in tools and processes based on SOX requirements are sometimes difficult for the owners of those businesses to appreciate and accept.  Most of these companies have a limited set of stakeholders and no immediate thought of expanding to seek an IPO or attracting a public company as a potential acquirer.  Nonetheless, owners of a closely held business are well advised to review SOX standards to identify ideas that can be used to manage the risks associated with the business and increase the value of their ownership stake.  The later consideration may be particularly important given that the business typically represents a substantial portion of the personal wealth of the owners.  Another element to consider is the possibility that the closely held business will shift its strategy quickly at some point in the future and become one of the other types of companies described herein.  For example, an attractive business opportunity in a new product or geographic market may lead to interest in obtaining capital from outside investors or a syndicate of institutional lenders.  In that case, the number of stakeholders, and associated scrutiny, will increase immediately.  Also, if one or more of the owners suddenly decides that he or she wants to liquidate his or her interest in the company, the owners may conclude that the best way to achieve maximum value is through a sale to a public company, which means that the firm must think and act as a “pre-acquisition” company.

Absent an immediate need for strict compliance with the requirements of SOX, closely held businesses should focus on those areas where there is value in adopting “best in class” practices.  One popular area of interest for closely held businesses is evaluating the documents and records used for common business transactions.  By standardizing procedures in this area, the company can operate more efficiently, and management can gain better access to information about those elements of the business that are most crucial from a tracking perspective.  Closely held businesses should also carefully consider adding one or more independent members to their board of directors.  In many cases, the owners are also all of the directors and senior managers of the business.  While this streamlines the communication process, it also can lead to insular thinking.  By bringing in independent experts with industry experience and other interests, the owners can obtain the benefits of a different perspective and independent directors are often sources of new business opportunities.