Corporate governance for private companies

Updated April 2011

In November 2010 the Institute of Directors published a paper entitled "Corporate Governance Guidance and Principles for Unlisted Companies" (referred to here as the Guidance). It is intended as an easy to follow set of principles that can be applied by directors of private companies to improve corporate governance. The Guidance largely tracks the UK Corporate Governance Code (the Code) which most listed companies appearing in the FTSE indices are required to apply. However it has been tailored to the specific needs of smaller companies and unlike the Code, there is no legal obligation for companies to conform to it. It is also drafted so as to be practical to apply.

Purpose

The purpose of the Guidance is to provide practical steps and principles that private companies can apply to improve how they are run and managed. In all there are 14 principles, the last five of which only apply to larger private companies. These cover a range of areas but generally they are designed to:

• Ensure value is protected for shareholders, as there is often no ready market for shares in private companies;
• Balance the interests of founder families with the success of the company; and
• Promote long term success and attract external investment.

This note considers how the Guidance is intended to deliver the above results.

Protecting value

The guidance suggests that all private companies should have an appropriate constitution in place to regulate how the directors and shareholders interact with each other. In practice this refers to the articles of association (articles) which is the main constitutional document of any company.

Often a company is formed with standard articles and over time these stay the same, while the business and composition of the company can change dramatically. Well drafted articles can, amongst other things, prevent dilution of shareholdings, ensure that disgruntled employee shareholders are forced to sell their shares upon leaving the company, and also remedy shareholder and director disputes, generally preventing the situation where interested parties reach a deadlock.

Leading on from this the Guidance stresses the importance of having an effective board, of a size and composition relative to the size and complexity of the company. A board should have an appropriate mix of skills and experience without being so big as to be unwieldy. Most importantly of all the board should have some form of succession planning in place. Again, the articles can assist with providing for the orderly rotation and resignation of directors to constantly refresh the board.

Like the Code, the Guidance also recommends employing non-executive directors if possible to provide an independent oversight of the board. This is particularly important where there are non-director shareholders, especially when setting executive remuneration.

Family companies

One area where the Guidance differs significantly from the Code is in respect of family controlled companies. Research has shown that family controlled companies rarely survive past three generations. The reason for this, according to the Guidance, is the failure to distinguish between the interests of the company and those of the family. It is also natural that over time as shares pass down generations the number of family shareholders can quickly increase, which can lead to administrative difficulties and disagreements. This is currently in the news in respect of several large luxury fashion firms in France.

To address this problem the Guidance suggests forming a family council and a family assembly. The family council is a small body of family members, voted for by family members to represent them, liaise with the board and to make decisions on behalf of the family. The family assembly consists of all family members and should meet twice a year to discuss their concerns with a view to pre-empting and preventing conflicts.

The Guidance suggests formalising this by putting in place a family constitution, which may take the form of a shareholders' agreement or nominee agreement. This should set out:

• the family's values, mission statement and vision;
• the role of a family council; and assembly;
• the role of the board of directors and its relationship with the family council;
• policies for important family issues, such as employing family members, restricting transfer of shares and succession planning for the chief executive; and
• nomination of family members to the board.

The intention of this is to balance the interests of the family together with promoting a strong independent board and promoting the long term success of the company.

Long term success

The overall purpose of the Guidance is to improve the corporate governance of private companies with a view to promoting their long term growth. A good example of this is the suggestion that companies should promote the professional development of their board members by encouraging ongoing training.

The Guidance stresses the importance of an independent board and a separation of power between those running the company and those with a financial interest. In smaller companies these will often be the same people, however the Guidance emphasises that no one person should have unfettered control or powers of decision making. It also suggests that larger companies should regularly appraise board performance to identify any room for improvement.

In the future it is likely that private equity investors will see a commitment to applying the guidance as a positive signal for making investments. Of course it is inevitable that professional investors will seek to apply their own corporate governance procedures to an investee company, such as appointing their own non-executive director. However a company with strong corporate governance already in place will be able to adapt to the requirements of external investors more easily. Applying the suggestions in the Guidance would be a good place to start.

More information

Please see Related links for the full text of the Guidance.

If you would like to discuss any aspect of this further please contact a member of our team.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at April 2011. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

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