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Corporate Governance for Closely Held Businesses: Impressing Upon Your Clients the Importance of Following FormalitiesQuarles & Brady LLPMarch 9, 2017

PresentersJeff SwensonAssistant Center Director, Maricopa Small Business Development Center [email protected]

Wayne LorgusPartner, B2B CFO480.424.5139 [email protected]

Daniel YoungPartner, Quarles & Brady [email protected]

I. Introduction/OverviewA. Closely held companies today face many new, challenging and

complex threats as well as great opportunities.1. The previous model of the mom-and-pop style governance that has

long separated public and private concerns, has been changing. 2. Many private company executives today are embracing the more

structured governance processes used by their public counterparts.3. In regulated private companies, e.g. hedge funds, a formal board and

corporate governance process may be a business necessity.B. There is a need for private companies to consider what model fits

best for their organization. However, there’s a challenge for closely held companies:1. Strengthening governance without compromising or losing the speed

and flexibility that many see as their primary advantage in the marketplace.

C. While most public companies have clear rules and strict procedures to ensure everything from regulatory compliance to risk assessment, private companies may be wary of becoming too bureaucratic or beholden to governance process, rather than being able to anticipate or adjust to the marketplace

II. Some General Consideration for Private Companies

A. What Model works for your organization?1. Aligning the right model with the goals of the Company.

a) Issues regarding financial, cultural and conflicts of interest. b) Governance models need to be reviewed, updated and fine-tuned. c) The use of technology as your friend. Spot trends and the use of big

data/analytics. d) The downside includes security breaches of data.

i.e. ABA Journal article March 2017 re: law firmsConsider Yahoo from the NYT article March 1, 2017. A recent board investigation led to findings of theft concerning data on more than 500 million user accounts. What Yahoo believes to be a foreign government hacked in and used stolen info to forge a cookie that could be used to access 32 million Yahoo accounts. The investigation into the 2014 hack found that senior executives, company lawyers and information security staff were all aware of it and knew about attempts to break into affected accounts, but failed to "properly comprehend or investigate" the situation. As a result, Yahoo's top lawyer, Ronald S. Bell, resigned. Yahoo's CEO, Marissa Mayer, lost her 2016 bonus and her 2017 equity compensation.

2. Use of Boards can be used to monitor the management of the organization and to help with the long-term success of the company.

II. Some General Consideration for Private Companies (cont'd)3. Commitment to growth and leadership of the Company.

4. Tradeoffs between time and money for the increased rigor in overall governance. The usefulness of experienced and independent board members.

5. While the needs of private companies vary widely based on their size and type of business, adopting the leading governance practices of public companies can help them move beyond insularity and invite fresh ideas for building the business.

B. Duties of Private Company Boards1. Duty of Care

a) Board must be diligent in its activities2. Duty of Good Faith

a) Board must act in good faith for the company's best interest3. Duty of Loyalty

a) Board must act in good faith for the company's best interest, even at the expense of their own individual interest

b) Conflicts of interest

II. Some General Consideration for Private Companies (cont'd)

C. Board Composition 1. Companies should consider the type of board they need. How many

committees can address the company’s needs? Generally, management and directors overlap more in private companies than in public ones, so boards could include outside directors to encourage fresh perspectives. Having more outsiders on the board can make discussions of risk, strategy and succession more robust.

2. To determine the type of outside director a company needs, the existing board should assess long-term goals and identify gaps in the expertise of the current directors. Does a company need more financial experience on the board? Should it hire a director who has a background in international expansion?

3. Private companies also should consider evaluating diversity. Family-owned businesses may have multiple generations represented, but age isn’t the only consideration. Is there ethnic and gender diversity? In addressing these issues, companies may want to consider their customer base and whether the makeup of the board reflects that base.

4. It is also important for private company directors to understand their fiduciary duty to stakeholders, just as a public company board does.

II. Some General Consideration for Private Companies (cont'd)5. From the Article posed by Mary Ann Cloyd on Board dynamics:

a) Bringing the right people together is the first step to creating an effective board. What else is needed?

1) An appropriate board structure, possibly including committees2) Enough meeting time to allow the board to carry out all of its responsibilities3) The right information to support board decision-making4) An environment that encourages candid discussions and healthy debate5) The Harvard Law School Forum on Corporate Governance and Financial Regulation

article posed by Mary Ann Cloyd on family boards.1. Wide range of reasons for a Board:

a) At the low end: To satisfy legal requirements to the longer term success of the Company. Compliance board, insider board or fully independent board.

b) The framework for Governance is based on many factors including the founders or controlling members' goals/objectives.

c) The use of advisory boards. One way some boards check on whether they are effective is to periodically assess their own performance.

b) Family company boards may face even more challenges than other companies in ensuring they have effective board dynamics.

1) Why? 1. Because sometimes family issues become intertwined with company issues2. When the two overlap they can distract management and the board


D. Succession Planning 1. Planning for the replacement of a chief executive officer or founder

can be difficult, especially for a family-run business. But companies should be prepared for the unexpected, such as the sudden passing or disability of the CEO. Both the board and the CEO should agree the successor and how that person will be selected. Succession stability benefits not just the company and its employees, but also customers, vendors, lenders and other stakeholders who could be affected by the uncertainty of a leadership vacuum.

2. This isn’t a single-discussion or decision. Even after a plan is adopted, boards should consider regularly revisiting the issue to ensure the plan is still effective and that the chosen successor still meets the company’s long-term strategy goals.

3. Recruiting and talent retention is an outgrowth of succession planning. Public companies typically identify key employees and determine who will fill their roles if they leave. Private companies should be equally prepared for key executive changes, even in family businesses where the possibility of turnover may seem remote. The board may consider creating a compensation and nominating committee to handle these processes.


E. Strategy and Risk Oversight1. Boards should consider regularly addressing strategy and risk

management issues. Strategy often is identified by companies, both public and private, as one of their greatest challenges.

2. Boards and executives should consider regular strategy retreats or meetings in which they discuss strategic objective and set metrics and develop a strategy for achieving them.

3. Once the goals are set, these sessions should focus on executing such objectives.

4. Risk management is a key part of corporate strategy, and the board may consider creating a separate risk committee. Depending on the industry and size of the company, the audit committee may be responsible for overseeing risk management.

5. Generally, the committee is responsible for overseeing the risk policies and program. The full board ultimately is accounting for risk oversight and is responsible for discussing the strategic risks to the business.


F. Consequences of Poor Governance:1. Decreased enterprise value2. Lack of organizational focus3. Increased discontent with Board, Executive team, management,

family4. Personal liability for owners. Veil Piercing

a) Your client has commingled corporate and personal assets, failed to observe corporate formalities, and kept sparse corporate records.

b) In a lawsuit against the corporation, the court finds that the client disregarded the corporate form and pierces the corporate veil.

c) Result: Client is on the hook personally for corporate debts and liabilities.

III. Wayne's Real World ExamplesA. Real world examples of good governance and outcomes

1. Private company Aa) Formed composed primarily of investors to keep them engaged

in the business during early yearsb) Board had vital advisory role during 2008 recession when

revenue dropped 35% and company operated below breakevenc) Board continued to provide support as company recovered and

achieved double-digit growth and record profitabilityd) Company sold to private equity firm in 2016 at 7x EBITDA;

investors saw 720% return on investment

III. Wayne's Real World Examples (cont'd)B. Real world examples of not so good governance and outcomes

1. Biotech startupa) Raised $6.5m in A round financingb) Board composed of CEO, chief scientist, and independent

directors nominated by investor fundsc) Board did not question CEO’s decision to pursue 3 drugs

simultaneously with A round financing, rather than concentrate on getting one drug to NDA stage (and sale/license)

d) CEO did not discuss with board his strategy to “force” investors to provide B round financing

e) Company ran out of cash; investors wrote off investment

III. Wayne's Real World Examples (cont'd)

2. Private company Ba) CEO owned 100% of company he foundedb) Company positioned in high growth segment of mature industry

(disruptive of existing business models)c) No board of directors or corporate governanced) CEO pursued various strategiese) Newer entrants surpassed companyf) Revenue in 2006 $3.5m; revenue in 2016 $5m

IV. Jeff's Real World Examples A. Real world examples of good governance and outcomesB. Real world examples of not so good governance and outcomesC. SBA as a resource for private/closely held businesses

V. Trends/ChallengesA PwC 2013 survey asked CEOs and CFOs of 147 family-owned/owner-operated companies that question.

What are the board’s main responsibilities?

Monitor company performance 85%Set corporate strategy 74%Oversee/approve capital budget and key operating budgets

62%

Set/approve compensation for top executives

61%

Oversee risk management 59%Evaluate top executive performance 56%Succession planning 56%

V. Trends/Challenges (cont'd)These findings are similar to what the National Association of Corporate Directors found in its 2013-2014 Private Company Governance Survey.

Which three governance issues are the highest priorities for your board in 2013?

Strategic planning and oversight 57%Corporate performance and valuation 46%Financial oversight/internal control 27%Risk oversight 25%Executive talent management and leadership development

24%

CEO succession 17%Board effectiveness 16%Director recruitment and succession 12%

Attachment - Annual Reminder Letter

Attachment – Incorporation Letter

© 2017 Quarles & Brady LLP - This document provides information of a general nature. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations or issues. Additional facts and information or future developments may affect the subjects addressed in this document. You should consult with a lawyer about your particular circumstances before acting on any of this information because it may not be applicable to you or your situation.

Thank You! Questions?Jeff [email protected]

Wayne Lorgus480.424.5139 [email protected]

Daniel [email protected]