Over the past few years we have seen many entrepreneurs beginning to use outside directors in their management model.  This trend is expected to continue as business owners look for new approaches for running their businesses. 

What is an Outside Director

First we need to know the meaning of an Outside Director.  The common definition of an Outside Director is a person selected or elected by shareholders to a corporation's board of directors who is not affiliated with the company in any other capacity.  Plain and simple, the individual more than likely has an independent point of view.

What Purpose Do They Serve

When queried, most owners acknowledge that the presence of Outside Directors in a family or closely held business serves only one meaningful purpose: to add value and perspective to management. This is accomplished in several ways.

Most entrepreneurs or Chief Executive Officers of family held businesses will agree that it's lonely at the top. Creating a board of directors with outside representation provides the entrepreneur with a peer group with whom they can discuss problems and business issues. Without question confidentiality is associated with outside board members, further enhancing the value of the advice provided.

Obviously this fresh prospective adds another point of view when a business addresses questions ranging from capital investment decisions, such as whether to buy a new piece of machinery or develop a new product, to personnel matters, such as whether to terminate a long time employee who is no longer functioning at the level required, or to name a successor to the leadership position in the business.

Change in the Decision-making Process

The presence of Outside Directors on the board changes the decision-making process. This structure encourages management to more fully analyze and justify management decisions to board members. This also allows the outside board to act as a safety net in the decision making process.

Inactive Family Member Perspective

Outside Directors also serve an important role in family businesses in which family member shareholders are not active in the business.  Many look to outside board members as reassurance that the business is not being run for the personal benefit of the active family members. As an example, the board might set the CEO's compensation and approve promotions of family members within the business.

Selection of Directors

After making the decision to utilize outside individuals on the board of directors, the most important decision is the selection process. A natural inclination is to appoint "trusted advisors," such as the company's lawyer or accountant.  This is generally not advisable since most lawyers or accountants have only limited experience with management of operating companies.

Similarly, tennis, golfing buddies or close friends should be precluded because of the natural unwillingness to jeopardize close personal relationships when decisions need to be made. Another group is individuals associated with customers.  While they can offer crucial insight, conflicts will naturally exist when there is a need to discuss and share confidential financial data regarding business relationships.

Many believe the best choices are individuals who can bring special skills, experience, or perspective to the board. Circumstances and needs play a role, for example (1) consider former owners of businesses in the same or a similar industry – they've been there, or (2) consider an individual who has served as an officer or upper level manager of a public company or in a private company that raised significant outside capital from a venture capitalist if your organization is looking for an outside investment vehicle , or (3) look for individuals with experience with human resource management or financial management if this is a weakness in your organization.  Most important – look for individuals with special skills.

Establish Well Defined Expectations

When selecting directors, be sure your expectations are clear and ascertain that the candidates are willing and able to fulfill their commitment. Candidates should be prepared to attend and actively participate in regular meetings.  A tool to ensure the role is taken seriously is to provide adequate compensation. Fees of $1000 to $3000 per quarter for attendance at a quarterly board meeting are not uncommon in the current business environment.

Liability Concerns

The matter of legal liability is always an important topic for individuals considering board membership.  Some entitles often establish an Advisory Board of Directors. Some believe this structure eliminates liability because the board has no legal authority and their actions are nonbinding in nature only. We'll leave that interpretation to the legal community.

In any case legal counsel should be involved in the review of the company's Articles of Incorporation and Bylaws to ensure that the board has the maximum liability protection. And, as always, the business should continually investigate the availability and costs of procuring directors and officer's liability insurance.

The Bottom Line

Outside directors can serve a valuable role for any closely or family held business. Properly selected and utilized, the outsiders may offer a valuable perspective and provide helpful advice to the business.  This can be a valuable tool in today's ever-changing competitive environment.

For More Information

For more information about Corporate Governance, contact Bruce E. Seagrist by phone at 717.761.7910 or by email at BSeagrist@macpas.com.  Mr. Seagrist is a Principal in the Accounting and Auditing Group of McKonly & Asbury, LLP.