Family Business Governance and Family Constitutions

Family business governance: why it matters

Family business governance is the set of rules and bodies that allows a family to own and run a company across generations without losing control or cohesion. In Germany, family businesses form the backbone of the Mittelstand, and many of them are now in their third, fourth or later generation, with dozens or hundreds of family shareholders. German company law provides the legal shell, usually a GmbH, a GmbH & Co. KG or a stock corporation, but it says little about how a family should organise itself.

Good family business governance therefore combines three layers: the corporate documents (articles of association or partnership agreement), contractual arrangements among the shareholders (pooling and shareholders' agreements), and non-binding family rules (a family constitution or charter).

The aim is to separate ownership and management where appropriate, professionalise oversight, keep shares in the family and resolve conflicts before they reach a court.

This briefing explains the main instruments, how they interact with German company, inheritance and tax law, and how to design them for the long term.

The three layers of family business governance

The decisive design question is which rules belong in which layer. Rules that must bind future generations and third parties, such as transfer restrictions and succession clauses, belong in the articles. Rules that need confidentiality belong in a shareholders' agreement. Rules about family behaviour and values belong in the family constitution, where flexibility is an advantage. Inconsistencies between the layers are a frequent cause of disputes.

Key clauses in the corporate documents

• Transfer restrictions. The articles of a GmbH can make the transfer of shares subject to the consent of the company or the shareholders (§ 15(5) GmbHG), and partnership agreements can restrict transfers of interests. Typical clauses allow transfers only to descendants or other family shareholders.
• Succession clauses. GmbH shares are inheritable by law (§ 15(1) GmbHG). The articles cannot prevent inheritance, but they can provide that shares inherited by persons outside the permitted circle must be transferred or can be redeemed against compensation (§ 34 GmbHG). In partnerships, the agreement can determine directly who succeeds a deceased partner.
• Compensation. Exit and redemption clauses often limit compensation to protect the company's liquidity. Courts accept reasonable limitations but intervene where compensation is grossly disproportionate; see our briefing on shareholder disputes in the GmbH.
• Majorities and minority protection. Qualified majorities for key decisions protect family branches, while clear rules avoid blockades.
• Marital agreements. Articles often require shareholders to agree with their spouses that the shares are excluded from the statutory community of accrued gains, to avoid liquidity outflows on divorce.

The advisory board

Many family companies establish an advisory board (Beirat) with external members to supervise and advise management and to mediate between family branches. In a GmbH, the articles can establish a voluntary supervisory board or an advisory board.

If the body is called a supervisory board, certain AktG provisions apply by default unless the articles provide otherwise (§ 52(1) GmbHG). An advisory board can be given far-reaching powers, including the appointment and dismissal of managing directors, approval of significant transactions and the setting of remuneration, or a purely advisory role. In larger companies subject to co-determination, a mandatory supervisory board exists in addition, and the advisory board's competences must be coordinated with it.

The value of an advisory board depends on its composition and independence. Experienced external members can professionalise governance, challenge management and, crucially, act as a neutral authority when family members disagree. The articles should define the board's powers, the appointment rights of family branches, the qualifications and independence of members, terms of office, remuneration and liability.

The family constitution

A family constitution, also called a family charter or family code, sets out the family's shared values, its long-term goals for the business and its rules on matters that the law does not regulate. Typical content includes the role of family members in management and the requirements for family members to work in the company; the dividend policy and the balance between distributions and reinvestment; education and preparation of the next generation; family bodies such as a family council and a family assembly; communication between the company and the family; and procedures for conflict resolution, such as mediation.

Family constitutions are typically developed in a structured process involving all generations, which can take months. The process itself often contributes as much to family cohesion as the resulting document. The constitution should be reviewed periodically, for example once a generation, and its key rules should be mirrored in the legally binding documents. Corporate governance codes for family businesses published by private initiatives can serve as a reference, but each family needs rules that fit its own situation.

Separating ownership and management

A central question for every family business is whether family members should manage the company or whether the family should act as owners who appoint external managers. There is no single right answer, but many families adopt rules on the conditions under which family members can join management, for example relevant education, several years of experience outside the company and a selection process involving the advisory board. Such rules reduce the risk that management positions become a matter of family politics and protect family managers against accusations of nepotism.

Where family members manage the company, governance must ensure that they are supervised effectively. In a GmbH, the shareholders can instruct the managing directors, which may give family shareholders in management a double role. An advisory board with external members, clear approval catalogues and a separate remuneration process create the necessary distance. Where external managers run the company, the family needs a channel to communicate its expectations, typically through the advisory board and a family council, without interfering in day-to-day management.

Dividend policy and exits of family members

Dividend policy is often the most emotional topic in family companies. Active family members tend to favour reinvestment, while passive shareholders, especially in later generations, rely on distributions. A written dividend policy, for example a target payout ratio subject to the company's equity ratio and investment needs, creates predictability. It can be laid down in the family constitution and reflected in the advisory board's approval rights.

Family members who want to leave are a second source of tension. Articles that permit exits only with long notice periods and limited compensation keep capital in the company but can trap family members who have lost interest. Many families therefore establish an internal market: shares may be sold to other family members or the company at a formula price at regular intervals, with a right of first refusal for each family branch. Such mechanisms must respect the capital maintenance rules, because the company may acquire its own shares only from free reserves, and must be coordinated with the pooling agreement to avoid jeopardising inheritance tax relief.

Tax, pooling and succession planning

Family business governance has a direct tax dimension. Inheritance and gift tax relief for business assets under §§ 13a and 13b of the Inheritance and Gift Tax Act (ErbStG) applies to shares in corporations only if the deceased or donor held more than 25% of the capital directly. Smaller holdings can be aggregated where the shareholders are bound by a pooling agreement under which they must dispose of their shares uniformly or transfer them only to other pool members and must exercise their voting rights uniformly towards non-pooled shareholders (§ 13b(1) no. 3 ErbStG). Pooling agreements are therefore a standard instrument in family companies with dispersed shareholdings.

The relief also depends on the composition of the business assets, holding periods and payroll conditions after the transfer. Succession planning should therefore coordinate the corporate documents, the pooling agreement, wills and inheritance contracts of the shareholders and, where relevant, family foundations. See our pages on succession planning and family foundations. Many family businesses use the GmbH & Co. KG as their legal form, which combines limited liability with partnership taxation.

Common problems and how to avoid them

Experience shows recurring problems in family business governance: articles that have not been updated for decades and no longer fit the shareholder structure; succession clauses that conflict with shareholders' wills; compensation clauses that are invalid or threaten the company's liquidity; advisory boards without real powers; and family constitutions that were never implemented. Regular governance reviews, ideally linked to generational transitions or major transactions, help to identify these issues before they escalate.

Family business governance also matters when outside capital is brought in.

A minority investor, a private equity fund or a strategic partner will review the articles and shareholder agreements closely and will typically ask for information rights, consent rights for key decisions and an exit route. Families should decide in advance which rights they are prepared to grant and ensure that new investor rights do not undermine the family's pooling arrangements or the advisory board's role. Where a sale of the whole company is considered, clear governance rules on who decides and with which majority make the process faster and less contentious; see our briefing on selling a Mittelstand company.

Illustration: a hypothetical third-generation family company with 40 shareholders in three family branches adopts a new governance package. The articles of the GmbH & Co. KG restrict transfers to descendants, establish an advisory board with two family and three external members and set qualified majorities for structural decisions. A pooling agreement secures inheritance tax relief for the smaller holdings, and a family constitution sets rules for family employment and the dividend policy. The process takes a year and involves all branches.

How TRW & Co helps

We advise family businesses and their shareholders on family business governance: drafting and updating articles and partnership agreements, pooling and shareholders' agreements, advisory board structures and rules of procedure, and supporting family constitution processes, together with tax advisers on succession and inheritance tax. When conflicts arise, we advise on mediation and, where necessary, disputes. Our corporate governance team works with our private client colleagues. Contact us to discuss your family's governance.