It happened to us. Twice.
Family business fraud is never expected, but it's even more unexpected when it's from someone inside your business.
Why is it that family businesses are such a target for business fraud? You would think that with the more hands-on management style and inherent trust within a family business that it would be less prevalent. Oddly enough, it's these two factors that actually enable more fraud to exist.
Our family business experienced two instances of fraud, both caused by employees inside the business. One was relatively minor, while the other was major and almost brought our business to its knees.
The minor incident was caused by an accounting department employee. This employee set up a fictitious company as a supplier and invoiced the company for services. The amounts were small but frequent and added up over the course of the year. We worked with so many small suppliers that it flew beneath the radar and went unnoticed until our year-end audit. Because it involved an accounting employee, the approval financial control was circumnavigated. The employee was confronted (by law enforcement) while out on a sick day, swimming in their new pool, likely purchased through the fraud.
The major incident was caused by a senior management non-family member. It wasn't so much fraud as it was deceit. The deceit was more associated with the operations of the business than finances. The executive diverted capital spending towards high revenue but highly unprofitable new venture activities. This wholly benefited their individual compensation plan to the detriment of the business. Even though this wasn't directly a financial issue, it was a management issue that went on long enough to create a financial strain on the business.
Why are family businesses such a target of fraud?
- Family businesses tend to be a trustworthy group, almost to a fault.
- Most owners come from a small business background and never experience the dishonest side.
- Smaller family businesses often don't have the financial controls in place to detect fraud.
- Fast growth helps disguise fraud and allows it to expand quicker before it is detected.
- Operational fraud can be even more serious than financial fraud.
How to Prevent Family Business Fraud
- Strengthen financial controls using an outside auditing firm.
- Operate the financial function of the business almost as if you were publicly held.
- Hire a strong auditing firm with auditing experience for your size business.
- This is one instance that you won't mind being a little bureaucratic.
- Monitor senior management closely and keep them motivated and challenged to prevent them from wandering into areas where they are less competent.
- Instill management controls, similar to financial controls, to hire and retain senior management. Form an advisory board to serve this purpose and spread the decision-making over more people and prevent one individual from making unilateral hiring and compensation decisions.
- Consider an operations audit, performed by an outside firm, for the non-financial functions of the company. It can point out where there are conflicting interests and responsibilities.
These incidents created long-term trust issues for me and it was a long time before I was able to begin fully trusting others. Even today several years past these incidents, I still keep my guard up.
Reprinted with permission of the Center for Family Business at Northeastern University.