How to Approach Succession in a Family Business
One of the most critical issues for family businesses is how to deal with the next generation. They are distinctly different from other employees as current or potential owners of the company whose assets and reputation are at stake. On the other hand, most parents rightly fear that providing too many unearned benefits not only erodes the next generation’s work ethic, but also the very soul of the company. In answering this question, families often fall to one extreme or another: give the next generation special treatment that doesn’t hold them to the same standards as other employees (the “inheritance model”), or require them to deserve everything what they get (the “performance model”). This article describes a path that combines elements of both and that makes family members much more likely to succeed.
“Some people are born on third base and go through life thinking they hit a treble.” Often attributed to NFL football coach Barry Switzer, this quote perfectly captures what many people think of family businesses. Family members get jobs, promotions, and salaries they would never have achieved without their names on their doorstep. As one non-family executive put it, “He’s the company’s COO — the owner’s child.”
One of the most critical issues for family businesses is how to deal with the next generation. They are distinctly different from other employees as current or potential owners of the company whose assets and reputation are at stake. On the other hand, most parents rightly fear that providing too many unearned benefits not only erodes the next generation’s work ethic, but also the very soul of the company. In answering this question, families often fall to one extreme or another: give the next generation special treatment that doesn’t hold them to the same standards as other employees (the “inheritance model”), or require them to deserve everything what they get (the “performance model”). In my experience, a path that combines elements of both is far more likely to result in family members being successful.
The risks of inheritance or earnings
When roles are given rather than earned, an attitude of entitlement often ensues, well exemplified by Cho Hyun-Ah, daughter of Korean Air’s CEO, who “known to get angry when she was served macadamia nuts in a bag rather than open a plate on a flight from New York to Seoul in December 2014.” When family members exercise their privileges in this way, the company is devastated. More subtle entitlements, such as being late for work or taking long vacations to exotic locations, also undermine corporate culture.
Faced with these dangers, there can be a temptation to remove the role of inheritance from the business altogether and get family members to earn not only their job but even their ownership of the business. This performance model may seem tempting, but it also comes with real risks. Pitting family members against one another in a sort of talent horse race can create sides within an organization and possibly even split it, which is what happened when such sibling rivalry led the Dassler brothers to split their company, Sportfabrik Gebrüder Dassler (Geda for short), into two competing companies , Adidas and Puma.
Forcing family members to purchase their property can make them feel compelled to work for the company even if it is not a good fit for them. These “golden handcuffs” can have a negative impact both on this person and – due to their dissatisfaction – on the entire company. And if someone decides to leave, the company’s resources may need to be redirected away from growth investments and toward funding a repurchase of its stock.
Find the right balance
In extreme cases, neither the inheritance nor the earnings model can be implemented. A successful family business needs a bit of both. There are three main steps you can take to find the right balance.
1. Distinguish between compensation and dividends.
This line is often blurred in family businesses. Family members can receive money that reflects both their day-to-day work duties (compensation) and their equity interest in the company (dividends). Often this mess is fueled by tax efficiencies. A family business pays everything out in compensation because their corporate structure means dividends are taxed twice. Another family business does the opposite and pays very low salaries but high dividends due to the comparatively favorable tax treatment. Another driver of this blurring is the push for equality under the assumption that it is fair to treat everyone equally. In many cases, family members receive the same amount of money regardless of their role, or sometimes even whether they actually work at the company or not.
If the family members’ contributions are about the same, then there is no problem. Figure out what is a reasonable amount to pay family members for their labor and capital invested, and distribute that amount in the most tax-efficient way possible. However, this level of symmetry is rarely the case beyond the first or second generation. It is much more likely that the skills and passion for the business will vary within the family. In such situations, a one-size-fits-all approach is likely to lead to resentment (“I make so much more, why should we get the same? Company, why should they get more?”).
The best way to address these issues is to develop separate systems for calculating compensation and dividends received by family members. Compensation should be performance-based – it should reflect the market value of the role performed. Some families pay slightly above market rate to encourage family members to work in the business; others pay a little less to discourage them. But the core principle stands. Someone who serves as a CFO is worth more to the company than a sales starter. Your compensation should reflect this reality.
Another reality is that the owners of a business deserve a return on their investment. If the only way to get any financial benefit from the business is to work there, then you’ve got the golden handcuffs on. Develop a dividend policy instead. That could mean paying a fixed amount each year, a percentage of equity or profits or whatever is left over after paying the bills and funding the necessary reinvestment. Dividends should be based on the “inheritance” model – if we’re cousins who all received an equal share from our parents, but you’re an only child and I have two siblings, you’ll receive triple the dividend pool. Differentiating compensation and dividends is essential to finding the merit/inheritance balance.
2. Clarify the decisions that come from management, from those who oversee the ownership.
In a family business, two siblings had taken over the leadership from their father, who had started the business. They made all decisions – from operational to strategic – by consensus. Employees had learned a simple rule to ensure their requests, big or small, were supported: “Ask the owners.” This approach worked because they were both deeply involved in all aspects of the business.
As they looked to the next generation, it became clear that a different approach would be needed. Of their seven children together, three worked in the business and four did not (with no plans to join). Decisions by seven people not only seemed daunting, but how could those who didn’t work at the company make informed decisions about hiring staff or changing prices? If at the same time those who worked in the company made all the decisions, how was that fair to the four people who together owned more than half of the equity? Surely they should influence some decisions. But not in a way that would bring the company to a halt.
The way out of this dilemma was to distinguish the decisions coming from the Merit and Inherit models. The siblings made a list of all the decisions they had made about the company. They then divided them into three categories: 1) decisions for executives to make (e.g., hiring a new regional sales manager); 2) decisions that should be taken by the owners (e.g. payment of a dividend); and 3) decisions for which management should make a recommendation but owners should approve or disapprove (e.g., an acquisition). Taking the time to develop this “decision-authority matrix” helped the next generation find the right balance of merit and inheritance.
3. Create a family culture that recognizes the importance of both active participation and passive ownership.
There is a tendency to glorify the role of “wealth creator” in a family business. At one of my seminars, a family CEO raised his hand and asked the question, “If I’m the one creating all the wealth, why should I share it with my two siblings who don’t even work at the company?” It is understandable question to be sure. But he realized the mistake when asked in response, “What would you do if you had to buy out your siblings’ shares in the company?” He said he had to do one of three things: a ton of money from lend to the bank; to divert the Company’s profits to fund acquisitions for the foreseeable future; or take on other equity partners who may be far more sophisticated than its siblings. With none of these options remotely appealing, he realized that his siblings brought something of value: their willingness to keep their money invested in a business he ran.
The value of passive stock ownership is one of the most underestimated contributions to a family business. Growth through retained earnings is one of the surest paths to long-term success, especially when compared to highly leveraged or equity partners that require an exit to recoup their investment. As long as the demands of non-company shareholders are reasonable and don’t distract their actions too much, there is a tremendous benefit in keeping your money in the company. If those who work at the company run it well and those who don’t think long-term and keep most of their money invested, there should be more than enough. Emphasize these two levers of contribution. The passive shareholders should express their gratitude for the hard work of those who work in the company (and financially reward them with compensation in line with the market). And those who work at the company should show respect (and generate good dividends) to their investors in their communications.
The extreme versions of nepotism and meritocracy will ruin most family businesses. Instead, differentiate compensation from dividends, management from ownership decisions, and value the contributions of both active participation and passive ownership. How to find the right balance between merit and inheritance.