One of the most critical questions facing family businesses is how to handle the next generation. The current or potential owners of the company, whose wealth and reputation are on the line, are clearly distinguished from other employees. On the flip side, many parents are rightly concerned that offering too many unearned benefits will harm not only the next generation’s work ethic, but the very soul of the company. When answering this question, families often go to one extreme or the other: giving the next generation special treatment that doesn’t hold them accountable to the same standards as other workers (the “inheritance model”) or letting them get everything they’ve earned (the “value model”). This article describes an approach that integrates both elements, and that is more likely to set family members up for success.
“Some people go through life thinking they were born on the third and hit three times.” This quote, often given by NFL football coach Barry Switzer, perfectly captures what many people think about family businesses. Family members are given jobs, promotions, and salaries that they would never have gotten if their names weren’t on the front door. As one family executive put it, “He’s the COO of the company — the son of the owner.”
One of the most critical questions facing family businesses is how to handle the next generation. The current or potential owners of the company, whose wealth and reputation are on the line, are clearly distinguished from other employees. On the flip side, many parents are rightly concerned that offering too many unearned benefits will harm not only the next generation’s work ethic, but the very soul of the company. When answering this question, families often go to one extreme or the other: giving the next generation special treatment that doesn’t hold them accountable to the same standards as other workers (the “inheritance model”) or letting them get everything they’ve earned (the “value model”). In my experience, an approach that integrates both elements is more likely to set family members up for success.
Inheritance or competence risks
When roles are given rather than earned, they often create an attitude of entitlement, a good example being Cho Yoon-ah, the daughter of the CEO of Korean Airlines, who “was furious when she was offered a bag of macadamia nuts.” And it’s not on board on a December 2014 flight from New York to Seoul. When family members exercise their rights in this way, the impact on the company is devastating. Signs of entitlement, such as showing up to work late or taking long vacations to exotic locations, undermine more subtle corporate culture.
Given these risks, the challenge may be to completely remove the role of inheritance from the organization and ensure that family members get not only their jobs, but even their ownership in the organization. This model may seem attractive, but it brings with it real risks. Pitting family members against each other in a talent horse race can create divisions within an organization and even divide it. short), to two competing companies, Adidas and Puma.
Forcing family members to earn ownership rights forces them to work even when it’s inconvenient for the company. These “golden handcuffs” can have a negative effect on that individual, and because they are not satisfied with being there, the wider company. And when someone chooses to leave, company resources may need to be diverted from investing in growth and funding to buy back their shares.
Striking the right balance
Therefore, in the extreme, neither inheritance nor competence models are applicable. A successful family business requires some of both. There are three main steps to finding the right balance.
1. Distinguish between compensation and components.
This line is often blurred in family businesses. Family members can receive money that reflects both their day-to-day job responsibilities (compensation) and their equity stake in the company. Often this clamor is driven by tax efficiency. A family business pays out everything as compensation because their corporate structure causes dividends to be taxed twice. Due to the comparatively favorable tax treatment, a separate family business pays very low wages but makes high dividends. Another driver of this blurring of boundaries is the drive for equality on the assumption that equality is fair for all. In most cases, family members are paid the same amount regardless of their role, or sometimes whether they actually work for the company or not.
When the contributions of family members are roughly equal, there is no problem. Find out what is a reasonable amount to pay family members for their work and invested capital, and distribute the money in the most tax-efficient way possible. However, this degree of symmetry is rarely higher than the first or second generation. Chances are that abilities and passion for business don’t run in families. In such situations, a one-size-fits-all approach can create resentment (“I’m doing more, why do we get the same thing?”) and entitlement (“We both own 50% of the company, why should she get more?”).
The best way to address these issues is to develop separate systems for calculating what family members receive as compensation and dividends. Compensation must be managed efficiently – it must reflect the market value of the role performed. Some families pay slightly above the market rate to encourage family members to work in the business; Others pay less to discourage. But the main principle stands. Someone serving as a CFO is more valuable to a company than an entry-level salesperson. Their compensation should reflect this fact.
Another fact is that the owners of a company deserve a certain return on their investment. They slap on the golden handcuffs if working there is the only way to gain financial benefit from the business. Instead, develop a dividend policy. 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 paying the required reinvestment. Dividends should be based on an “inheritance” model – if we’re all cousins given equal shares of our parents, but you’re an only child and I have two siblings, you’ll receive three times more than the dividend pool. Separating compensation from dividends is essential to achieving the value/inheritance balance.
2. Clarify the decisions coming from the management related to ownership.
In a family business, two siblings took over the leadership from their father who founded the company. They made all the decisions – everything from operational to strategic – by consensus. Employees have learned a simple rule to ensure there is buy-in on their requests, big or small: “Ask the owners. This approach was effective as both were heavily involved in the business sector.
Looking at the next generation, it became clear that a different approach was needed. Of their seven combined children, three are working in the business, while four are not (with no plans to join). Not only does the decision of seven people seem difficult, but how can employees who have never worked for the company make an informed choice about hiring or changing prices? If the people who worked in the company at the same time made all the decisions, how was it fair for the four people who had more than half of the shares? Of course, they should have an influence on some decisions. But not in a way that would end the company.
The way out of this dilemma was to separate the decisions from legacy and inherit models. The brothers and sisters made a list of all the decisions they were making about the company. They then divide them into three categories: 1) Decisions within management (eg hiring a new regional sales manager). 2) decisions to be made by the owners (for example, paying dividends); and 3) when people in management make recommendations, but the owners must approve or reject them (eg, making a purchase). Taking the time to develop this “decision-authority matrix” helps the next generation find the right balance between competence and legacy.
3. Creating a family culture that recognizes the importance of both active participation and passive shareholding.
There is a tendency to respect the role of “wealth creator” in family business. At one of my seminars, a family CEO raised his hand and asked, “If I’m the one who created all the wealth, why should I share it with my two siblings who don’t even work in the company?” He asked a question. It’s a question that helps to be sure. But what would you do if you had to buy your siblings’ equity in the company? When questioned, the flaw in it became clear to him. He said he had to take one of three actions: Borrow a ton of money from the bank; Revolving the company’s profits for future purchases; Or find other equity partners who may claim more than his siblings. None of these options were the least bit appealing, so he realized that his siblings had brought something important to the table.
Passive shareholding value is one of the contributions to a family business. Growing with retained earnings is one long-term path to success, especially when compared to higher debt or equity partners seeking an exit to recoup their investment. As long as the demands of non-working shareholders are reasonable and their actions are not too distracting, it is a great benefit to keep their money in the company. If the people working in the company do a good job and don’t have a long view and leave a lot of their money invested, there should be more than enough to go around. Place a value on both of these contribution bands. Passive shareholders should be thanked for their hard work in the organization (and financially rewarded with market-based compensation). And the people working in the company must show respect to their investors through their relationships (and generating good profits).
Extreme versions of nepotism and nepotism lead to the destruction of most family businesses. Instead, separate compensation from dividends, separate governance from ownership decisions, and place value on both active participation and passive shareholding. By doing this, you will find the right balance between inheritance and inheritance.
