One of the most critical questions facing family businesses is how to handle the next generation. They are distinctly different from other employees, such as actual or potential company owners, whose fortunes and reputations are on the line. On the other hand, most parents rightly worry that offering too many unearned advantages damages not only the next generation’s work ethic, but also the company’s spirit. To answer this question, families often posit one extreme or the other: giving the next generation special treatment that does not hold them accountable to the same standards as other employees (“the legacy model”) or require them to earn everything they get (the “merit model”). This article describes a path that combines elements of both and is much more likely to set family members up for success.
“Some people are born on third base and go through life thinking they hit a triple.” This quote, often attributed to NFL football coach Barry Switzer, perfectly captures what many people think about family businesses. Family members are given jobs, promotions and salaries they would never have gotten without their name on the front door. As one non-family executive put it, “He’s the COO of the company—the owner’s kid.”
One of the most critical questions facing family businesses is how to handle the next generation. They are distinctly different from other employees, such as actual or potential company owners, whose fortunes and reputations are on the line. On the other hand, most parents rightly worry that offering too many unearned advantages damages not only the next generation’s work ethic, but also the company’s spirit. To answer this question, families often posit one extreme or the other: giving the next generation special treatment that does not hold them accountable to the same standards as other employees (“the legacy model”) or require them to earn everything they get (the “merit model”). In my experience, a path that combines elements of both is much more likely to set family members up for success.
Succession or Merit Risks
When roles are given rather than earned, it often creates an attitude of entitlement, well exemplified by Cho Hyun-Ah, daughter of the CEO of Korean Air, who, “celebrity got angry when she was served macadamia nuts in a bag . and not on a plate on a flight to Seoul from New York in December 2014.” When family members use their privilege in this way, the impact on the company is devastating.Even the most subtle signs of entitlement, such as showing up late to work or taking long vacations to exotic locations, will undermine the corporate culture.
In light of these risks, the temptation may be to remove the legacy role from the company and have family members earn not only their jobs but also their ownership in the company. This merit model may seem attractive, but it also carries with it real risks. Pitting family members against each other in a kind of talent horse race can create factions within an organization and even divide it, which is what happened when such sibling rivalry led the Dassler brothers to split their company. theirs, Sportfarbrik Gebrüder Dassler (Geda for February), in two competing companies, Adidas and Puma.
Forcing family members to acquire their own ownership can make them feel compelled to work for the company even when it is not convenient for them. These “golden shackles” can have a negative impact both on that individual and, because of their displeasure at being there, on the wider company. And when someone chooses to leave, the company’s resources may need to be diverted from investing in growth and toward financing their stock buyback.
Striking the right balance
So, in the extreme, neither inheritance nor meritocratic models are viable. A successful family business needs some of both. There are three main actions 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 both reflects their day-to-day job responsibilities (compensation) as well as their equity shares in the company (dividends). Often this confusion is driven by tax efficiency. A family business pays everything in compensation because their corporate structure results in dividends being taxed twice. Another family business does the opposite, paying very low wages but high dividends due to relatively favorable tax treatment. Another driver of this blurring of boundaries is the impulse for equality, under the assumption that treating everyone the same is fair. In many cases, family members are given the same amount of money regardless of their roles, or sometimes even whether they work for the company or not.
When the contributions of family members are roughly equal, 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 rarely occurs beyond the first or second generation. It is much more likely that the skills and passion for business will be uneven across the family. In such situations, a one-size-fits-all approach is likely to result in feelings of resentment (“I’m making so much more, why should we get the same?”) and entitlement (“We both own 50% of the company, why should he 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 should be merit driven – it should reflect the market value of the role performed. Some families pay slightly above market rates to encourage family members to work in the business; others pay a little less to discourage them. But the main principle remains. Someone who serves as a CFO is worth more to the company than an entry-level salesperson. Their compensation should reflect this reality.
Another reality is that the owners of a company deserve a return on their investment. If the only way to get a financial benefit from the business is to work there, then you have put on golden handcuffs. Instead, develop a dividend policy. This could mean paying a certain amount each year, a percentage of capital or profits, or whatever is left over after paying bills and funding the necessary reinvestment. Dividends should be based on the “inheritance” model – if we’re cousins who’ve all been given equal shares of our parents, but you’re an only child and I have two siblings, you’ll get three times as much from the dividend group. Differentiating compensation from dividends is essential to finding the merit/legacy balance.
2. To clarify the decisions that come from management from those that accompany ownership.
In a family business, two siblings had taken over from their father, who founded the company. They made all decisions – from operational to strategic – by consensus. Employees had learned a simple rule to ensure that their requests, large or small, were granted: “Ask the owners.” This approach worked because both were very involved in all aspects of the business.
As they looked ahead to the next generation, it became clear that a different approach would be needed. Among their seven combined children, three worked in the business and four did not (with no plans to join). Not only did the decisions of seven people seem daunting, but how could those who did not work at the company make informed choices about hiring employees or changing prices? At the same time, if those who worked in the company made all the decisions, how was it fair for the four people who together owned more than half of the capital? Of course, they must have an influence on some decisions. But not in a way that brought the company to a standstill.
The way out of this dilemma was to distinguish between decisions coming from merit and inheritance models. The siblings created a list of all the decisions they had made about the company. They then divide them into three categories: 1) decisions that must be made by those in management (eg hiring a new regional sales manager); 2) decisions to be made by owners (eg dividend payment); and 3) decisions where those in management must make a recommendation, but the owners must approve or reject it (eg, making an acquisition). Taking the time to develop this “decision-authority matrix” helped position the next generation to find the right balance between merit and legacy.
3. Create a family culture that recognizes the importance of active involvement and passive participation.
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 who creates all the wealth, why should I share it with my two siblings who don’t even work in the company?” It’s an understandable question, surely. But the flaw in it became clear to him when he was asked in response, “What would you do if you had to buy out your siblings’ equity in the company?” He said he would have to do one of three things: borrow a ton of money from the bank; diversion of the company’s earnings for the foreseeable future to finance acquisitions; or take on other equity partners who may be much more demanding than its siblings. Since none of these options were at all appealing, he realized that his siblings were bringing something valuable to the table: their willingness to keep their money invested in a business he was running.
The value of passive shares is one of the most underrated contributions to a family business. Growth through retained earnings is one of the surest paths to long-term success, especially compared to high borrowing rates or equity partners who will require an exit to recoup their investment. As long as the demands of non-working shareholders are reasonable and their actions are not too distracting, keeping their money in the company is a tremendous benefit. If those who work in the company do a good job of running it and those who don’t are willing to take the long view and leave most of their money invested, then there should be more than need to go The value of placing in both of these contribution levers. Passive shareholders should express their appreciation for the hard work of those working in the company (and reward them financially through market-based compensation). And those working in the company should show respect for their investors in their communication (and generate good dividends).
Extreme versions of nepotism and meritocracy will lead to the destruction of most family businesses. Instead, distinguish compensation from dividends, distinguish management from ownership decisions, and place value on the contributions of active involvement and passive shares. By doing so, you will find the right balance between merit and legacy.