Family-Owned Businesses

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Family owned businesses ("FOBs") have historically represented the lifeblood of the U.S. economy, occupying the greatest portion of the nation's wealth. FOBs also play a significant role in the economy. According to the Family Firm Institute ("FFI"), family-controlled companies account for 78% of the nation's job creation, 60% of its employment, and over 50% of its gross domestic product.

Family Succession Facts

The FFI estimates that over the next 20 years, $4.8 trillion of net worth will be transferred and $10.4 trillion by 2040. Given these statistics, the U.S. Small Business Administration estimates that at any given time, 40% of businesses are facing the issue of transfer of ownership and control, and considering the following options:

According to a recent survey of family business owners by the National Federation of Independent Business (NFIB), 48% of family business owners indicated that they would like to have one or more of their family members take over and operate their business, but only 13% believe it is "very likely" that a family member actually will take over. The majority indicated a preference for having someone outside the family take over.

The FFI reports that only about 30% of all family-owned businesses survive into the second generation, which drops to 12% in the third generation, and only 3% through the fourth generation and beyond. As a result, the average lifespan of a FOB is only 24 years.

Planning for Family Succession

Because building a comprehensive succession strategy can take years of careful planning, advisors recommend that business owners initiate the process at least five years before they plan to retire or exit their business. Failure to effectively prepare for and manage the succession process, inadequate estate planning, and insufficient funds for estate taxes are the three leading causes of failed FOBs. According to a survey of failed FOBs (conducted by the University of Connecticut Family Business Program and reported by the FFI), 47.7% cited the founder's death as the precipitating reason for the transition and ultimate collapse of the firm.

Benefits of Family Succession

The decision to keep business ownership and control in the family often depends on a number of preexisting conditions, including the presence and ability of a qualified heir, a stable financial scenario, and a secure plan for the future goals of the company. With these factors in place, family succession has a number of distinct advantages, including the following:

Future leaders know the business. – It is likely that a family-owned business heir was first exposed to the business at a very early age, and by the time of succession, may have had multiple positions and roles within the company, making him or her well equipped to move into the lead role. If coupled with business acumen and drive, this makes for a powerful combination of experience and ability that may be lacking in an outsider brought in to run the business.

Emphasis is on long-term gains. – Because of the orientation that the business is going to remain in the family for years to come, FOBs tend to have a long term outlook, and pursue strategies that may hinder their short-term earnings, but ultimately lead to sustained growth. Privately-held FOBs, that do not have to answer to securities analysts and outside investors who tend to favor short-term results, are particularly oriented toward longer-term success.

Better employee relationships. – The business adage "we always take care of our people" holds particularly true in FOBs. FOBs often have a strong paternalistic culture, providing good benefits and job security to loyal employees. In the best situations, this climate makes for a tight-knit, dedicated culture and low turnover.

Significant tax benefits. – A family business offers an excellent opportunity to develop tax deferred wealth within a family. A number of tax planning strategies are available that can greatly benefit the company and its owners, should the business stay in the family.

Drawbacks of Family Succession

Lack of family harmony. – Personal issues, tensions, jealousies, and sibling rivalries are all behaviors that can be detrimental to the successful operation of the company. In addition, a lack of communication is particularly destructive to successfully running a business. The Williams Group (a consulting FFI firm specializing in family succession) together with the University of the Pacific found that 60% of FOB failures are due to the breakdown of trust and communication within the family.

Current owner cannot let go. – A first generation family business owner is often single-handedly responsible for building the business from the ground up, accounting for years of hard work and struggle. Hence, the relinquishing of ownership often represents an enormous emotional and financial hardship. In addition, the success of a FOB is often tied tightly to the unique abilities and proprietary knowledge of the founder, built through years of experience. As a result, it is not uncommon for a founder to try to retain the influence and privilege they have become accustomed to, and for the second generation to end up frustrated and ill prepared.

Successor is not qualified. – It is estimated by family planning experts that children are not suited to take over a FOB approximately 30% of the time, either because of lack of ability, commitment, or interest. Inheritors often grow up in a richer lifestyle, with significantly more material possessions than their parents, and while they recognize the importance of their legacy, they may not be as motivated as their parent, who actually built the business from nothing. The next generation also may not possess the entrepreneurial drive, or the intellectual and interpersonal abilities of their predecessors. Owners are typically advised that if a planned successor is not capable of continuing the business successfully, the company should be sold instead of passed down. Unfortunately, because of family loyalties, the latter situation often occurs, with unsuccessful consequences.

Disagreeing on how to run the business. – A change in leadership often comes with a change in the management model and a corresponding shift in the corporate culture, difficult realities for the original owner, and longtime management to accept. A successful intergenerational transfer requires mutual respect between generations, and a common philosophy about the future direction of the company.

Retirement cannot be financed. – Because the business is usually his or her single largest asset, an owner's retirement income is typically tied up in the business. However, the transfer of the company to the next generation often occurs with little or no exchange of money to the owner. The highest value of a company is usually not recognized via an intergenerational transfer.

Alternatives to Family Succession

For various reasons, including the lack of a logical and capable successor, the desire to truly retire, and the desire cash out, family succession is not a viable option for many business owners. As an alternative to family succession, middle-market business owners have access to various liquidity or "exit" options, including:

In each and every situation, the proper and most beneficial succession or exit plan will be different. Every family has different dynamics and each family member has differing desires, abilities, and talents. Furthermore, every business and industry is different. Consequently, numerous and multiple variables come into play.

Perhaps the most critical factor is for the owner to recognize the need for a succession or exit plan. Often owners are emotionally unable to "let go" or they feel they "need to be needed" and fail to establish an exit or succession plan. All the owners hard work and the ability to pass along that wealth to family members is jeopardized if an owner becomes incapacitated, or worse, prior to implementing a succession or exit plan.