Succession Planning in Family Business – Is it really merit based?

As a family business consultant I meet way too often family members that are given jobs, promotions and salaries that they would never have achieved hadn’t they been family members in the first place. One of the most critical juncture and challenge facing any family businesses is how to treat the next generation. Most parents and current family business leaders, rightfully worry on providing their children with too many unearned advantages that undermines not only the next generation’s work ethic, but the soul of the family business itself.

Whilst family and next generation members are clearly different from other employees, as current or potential owners of the company, I always sense a level of difficulty as how to handle the journey of these persons within the family business. Families often default to one extreme or another: giving the next generation special treatment that doesn’t hold them accountable to the same standards as other employees or requiring them not only earn everything they get but they are also held to higher standards then the rest, whilst not being rewarded fairly for the effort they are putting in.

In my experience, a path that blends elements of both is far more likely to set family members up to succeed and to have a successful journey in any succession plan.

The Risks
When roles are given rather than earned, it often creates an attitude of entitlement, whose impact on the business is destructive. The most subtle signs of entitlement, such as showing up late to work or not performing adequately, will undermine the culture within the family business. This is the greatest risk of the so called “inherit model”, whereby the next generation will move up the business ladder without any link to performance.

In such circumstances, when there is any manifestation of entitlement by the next generation, the temptation can be to remove the possibility of any inheritance altogether and make next generation family members earn not only their job, but even earn any future ownership in the family business. This “merit model” can seem appealing, but it also brings real risks with it. Pitting family members against each other in a kind of talent horse race can create sides within an organisation, potentially even splitting it up – the classical case study here is that of the Dassler Brothers who split in the famous Adidas and Puma brands. Moreover, when forcing next generation family members to earn their ownership, you will likely make them feel compelled to work for the company even when it’s not a good fit for them. This will very likely have a negative impact both on that individual and the family business.

Striking a Balance
As I hope you understood so far I am not a supporter of neither the extreme inherit or merit models. I believe that a successful family business needs a bit of both. I advocate that there are some categories of action that if addressed well can help achieve this much needed balance.

  • Compensation based on Contribution: I still see many cases where family members are given the same amount of compensation irrespective of their roles, or sometimes even whether or not they actually work in the company. When the contributions of family members are roughly equal, then there’s no problem. However, this level of symmetry is rarely the case beyond the first or second generation. It’s far more likely that capabilities and passion for the business will be uneven across the family. In such situations, a one-size-fits-all approach will likely result in feelings of resentment (“I’m doing so much more, why should we get the same?”) and entitlement (“We both own 50% of the company, why should he/she get more?”).The best way to address these issues is to develop separate systems for calculating what family members receive as compensation. Compensation should be driven by merit — it should reflect the value of the role performed and the individual’s performance in that role. It should also be in line with market rates paid for such a role. Some families pay slightly above market rates to encourage family members to work in the business; others pay slightly less to test their real attachment to the family business. However the the core principle should stand – someone who is serving as CFO is worth more to the company than an entry-level salesperson. Their compensation should reflect this reality.
  • A clear dividend policy: If the only way to get a financial benefit from the business is to work there, then that means that you are risking attracting family members that would prefer not too work in the business. It is advisable to instead set a dividend policy. That would mean setting parameters of what dividends will be based upon, based on a percentage of equity or profits or whatever remains after paying the bills and funding necessary reinvestment. Differentiating compensation from dividends is essential to finding the merit/inherit balance.
  • Clarify the boundaries and remits of management from those of ownership: It is very common to meet family businesses in their second generation, whereby the children that have taken over the leadership of the business from their father, make all the decisions, from operational to strategic. This normally leads to a company culture, whereby employees learn a very simple rule “To survive here and make sure you do not get in any trouble on anything, do not decide on anything and just ask all the owners!” This approach could work across the 1st and 2nd generation, but when more people are likely to get involved across future generations it becomes clear that a different approach would be needed. It is virtually impossible to have decisions taken after consulting all family members involved, especially in the eventuality that as the pool of family owners involved grows there is an increased likelihood of having family owners working in the business and others that do not. The path out of this dilemma is to distinguish between the decisions that should be made by those in management, the decisions that should be made by the owners (e.g. paying out a dividend) and decisions where those in management should make a recommendation, but the owners should approve or reject it (e.g., making a major capital investment). Taking the time to develop this “decision-authority matrix” helps position the next generation to find the right balance between merit and inherit.
  • Create a family culture that recognises the importance of everyone’s role: There is a tendency to glorify the role of the “wealth creator” in a family business. It is quite regular that tension is created between a family business owner or owners who work in the business and create all the wealth and other family business owners who do not even work in the family business but still expect a share of the wealth created. However, while this tension can be understandable, the ones creating the wealth need to think calmly and consider all the options. I always ask such family owners of the consequences of having them buyout other family owners. Would you need borrow a ton of money? Would you need to divert the company’s profits for the foreseeable future to fund such buyouts? Or would you need to take on other external non-family equity partners who might be much more demanding than the present family owners? My point is that the contribution of the so called “passive” family business owners need not be under estimated – They are the ones who have decided to keep their money invested in the family business. So in my opinion, as long as the demands of family shareholders who don’t work in the business are reasonable and their actions are not too distracting, keeping their money in the family business is a tremendous benefit. If those working in the company do a good job of running it and those who do not run the family business leave their money invested in the family business, then there should be more than enough to go around. Placing value on both of these levels of contribution is important – Passive shareholders should express their gratitude 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 to their investors in their communication and by generating good dividends.

The extremes of either nepotism or unfair dealing of family members, will lead most family businesses to ruin. Instead, proper compensation and dividend polices, distinguishing management from ownership decisions and placing value on the contributions of both active and passive shareholders will help a family business find the right balance to grow further.

In the recent Family Business training sessions, I spoke extensively about how to handle the journey of succession planning and various other themes I touched upon today. Click HERE to view these sessions.

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