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In the lifecycle of a family business, the family undergoes three major events: birth, marriage, and death. While each event occurs at vastly differing points in the timeline, they all have profound implications that can drastically alter the trajectory of the firm. This article describes the birth of a new generation and its impact on the ownership and management.
The story of a family business begins when it is established by one or two family members (the first generation). In a first generation business, the transfer of ownership is often only spoken of once the founder is considering retirement or is no longer able to participate in the management of the business.
This type of planning is reactive to the needs of the first generation and does not proactively deal with the impact of an expanding family on:
- The need to divest the ownership of, and therefore the wealth earned from, a family business between the generations or the branches of a family; or
- The management of a family business to secure its future success.
The transfer of ownership and management needs to be discussed, structured, and achieved in a way that avoids disputes amongst the family.
The issue that families need to consider is how far ownership and management participation evolves. For example, children of the first generation owners could be treated equally so that all shares in the company are passed down to all of them. If that process is repeated, participation in the capital of the business will dilute exponentially for each of the next generations. At the other end of the spectrum, the founder may decide that the shares be placed into a trust with only limited rights for the next generations to benefit from the underlying shares.
A family business needs to consider both the commercial and the emotional impact for the family:
- An individual family member’s entitlement to participate in the success of the business through direct share ownership – should greater share ownership or a different class of shares with greater capital or income rights be given to those involved in the company to incentivise them to grow the business?
- When do children become entitled to own shares? Is this controlled by the parents who can transfer shares freely to other family members, or should it be subject to the approval of the company’s board of directors?
- When a family reaches a certain size and before share ownership becomes widely spread across family branches and generations, should the ownership of the company move away from direct ownership and go into a trust or foundation to benefit all family members?
In the case of the family firm, a growing family has an impact on:
- Generational management within the business; and
- Family members who are not involved on a day-to-day basis in the business.
Although it is not always an immediate issue, planning for the future participation of children in the business is going to be an important process for the family. As the family expands beyond the first generation, how will the next generation make the decision to join the business? Many family businesses have found themselves in a situation where there is an unsaid expectation that the son or daughter will take over the running of the family business but the individual is either not ready or lacks the experience to fulfil that role. This creates tension within the family and ultimately impacts the success of the business.
Long term planning should be put in place early on so that regular, open dialogue takes place between family members. In addition, families can encourage the next generation to develop their commercial skills by funding their business education by requiring that they spend the initial part of their working lives in an alternative career to gain experience to prepare them for joining the family business.
Family members who are not involved in the management of the business
For adult children who do not work in the business, it is important that they retain a connection to the business within the family environment. They will still want to ensure the success of the business and will want to be given an opportunity to determine how the business is being run. If they are not privy to the financial performance of the business, tensions between those inside the business and those outside can arise. We have seen examples where it has led to a fundamental and irreparable breakdown between branches of the family.
This can be addressed by establishing a family council or similar body to represent their interests. A family council can hold regular meetings with all of the family members even if they are not direct shareholders in the business. This provides the opportunity for views to be shared and to exchange information on the performance of the business in an open and transparent forum.
The arrival of a new generation into a family can have a fundamental effect on the business and the family as a whole. It is important that the family business recognise these challenges and have the collective support of the family to plan for such a drastic change.
We see the following areas as integral to establishing a sound relationship, commercially and within the family, to encourage the long-term sustainability of a family business:
- Communication: This is key component that can be achieved by the establishment of a formal family council with all generations of the family represented that meets regularly to openly discuss the business
- Shareholders agreement: A family business should adopt or review its existing shareholders agreement to clarify how shares can be transferred between family members and what rights accompany those shares
- Family constitution: A constitution helps create an agreement on how family members treat each other in areas where family and business matters overlap and, in particular, how those involved in the business report to other members of the family.
Brought to you by Farrer & Co.