Keeping the family in family firms

What sets family busi­nes­ses apart

Skeptics may consider them outdated because of a perceived lack of rationality. But family firms have proven both successful and enduring – as long as their owners understand how to leverage their specific advantages and overcome their disadvantages through clever management. Family firms need a tailor-made governance system that takes their unique complexities into account, for example. In the end, their success and their survival depend on one thing: a vision based on values that are shared by all members of the family. by Sabine B. Klein and John L. Ward

FAMILY FIRMS are widespread and successful. Family firms have continuity. Family firms are different because their inner workings remain closed to outsiders. They perplex many professionals, who consider family businesses to be irrational. Indeed, family firms do not follow simple business logic. But as Dan Ariely puts it, sometimes the irrational is “predictably irrational.” [1]

The family aspect of a family firm starts when the entrepreneur and owner-manager realizes that his or her “baby,” the business, is changing because of its newborn sibling, the first child. This is the moment when the entrepreneur decides – usually unconsciously – whether the business should become a family business. There are many pros and a plethora of cons. To start with the downside, turning a first-generation business into a family business restricts the firm’s discretion. Because family businesses are built on the dominant influence of a family, possibilities for leveraging its capital are limited. Around the world, except on the stock exchanges of market-oriented countries such as the UK and the USA, families retain a dominant ownership share of their family businesses to secure control. This applies even more to privately owned companies, which represent the majority of the world’s family firms; here, families tend to have a qualified majority. In fast-growing, capital-intensive sectors such as biotechnology and IT, therefore, family ownership can restrict growth opportunities.

A generational perspective

On the positive side, turning a first-generation business into a family business opens up long-term perspectives. When viewed as a family business, the firm’s timeline shifts from a focus on the fiscal year to a generational outlook. The implications of this change are manifold. First, stakeholder and shareholder perspectives merge. Given a one-year perspective, the goals of different stakeholders are in conflict – growth versus payout, investment versus current profits, sustainability versus profit maximization. However, once the entrepreneur starts to look 30 years down the road, the needs of the employees, customers, local community, and owners more or less merge into one perspective. It is only possible to secure the long-term survival of the firm if the management meets the needs of all stakeholders equally.

With this long-term perspective in mind, the owners evaluate innovative activities as well as investment projects differently. Because the cost of capital is lower in family businesses and no one asks for returns on an annual or even quarterly basis, a family firm can invest in projects that will only show returns after several years. This means innovations in family businesses can both be radical and move along in increments. At the same time, family business owners must be averse to risk by definition. They cannot endanger the existence of the family business, which rules out high-risk endeavors – even if there is only a marginal probability of the risk playing out. In the unlikely event that this risk becomes reality, the company’s continuity would be threatened.

Shared values are vital

Feuding family members are the downfall of the family firm. From the Buddenbrooks to the Gucci family, we have all heard horror stories of relatives fighting each other until the business fails. It is one of the defining paradoxes of a family business – that the family can be both its strength and its weakness. A healthy family business is rooted in the family’s shared values and norms, making them vital to the survival of the business as a family firm. During the first two generations these values and norms are usually rooted in the personality of the founder, which is deeply engraved into the corporate culture. Norms originating from the founder’s values, personality and behavior are transmitted from generation to generation by stories and rituals, dos and don’ts.

When the common values and norms are transferred soundly, even later generations will continue to share a value base, giving the family firm a vital competitive advantage. Consider the following example: The Merck family of Merck Darmstadt discussed a potential merger with Ernesto Bertarelli, who at that time owned Serono, a Swiss-listed, family-controlled biotechnology firm. Bertarelli asked when the negotiations could start. Jon Baumhauer of Merck replied “immediately,” which took away the breath of Bertarelli and his adviser. [2] Baumhauer was able to act quickly on the basis of discussions within the family that had been going on for the past six months. Although more than 150 family members were involved, not a single word had leaked to the market.

On the other hand, as family businesses grow older and the group of family owners becomes increasingly heterogeneous, the tendency for entropy grows if not counterbalanced by shared values and norms. Even if the owners are not fighting openly, their divergent intentions and latent conflicts over goals open opportunities for outsiders to benefit. In academia we have recently started to describe the phenomenon of “expropriation of family business owners by outsiders.” [3] For a family firm, expropriation is the most dramatic form of loss of influence over its own business. Expropriation starts with a power vacuum within the owner family. This power vacuum usually has its roots in a lack of shared values and resulting contradicting visions, if not a complete lack of vision. Over years, often over decades, the overall cohesion of the owner family shifts from an emotional cohesion of the family and the business towards a more financial cohesion. [4] Family businesses held by extended families, so-called cousin consortiums, suffer from a high level of diversity in terms of the age span of the multiple owners, their diverse cultural and professional experiences and, most of all, a lack of communication. Dispersion and disinterest are the greatest enemies of older business families.

The challenges of survival

When Rupert Murdoch considered taking over Dow Jones and the Wall Street Journal in 2006/07, his chances from a legal point of view were close to zero. The ownership was organized in trusts governed by the senior generation, who had no interest in selling. After in-depth analysis he therefore approached the younger generation, which at that time was a toothless tiger. In private one-on-one talks with members of the younger generation, Murdoch questioned whether it was fair that the senior generation as trustees withheld the ownership rights from the younger generation. He used these tactics to urge members of the younger generation to put pressure on their parents to agree on the sale, and finally succeeded. After this lengthy process, the Bancroft family, former owner of Dow Jones and the Wall Street Journal, agreed to accept a 27-year-old European-based opera singer, a family member chosen by Rupert Murdoch, as a board member. Without the power vacuum within the Bancroft family, the lack of shared values, and the resulting lack of communication and trust, Murdoch would have had no chance of taking over Dow Jones and the Wall Street Journal.

Describing the family business as a tree helps illustrate the survival challenges faced by family firms. The tree’s leaves and the environment must correspond; otherwise the tree will suffer a premature death.

Why is this the case? The long-term perspective of the family business leads to an increased dependence on “good nutrition.” Healthy roots are needed to provide the family firm with a vision based on shared values. Only then will the trunk develop stability and support the necessary strength and flexibility of the leaders. And only then will the family firm meet the requirements of its markets – and might even be able to act proactively in shaping its future markets.

A tailor-made governance system

Governance of family businesses is more complex because of the family. When it comes to designing governance processes for a family firm, the family is often neglected. A simple rule states that the complexity of a family firm’s governance system should equal the complexity of the corresponding family business system, which is comprised of four subsystems: family, ownership, leadership and company in the market. [5] A special role is assigned to the level of trust which moderates the relationship. Looking at this basic rule, what does “equal complexity” mean in practice? Here complexity is defined as the number of elements constituting a subsystem and the heterogeneity of the respective elements. Focusing on the business family, it means that the more members a family has and the more they differ in terms of age, where they live, experience and professional training, the more complex the family system is. A difference in expectations (“I need the money from the family firm for my own little business, for our family holiday” versus “I couldn’t care less”) is perhaps the most significant complexity.

Governing a complex family requires a tailor-made system of processes such as rules of membership (who is “family” and what value should family add), rules of representation (who speaks for us and how are they elected) and rules of compensation (do family members who are not active in the business get compensated for the work they do for the family?). Coming back to the Merck family, they have a fascinating system for electing their board. Out of the roughly 150 owners, any family member who is elected by the majority of his or her peers gets a seat on the family representative board. Each family member can vote for a maximum of ten representatives. One can easily understand that it is not only a process of electing board members, but even more a process of facilitating communication and mutual awareness within the group of family owners.

Another important element in the governance of family firms is trust. Family businesses are governed by a group of owners who are related by blood or marriage. They spend far more time together than owners of other types of companies, giving them the opportunity to build trust among each other. If they succeed in doing so, their firm will require much less complex governance mechanisms than would be needed in a company with a comparable level of complexity, but no trust among the owners. Informal processes can replace formal ones, reducing cost to a certain extent. Family businesses with a high level of trust therefore have lower governance costs.

Managing complexity

During succession in early generations, the level of complexity can also change significantly. Take the example of a manager who owns 100 percent of the voting shares in his company and has four children. If he divides ownership equally among these children, one owner will be succeeded by four. With these four different sets of expectations, etc., the level of complexity rises dramatically. If the former owner-manager did not anticipate this situation by installing an outside board or drafting buy-sell agreements, for example, the complexity of the governance system will no longer equal the complexity of the new ownership system. How should he cope with the situation? There are two possible solutions: to draft a governance system that anticipates the increase in complexity prior to succession, or to hand on the business to only one of the children.

Governance in family firms is a challenge far beyond that of non-family businesses. Generally speaking, family businesses either outperform their non-family counterparts or fail dramatically. They require professional managers who understand the dynamics of complexity and long-term advantage. They also need family owners who understand the dynamics of expropriation and family values. When both the non-family executives and the family owners grasp these powerful forces, the family business can maximize its performance and unique competitive advantages.

1 Dan Ariely (2008). Predictably irrational – The hidden forces that shape our decisions. HarperCollins: London
2 The new Merck: Beating the odds. IM D Case 3-2137
3 Klein, S.B. & Decker, C. (2011). The sale of the family firm: A holistic alternative. Paper accepted at the Academy of Management Entrepreneurship Division. San Antonio 2011
4 Pieper, T.M. (2007). Mechanisms to assure long term family business survival: A study of the dynamics of cohesion in multigenerational family business families. Peter Lang Verlag: Frankfurt
5 Klein, S.B. (2009). Das Komplexitätstheorem der Corporate Governance in Familienunternehmen. Zeitschrift für Betriebswirtschaftslehre Special Issue 2/2009: 63-82

RESUMÉ Prof. Dr. Sabine B. Klein

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Prof. Dr. Sabine B. Klein holds the INTES Endowed Chair of Family Business at WHU (Otto Beisheim School of Management) in Koblenz/Vallendar. A third-generation family business member, she was Professor of Strategy and Family Business at the European Business School in Wiesbaden until 2009. She is a founding member and past President of the International Family Enterprise Research Academy (ifera).

RESUMÉ Prof. John L. Ward, Ph.D.

Nicht in Jahren, sondern in Generationen - Image 3

Prof. John L. Ward, Ph.D., teaches and conducts research on strategic management, leadership and continuity in family businesses. A Professor and Co-Director of the Center for Family Enterprises at the Kellogg School of Management in Evanston, Ward has written several publications on family business. He is a graduate of the Northwestern University (B.A.) and Stanford (M.B.A. and Ph.D.).