One of the most critical issues facing family businesses is how to treat the next generation. They are distinctly different from other employees, and their wealth and reputation are at stake as current or potential owners of the company. On the other hand, most parents are rightly concerned that offering too many unearned advantages will not only destroy the work ethic of the next generation, but also the soul of the company. In answering this question, families often choose one extreme or the other: giving the next generation special treatment, not holding them to the same standards as other employees (“inheritance model”) or requiring them to earn everything they get (“ Merit Model”). This article describes a path that blends elements of both and is more likely to allow family members to succeed.
“Some people are born on third base and spend their lives thinking they can hit it.” This quote, often attributed to NFL football coach Barry Switzer, perfectly captures how many people think about the family business . Family members get jobs, promotions and salaries that they would never have gotten without their names on the front door. As one non-family executive put it, “He’s the COO of the company — the owner’s child.”
One of the most critical issues facing family businesses is how to treat the next generation. They are distinctly different from other employees, and their wealth and reputation are at stake as current or potential owners of the company. On the other hand, most parents are rightly concerned that offering too many unearned advantages will not only destroy the work ethic of the next generation, but also the soul of the company. In answering this question, families often choose one extreme or the other: giving the next generation special treatment, not holding them to the same standards as other employees (“inheritance model”) or requiring them to earn everything they get (“ Merit Model”). In my experience, a path that incorporates elements of both is more likely to lead to success for family members.
Risk of inheritance or merit
When a role is given rather than earned, it often creates an attitude of entitlement, a case in point being Cho Hyun-Ah, the daughter of the CEO of Korean Air, who is “famously delivered when macadamia nuts are delivered in a bag. When given to her, she’d be furious. Not on a flight from New York to Seoul in December 2014.” When family members exercise their privileges in this way, the impact on the company is devastating. Even subtler signs of entitlement, such as being late for work or taking a vacation to a foreign country, can undermine corporate culture.
Given these dangers, the temptation can be to remove the company’s inherited role entirely, allowing family members not only to get their jobs, but even their ownership in the company. This performance model may seem appealing, but it also poses real risks. Having family members compete against each other in some kind of talent race could create positions within the organization and possibly even split it, when this sibling rivalry led to the separation of the Dassler brothers from their company Sportfarbrik Gebrüder Dassler (Geda for short), divided into Two competing companies, Adidas and Puma.
Forcing family members to take their ownership can make them feel compelled to work for the company, even if it’s not for them. These “golden handcuffs” can negatively impact individuals and, because of their dissatisfaction with being there, negatively impact the wider company. When someone does choose to leave, the company’s resources may need to shift from investing in growth to funding the acquisition of their stock.
strike the right balance
Therefore, in extreme cases, neither the inheritance model nor the merit model is feasible. A successful family business requires 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 may receive money that reflects both their day-to-day job responsibilities (remuneration) and their equity in the company (dividends). This confusion is often driven by tax efficiency. A family business pays all expenses as compensation because their corporate structure causes dividends to be taxed twice. Another family-owned 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 urge to equality, the assumption that it is fair to treat everyone equally. In many cases, family members are given the same amount of money regardless of their role, and sometimes even whether they actually work in the company.
When the contributions of family members are roughly equal, there is no problem. Figure out a reasonable amount to pay family members’ work and investment funds, and distribute that amount in the most tax-efficient way possible. However, this level of symmetry rarely emerges after the first or second generation. It is more likely that the abilities and passion for the business will be uneven across the family. In this case, a one-size-fits-all approach can lead to resentment (“I do more, why do we want the same?”) and entitlement (“We all own 50% of the company, why should she get more?”).
The best way to address these issues is to develop separate systems for calculating compensation and dividends received by family members. Compensation should be performance-driven – it should reflect the market value of the role. Some families pay slightly above market rates to encourage family members to work in businesses; others pay less to discourage them. But the core principles hold. A person serving as a CFO is more valuable to a company than an entry-level salesperson. Their compensation should reflect this reality.
Another reality is that the owners of the company deserve some return on their investment. If the only way to profit financially from a business is to work there, you’ve got golden handcuffs. Instead, develop a dividend policy. This could mean paying a certain amount each year, a percentage of equity or profits, or whatever is left over after paying the bills and funding the necessary reinvestment. Dividends should be based on an “inheritance” model – if we were cousins, both owned equally by our parents, but you’re an only child and I have two siblings, you’ll get triple the dividend pool. Separating compensation from dividends is critical to finding the merit/inheritance balance.
2. Clarify management decisions versus ownership-related decisions.
In a family business, two siblings took over leadership from the father who founded the company. They make all decisions—everything from operations to strategy—by consensus. Employees have learned one simple rule to ensure their requests are supported, big or small: “Ask the owner.” This approach works because they’re all deeply involved in every aspect of the business.
If they look to the next generation, it’s clear that a different approach is needed. Of their seven children, three work in businesses and four do not (no plans to join). Not only does the seven-person decision seem daunting, but how do those who don’t work at the company make informed choices about hiring employees or changing prices? At the same time, if all the decisions are made by the people who work in the company, how is it fair that these four people together own more than half of the equity? Of course, they should have an influence on certain decisions. But it won’t bring the company to a standstill in some way.
The way out of this dilemma is to differentiate decisions from merit and inheritance models. The siblings created a checklist of all the decisions they made about the company. They then grouped them into three categories: 1) decisions that should be made by management (eg, hiring a new regional sales manager); 2) decisions that should be made by owners (eg, paying dividends); 3) management The tier should make a recommendation but the owner should approve or reject the decision (for example, to make an acquisition). Taking the time to develop this “decision-authority matrix” helps position the next generation to find the right balance between merit and inheritance.
3. Create a family culture that recognizes the importance of active participation and passive ownership.
There is a trend to celebrate the role of “wealth creators” in family businesses. 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 two siblings who don’t even work in the company?” To be sure, This is an understandable question. But when he was asked, “What would you do if you had to buy out your sibling’s equity in the company?” He said he had to do one of three things: borrow a lot of money from the bank; Foresighted future diversion of company profits to fund acquisitions; or approach to other equity partners who may be more demanding than his siblings. With none of these options attractive at all, he realized that his siblings brought something of value: their willingness to invest their money in the businesses he ran.
The value of passive ownership is one of the most undervalued contributions to a family business. Growth through retained earnings is one of the surest paths to long-term success, especially compared to high-interest borrowing or equity partners requiring exits to recoup their investment. As long as the demands of shareholders who do not work in the company are reasonable and their actions are not too distracting, keeping their money in the company is a huge benefit. If those who work at the company run it well, and those who don’t have a long-term vision invest most of their money, there should be plenty of leeway. Pay attention to these two contributing levers. Passive shareholders should appreciate the hard work of those who work for the company (and reward them financially through market-based compensation). People who work for companies should respect their investors in their communications (and generate good dividends).
Extreme nepotism and meritocracy can cause most family businesses to go bankrupt. Instead, separate compensation from dividends, separate management from ownership decisions, and value the contributions of active participation and passive ownership. By doing this, you will find the right balance between merit and inheritance.