Family businesses – surviving the generations

Family businesses are the backbone to the UK economy but few survive to the 3rd generation. Howard considers why, how to avoid being one of the statistics and what is the advisers’ role. This article was original published in the PS Magazine December 2013 edition.

Family businesses are a key element of commerce in the UK and, per a report from the Institute of Family Business, account for 30% of GDP and 40% of private sector jobs (9.5 million) and certainly do not equate just to small businesses with 10% of the FTSE 100 being family businesses.

Statistics show that approximately only 30% survive beyond the second generation and only 10% of family businesses survive beyond the third generation. This is not necessarily a bad thing, either because of “creative destruction” or as a result of an active decision by the family and shareholders to sell or voluntarily liquidate.  However in many cases it arises unnecessarily and unintentionally and causes significant damage (financially and emotionally) to the family and indeed the wider stakeholders community. Howard believes it is incumbent on the advisers to the business to understand the dynamics behind such statistics and to have a role in attempting to prevent unnecessary failure. This article addresses:

  • The conceptual framework that leads to the conflict that can result in failure
  • Guiding principles to consider in any governance structure
  • The advisers’ role

Conceptual framework

In addressing these issues I think we must first define a “family business” – of which there are many definitions. The most useful seems to be “any business where there are at least two generations of the family working in the business and where at least one generation has at least a 25% shareholding”. From this definition it becomes evident that there are three overlapping interested parties in the business:

  • The owners
  • Those working in the business
  • The family

And each of these interested parties can and do overlap resulting in seven types of stakeholder in the business as demonstrated by the following diagram:

These stakeholders range from the founder with a foot in each of the three camps to non-family employees with a foot in one, from family (non-shareholder) employed in the business with a foot in two to family members with no shareholding or employment with a foot in only one. Indeed this last category, which often include “in laws”, can be the most powerful and indeed disruptive element. Each has a different perspective as does one generation to the next. On top of this we need to understand that the attributes, values and nature of a successful business and a successful family are very different. A family for example, tends to be inward looking, averse to change, have lifetime membership and be emotionally based. On the other hand a business will be outward looking, continually adapting, have a perform or leave culture and be task based. In fact a diametrically opposed set of values!

Tensions will inevitably and almost invariably arise between the generations, the stakeholders and the differing value sets. It is when these tensions are not managed and addressed that conflict arises which then often leads to the failure of the business. The position gets particularly marked as the shareholding base widens as shares pass down the generations and it is at the transition stage that the problem becomes most marked and especially as the business moves to become a “confederation of cousins”. “Failure” is not however inevitable and is evidenced by the many longstanding family business across the UK. A well-managed family business which understands and manages the inherent potential for conflict can be a great force for good – both for its stakeholders and the wider community. This is because they tend to take decisions over a longer timeline than do listed companies and tend to be more aligned to the needs of their customers for the long term and are often rooted in a local community.

Governance structure

An effective governance structure will never “trump” relationship difficulties and indeed if open conflict is already apparent it is likely that the starting point of any assignment needs to be to address those difficulties first in an open, supportive and impartial way. However it is imperative to start addressing the issues in advance of such conflict arising – even if it may be simmering under the surface. By starting to address them this should help all parties to understand them and the counter viewpoints and the needs of “each stakeholder”. In this way a compromise set of proposals is more likely to be achieved and a “set of rules” established in harmonious times which can be used when conflict arises. When establishing these rules every business will believe they are unique and undoubtedly the people and the way they interact will be unique – but the issues and problems and their resolution are not, and will have been seen by experienced advisers time and time again. This is not to say a “one size fits all” solution is available but rather, a set of guiding principles are appropriate which will need to be adapted and changed to meet the particular circumstances. These principles focus on:

  • Establishing a family constitution
  • Having a mechanism for the narrowing of the shareholder base
  • Creating an internal market for shares
  • Establishing a valuation criteria
  • Having a dividend policy
  • Having a remuneration policy

The Constitution

One of the most fundamental issues for the family to understand is the difference between ownership and management. A proper appreciation of this often unlocks what seem to be intractable problems, as in a recent case where all directors were shareholders and it was only when they realised that shareholding did not give automatic directorships that the issues about management succession were resolved. Indeed in many cases having management succession plans that distinguish from ownership succession plans is the key issue to resolve. The normal governance documents would be the Articles of Association and a Shareholders agreement although it is often only at the 2nd generation that Shareholders’ agreements are contemplated. For the 3rd generation a Family Council should be introduced to represent the interests of the shareholders. At that stage there are usually a number of bloodlines and each bloodline should elect a representative on the Family Council who can vote for all the shares in their bloodline except for fundamentals such as the sale of the company. Also the Family Council is akin to an institutional shareholder and has rights and influence over a limited number of key issues and is clearly separated from management so it perhaps meets four times or less per annum and approves matters such as:

  • An annual business plan prepared by the Board before the start of the financial year
  • The appointment and remuneration of new directors
  • Borrowing in excess of certain limits e.g. 25% of the retained reserves
  • Disposal of part or all of the business
  • Acquisitions costing in excess of a specified limit
  • Variations to the dividend policy

In this way the Board can get on and manage the day to day activities of the business but without fear of interference from shareholders but while working within pre-agreed parameters. You always remember your failures though and we knew we had failed to get our message across with one client when the newly convened Family Council was determined to keep control of the Corporate ID and especially the letter heading!!

For an extended family it is often worth setting up an informal “Family Forum”. This can be likened to creating the “glue” within the family and often has a formality similar to that of an AGM and indeed could be the AGM, but then a social element thereafter. It will most likely include all family members whether or not they are shareholders or “in laws”.

Shareholding

Since the widening shareholder base increases the potential for conflict we try to encourage a constitution that trends towards narrowing the base of shareholding. We also tend to encourage those addressing succession to pass shares to family (usually their children) who are involved in the business but to balance this up with passing other assets to those not in the business. Even where there are insufficient other assets to do this fully, it is often possible to “carve out” loan notes or preference shares to those not in the business thereby giving shareholder control to those in the business. Of course who should take management control is an entirely separate issue where we would suggest it should be those who have the skills, the desire and the support.

In order to facilitate the narrowing of the base we encourage the creation of an internal market for shares so that value can be realised by any shareholder at any time – although there will always be funding constraints. In order to do this there needs to be a ready buyer and an easy way to agree the value. As to finding a buyer the obvious, often most easily funded and most tax effective buyer is the company itself. Should the company buy, this can however create unintended imbalances between the remaining shareholders and we usually provide that the company is the final backstop after sale within the bloodline and failing that a sale to other bloodlines. Clearly a limitation is both the funding available and for the company sufficient distributable profits. There is then the question of the value and as we all know if you ask and accountant what two and two makes the answer will be – “what do you want it to make” and this is particularly apparent in share valuation.  We therefore believe it is important that there is a clear valuation criteria established in the constitution and one that treats the company, as the Courts would do, as a quasi-partnership and not provide for minority discount. It should also cater for market conditions and varying results. One that we have successfully implemented is the higher of (revalued) net assets and an earnings basis of valuation where the earnings basis is based on a weighted average of recent and forecast results multiplied by a discounted current FTSE all share PE ratio.

Profit distribution

It is all well and good to have a mechanism to buy and sell shares but there is the issue of what is the benefit of owning them. There needs to be a proper understanding and agreement on how the profits of the company are distributed and in this regard there are three interested parties – the directors/employees, the company and the shareholders. Firstly as far as remuneration is concerned we believe that this should always be based on open market arm’s length criteria – family members should not be over rewarded nor under rewarded in comparison with what their role is independently worth if they were not family members. Having established this there will then be the question with what to do with the profits made in any one year. This is always a matter of balance but a model that we have successfully implemented has been to split any profits equally between the company, the shareholders and the directors/employees. Whilst the policy should be fully documented care should be taken over the wording of the dividend policy to avoid the need under accounting standards to have to provide the discounted value of the future dividends as a liability in the accounts. When setting the dividend policy there is an interesting (for accountants!) interplay between the likely dividend yield and the market value of the shares as determined by the earnings basis and market dividend yield – they should if at all possible be ”in sync” and scenario planning should be undertaken on differing levels of profits to ensure that the law of unintended consequences do not apply and that share transactions are achievable.

The advisers’ role

An audience of lawyers is bound to ask “who is your client” and we are the first to admit that this can be a difficult question and there is significant danger of creating an actual or perceived conflict of interest. Our answer is always that the business is the client and that we are acting in the best interests of that business. That is not an automatic “get out of jail free card” but does help in considering any assignment and the approach to that assignment. We also recognise that it is vitally important to get buy in to any solutions and not to be seen as siding with one “faction” or another. It is for this reason that we try very hard to have our first face to face meeting with as many family members or representatives of differing factions as possible. We will also (probably at the first introductory meeting) attempt to manage expectations of what is achievable, not to over promise and under deliver and to stress the importance of all parties being prepared to compromise. Indeed one needs to be prepared to turn down assignments of this nature where there are strongly entrenched positions and to convert it to a conflict resolution assignment.

Getting buy in is all about building trust with each of the key players and we find this is best done by conducting individual, one to one, confidential, structured interviews. These interviews are designed to elicit the key issues and attitudes and to enable possible solutions to be tested in a safe environment. They enable the adviser to then have sufficient facts to develop a set of proposals which are then brought to a meeting of all relevant parties. Indeed defining who should come to that meeting is often an issue.

The structure of the UK accounting and legal profession has, in our view, become increasingly polarised towards particular disciplines – in the accounting world, tax (and different types of taxes), audit and assurance and corporate finance amongst others. This is not helpful to a traditional mid market family business who (and I would say this!) seek multi-disciplinary advice from a lead adviser who can take into account a range of disciplines. These would include capital and income taxes, corporate finance, company valuation, pensions, strategic planning, fund raising and personal financial planning and a good understanding of company law and the legal issues involved. This is of course in addition to the softer skills necessary to manage the differing individuals and their expectations. In undertaking any assignment associated with family businesses it is therefore important to bring to bear a good knowledge of this range of traditional disciplines. Without such an integrated holistic approach there is a danger of the advice not being relevant to the “big picture” – which must be the long term future of the business and harmonious family relations. Of course there will be a need for specialist input to these assignments but they must be led by one individual who undertakes the majority of the face to face contact and who actually takes responsibility for the assignment. They must be prepared to tackle the difficult questions and be prepared to “come off the fence” and be able to put themselves in the shoes of the client and the differing factions.

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