Keeping the Family in Business Heinz-Peter Elstrodt, Director, McKinsey - Sao Paulo office Very few large family-owned enterprises thrive beyond the third generation. Those that do find ways to run themselves professionally while making the family happy. In advanced economies, as well as in emerging markets, most companies start out as family-owned businesses. From their humble beginnings, driven by entrepreneurial vision and energy, some have grown to become major forces in their economies. Indeed, this still happens not only in emerging markets, with their chaebols in South Korea and grupos in Latin America, but also in North America and Europe, where relatively young family-owned businesses such as Wal-Mart Stores, Bertelsmann, and Bombardier, to name just a few, have become front-runners. But family-owned businesses-companies in which a family has a controlling stake-face a sobering reality: the statistical odds on their long-term success are bleak. In fact, a number of studies, taken together, suggest that only 5 per cent continue to create shareholder value beyond the third generation. This statistic should come as no surprise, given the business challenges any company faces in increasingly competitive markets, to say nothing of the difficulty of keeping growing numbers of family shareholders committed to continued ownership. One kind of risk for these businesses comes from the generations that follow the founder, whose drive and business acumen they might not match, though they may insist on managing the company. By the time the third generation takes over, the scene is set for squabbles among members and branches of the ever-expanding family. Rather than looking after the interests of the business, they may fight over the size of the dividend payouts, the composition of the board, or who gets to be chief executive officer. Nevertheless, a few family-owned businesses defy the odds and continue to thrive generation after generation. To gain a better understanding of how to build and manage family businesses that last, McKinsey conducted interviews with the family leaders-either the chair of the board or the leader of the family holding-of 11 family-owned businesses. Of these, 9 were in the United States and Europe and 2 in emerging markets, where such businesses make up a much larger part of the economy but are mostly quite young. All of the companies are at least 100 years old-the youngest in its 4th generation, the oldest, founded more than 250 years ago, in its 11th. These survivors are not only venerable but also large and successful. Of the 11, 7 have revenues of more than $10 billion, and the families that own 6 boast a net worth of more than $5 billion each. All have delivered growth and profits over recent decades and are financially solid, with low debt-to-equity ratios. The companies in our sample-a few of them public-have made it through economic depression, war, and other forms of turmoil, with the families remaining in control. Their experience has great value for younger family businesses whose owners face a generational transition and must decide whether and how to embrace the challenge of creating an enduring business under family control. For the companies in the sample, the key to survival and success was strong governance in its broadest sense: a powerful commitment to values passed down through the generations and a keen awareness of what ownership means. Ownership is both a blessing and a curse, giving the family the power to destroy the business as well as to shape it and enjoy its returns. The families that own the businesses in the study recognised this danger and established systems of checks and balances for carrying out the family's roles in the three vital dimensions of governance: ownership, board supervision, and management. In what is usually a patchwork of oral and written agreements-some legally binding, some not-the family addresses issues such as the composition of the company board and how it should be elected; which key board decisions require a consensus, a qualified majority, or interaction with the shareholder assembly; the appointment of the CEO; the conditions in which family members can (and cannot) work in the business; how shares can (and cannot) be traded inside and outside the family; and some of the boundaries for corporate and financial strategy. These arrangements, typically developed over many decades, help defuse the often highly charged issue of the succession of power from one generation to the next and lay the foundation for fulfilling the two main conditions for the long-term success of any family-owned business: professional management and the family's ongoing commitment to carry on as the owner. Running the business well With a set of clear rules and guidelines as an anchor, and with family conflicts comfortably at bay, family-owned enterprises can get on with their strategies for long-term success. Some key factors show up over and over again: strong boards and uncompromising standards of meritocracy in personnel decisions, risk diversification and business renewal through active management of the business portfolio, and long-term financial policies. Strong boards are particularly important in family-owned enterprises to complement the family's business skills with the fresh strategic perspectives of qualified outsiders. As a fourth-generation family leader said, "We must not be managers. We must be experts in corporate governance." Indeed, the corporate-governance practices of most family businesses in the study surpassed those of average public companies. Even when the family holds all of the equity in the company, its board will most likely include a significant proportion of outside directors. One family has a rule that half of the seats on the board should be occupied by outside CEOs who run businesses at least three times larger than the family business. Another private family business set up an independent institution solely to nominate and elect one-third of the board members. But in most of the companies, the family nominates and elects the outside board members. The procedures-for all nominations to the board, not just nominations of outsiders-differ from company to company. One board perpetuates itself: it selects new members and then seeks approval by an inner family committee of around 30 members and formal approval by an assembly of shareholders. In another company, board members are elected, on the principle of one share, one vote, from a list of candidates at a meeting of all shareholders. A more common approach is for a limited number of family branches to pool their holdings and elect a block of board members. The formal mechanisms differ; what counts most is that the family must understand the importance of a strong board. All of these boards become deeply involved in top-executive matters and manage the business portfolio actively. Many have meetings stretching over several days to discuss corporate strategy in detail. In most of the companies, the chair and the vice chair typically spend at least half of their time interacting with other board members, top management, and the family, which is kept informed about the business through newsletters, informal gatherings, and regular reports. True meritocracy Nepotism is the obvious way to destroy a family-owned business in a single generation-and this happens, all the time and all over the world. To control the natural human desire to favour your own kin, family-owned businesses that want to last for generations must establish a true meritocracy, as all the companies in the survey did. Half of the families had decided not to have their members involved in management at all. "You cannot expect the family to consistently generate competent top managers," one family leader said. Another noted, "My uncle, who had been appointed chief executive, died early. Otherwise, he would have ruined the business." A third leader said, "Our key factor of success is that we hire the best people in the market, and if they turn out not to be the best, we fire them. We would not be able to do that if we had family members in management." In the remaining companies, family members who have proved their competence are welcome to serve as managers. Two of the companies require family members to start work outside the family business. After they have had 10 to 15 years of highly successful experience, its board may invite them to hold top-management positions. Said one family CEO: "I was surprised to be invited to run the company, but I guess the family found me competent." At the other companies, family members can enter the business after graduation and work their way up. Their performance and career prospects are usually evaluated every year, often by competent outsiders reporting directly to the board. If such family members lack the potential to become top managers in the long term, they leave the company. "Our policy is up or out," one family leader said. "Nobody gets promoted because he or she is family-rather, the opposite." One family member and CEO of a privately held company explained in great detail how he was put through a two-year process of outside evaluation and coaching before a board committee appointed him to the position. Another company uses a recruiting firm to find alternative, outside candidates for every top-management position and sometimes appoints them. Harsh as these policies may seem, they safeguard the family's long-term interests. Diversification strategy Most of the family-owned businesses in the study are privately held holding companies with reasonably independent subsidiaries, which might be publicly owned, although most of the time the family holding company fully controls the more important ones. By keeping the holding private, the family avoids pressure from outside shareholders for quick, high returns and thus allows the company to pursue diversification strategies to achieve steady profitability and survival over shifting business cycles. This approach might not make sense for a purely financial investor, but families that aim to keep control for generations have a different perspective. "We want to provide diversification for our shareholders within the business so that they don't have to take the money out and do the diversification themselves," one family leader said. All of the family-owned businesses surveyed see themselves as conglomerates, not as single-business companies. While some have a wide array of unconnected businesses, most focus on two to four main sectors. They all seek a mix between businesses with high risks and returns and businesses that have more stable cash flows. Many of them complement a group of core businesses with venture capital and private equity arms in which they invest 10 to 20 per cent of their equity. The ability to react quickly to opportunities that come up through these families' extensive networks is important: in one case, a timely investment of $5 million a few decades ago turned into a large stake in a $50 billion company. The idea is to renew the portfolio constantly so that the family holding can preserve a good mix of investments by shifting gradually from mature to growth sectors. For the company to survive, it is necessary to focus on the enterprise as a whole and not to be sentimental about individual businesses. Many companies in our sample had departed the founding core business-always a traumatic decision. In most of the companies studied, the criteria for selecting new opportunities were clear: asset-light businesses such as retailing, consumer goods, and trading were preferred to asset-intensive ones, to avoid competition with publicly traded companies that have better access to capital and-in the 1990s-often favoured growth over profits. Several family-owned companies in our sample exited asset-intensive businesses, though they were performing well and fitted nicely into the portfolios, for fear that they could drain off financial resources in the long term. Niche businesses-those competing in small world markets-are also popular, because they give the family control and a chance to be globally active without becoming financially and organisationally overstretched. The financial policies of the companies are consistent with their risk-averse portfolio strategy. Those in the study pay lower dividends than most public companies with similar levels of performance, because reinvesting profits is the only way to expand a family-owned business that doesn't want to dilute ownership by issuing new stock or to assume big amounts of debt. For many families a side benefit of this policy is that members do not amass (and possibly waste) large individual fortunes but rather stay focused on their ownership role. These companies' debt targets are conservative too, particularly for the holding company which usually aims to have a 0 to 20 per cent debt-to-equity ratio. Many don't guarantee the debt of their subsidiaries. "We explicitly tell all financial institutions we will not bail out a subsidiary in trouble. This makes debt more expensive at the subsidiary level, but protecting the family's wealth makes it worth it," one family leader said. Long-term-performance focus These family-owned survivors share a strong performance culture combined with quantitative targets for growth and returns. One business in the study aims to have returns 25 per cent above the relevant stock market index: as the company's leader said, "Why would you keep the family business if it returns less than the stock market?" Interestingly enough, when asked about historic returns, none of the family members interviewed for the study quoted the quarterly performance of the companies or even their performance over 1 or 2 years. The minimum period mentioned was 5 years, and one to two decades was more common. Over the past 10 to 20 years, most of the companies have enjoyed shareholder returns at or above those of stock market indexes. Economic cycles are a fact of life for family-owned businesses that have a very long past and anticipate an even longer future. "We have survived world wars and hyperinflation. We never expect good periods to last very long; neither do we expect that from bad periods," one family leader said. To sum up, these companies are performance oriented but risk averse, which might make them less successful in boom times but keeps them alive, with healthy profitability, over the very long term. Keeping the family happy No family-owned business survives for long unless it is run professionally. But ensuring that members of the family want to carry on as owners generation after generation is equally important. Outsiders may wonder why the family should bother with all the hard work; why not sell the company and let each family member invest the proceeds on capital markets? Leaders of family-owned survivors often argue that a pooled and professionally managed fortune stands a better chance of surviving and growing than it would if it were split, sometimes into hundreds of parts, each invested separately. That is an arguable point, and not all family members agree. But family-owned businesses undoubtedly offer non-economic benefits too: a respected position in society, the pride and the sense of belonging that come with carrying on a family tradition, and the chance for some members to work in the business and for others to pursue shared interests alongside it. Successful old family-owned businesses have found many ways to hold families together as owners. Private ownership serves as an incentive for families to stay with companies by allowing them to pursue diversification strategies that make it safe to keep most family wealth at home. It also functions as a disincentive to exit because there is a large market discount--often 20 to 50 per cent of the estimated economic value-for the shares of privately held companies as a result of low liquidity and the frequent lack of voting rights. To counter non-family ownership, many family-owned businesses also restrict the trading of shares. Family shareholders who want to sell must offer their siblings and then their cousins the right of first refusal. In addition, the holding often buys back shares from exiting family members through a share redemption fund. One company decided generations ago that shares could be sold only at prices well below their book value (usually two to three times less than the estimated market value) and only to other family members. Indeed, at the core of a durable family enterprise is the philosophy that ownership implies, not necessarily the right to sell, but rather the responsibility of handing a stronger company over to the next generation. Of the family-owned businesses in the study, two had gone through serious crises in the past few years-one, the result of business problems, the other, of difficulties in the interaction between the family and management. In both cases, the basic ownership structure made it unattractive to sell, so the family had an incentive to work problems out-and actually did so-rather than give up. Had these been public companies, their performance might have suffered much more and their ownership could have changed. Because exit is restricted and dividends are comparatively low, some family-owned businesses have resorted to "generational liquidity events" to satisfy the family's need for cash. These events may take the form of sales of publicly traded businesses in the holding or sales of family shares to employees or to the company itself, with the proceeds going to the family. One chairman said of his company, "Every generation has a major liquidity event, and then we can go on with the business." Liquidity events can be staged; for instance, members of the family might have the right to sell their shares every five years at a price calculated by pre-established rules, but the total volume might be limited and the payments staged over a couple of years to avoid straining the company's finances. Moreover, the families that own some of the companies don't derive much economic benefit and accept this because they have been educated to do so. As generations come and go, every old family business faces the challenge of making continued ownership attractive to an ever-larger family of which only a few members play any role in management. One of the attractions stressed by many interviewees is that family-owned businesses contribute to a more meaningful way of life. This lifestyle often centres on separate family institutions: a family council might be responsible to a larger family assembly, which may be used to vent family disputes and to build consensus on major issues. The council might also oversee a family office, financed by the business, that assists family members who want to pursue common interests, such as social work, often through large charity organizations linked to the family office. Charity is a way to promote family values, to provide meaningful employment for family members not active in the business, and to involve young ones in real decision making; a group of 14 to 18 year-olds, for example, was granted an annual budget of $100,000 to distribute to charity. As one head of a family holding said, this kind of activity "brings the group together"; family members "analyse issues and work together to form a strategy. They learn a lot about responsible decision making and about following through." Another way to keep the family happy is to provide services to its members. Asset management is the most prominent, but others may be equally important-for example, tax services, educational advice for new generations, and even concierge services. Some of the family offices employ as many as 40 professionals. The family office may also be involved in organising regular family gatherings, sometimes bringing together hundreds of members from around the world. These get-togethers offer large families a chance to bond, to discuss family and business matters, and sometimes to vote formally or informally on important propositions. No less significant is the opportunity to enlighten the younger, sometimes pampered, generation about the realities of running a big family-owned business. To help the children understand the complex skills and hard work required to do so, many families let their youngsters visit or serve internships in companies they control. Leo Tolstoy's famous observation that "Happy families are all alike; every unhappy family is unhappy in its own way" may hold some truth for family-owned businesses too. The similarities among the approaches used by a wide range of successful survivors certainly offer food for thought to younger aprising to join their ranks.