Some multigenerational small businesses should trim family tree

Family businesses that thrive are often galvanized by the force and will of the relatives running them. A business maturing from its founding by the start-up generation brings even greater opportunities—and challenges.

We all know the statistics: There is overwhelming attrition when the business that the first generation launched is handed off to the next generation, and there's continued falloff when the third generation takes the reins.

Trimming tree braches
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Why is there such attrition? There are a number of reasons—some good, some not so. A successful business may grow to such a level of profitability or market share that, in the interest of capital expansion or integration, it's best merged into a larger company.

Or there may be such dysfunction on the part of younger family members that the senior generation loses confidence in the business' likelihood of maintaining profitability and value. The introduction of additional generations of the family to employee ranks can be of far more risk to the business than any outside hire.

Avoiding family feuds

Studies show there is a falloff of performance as the number of family members in a business increases. That could be due to family members being financial drags or compromising hires, or their lack of maturity and training.

The price of a bad family hire is destruction to the family core. So how do you balance the value of bringing in a passionate, committed member of a younger generation with the risk that a wrong hire—eligible for hire only thanks to family membership—will bring pain that can reverberate for lifetimes?

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The issue grows more acute as still more family members are added to employee ranks. Family branches develop—aunts and uncles, nieces and nephews, and cousins.

Branches can be more protective of their own immediate family. Extended families spend far less time together as a large unit and can grow to have less in common, losing some of their initial camaraderie and sowing seeds of conflicting interests.

Eu Yan Sang's succession planning roadmap
Eu Yan Sang's succession planning roadmap   

Fairness can be questioned, and when that happens, family trust is fractured. A sense of betrayal of the family bond in a business is acute, emotionally charged and portends great danger to the enterprise.

Fortunately, those family businesses that do aspire to be multigenerational and multibranch can follow certain disciplines. Executed with rigor and led by the most senior generations, the adoption of shared values and rules can preserve order.

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Successful multigenerational business planning is found at the crossroads of family governance, the business' sound financial performance and strategic vision, and the personal planning of each generation.

Governance is one of the most critical and forgotten disciplines any great business needs. Governance has several elements; among the most critical are ownership structure, control and oversight, compensation to those active in the business and those not, family hiring policies and requirements, and succession planning.

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Taking control

Ownership structure sets the stage for the other elements. Determining who owns the majority shares, in what form they are held—e.g., outright, in trust or as an LLC—the makeup of ownership blocks in family branches and voting rights are key planning points for addressing the variety of interests in a family. A best practice is to structure a family branch's interest to accommodate those in that particular branch, thereby "taking care of their own."

Control is best addressed in a shareholder agreement that is signed by every shareholder at inception and as new shareholders are brought aboard. The agreement should be thoughtful about the types of issues over which shareholders have control.

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Control may mean a vote on a "fundamental transaction," such as a merger, acquisition or sale, as opposed to the day-to-day running of the business.

Compensation and profit distributions are a critical issue. After all, every shareholder expects cash distributions and sales proceeds for their interests. But conflicts can arise between family members who are working in the company versus shareholders who are not. In such cases, a compensation study setting salaries in parity with other similar positions at like companies is a best practice.

Pruning back

Developing hiring policies for family members will address potential problems before they become such. Best practices require an orderly process by defining the family member's capability, interest, temperament, education and outside training, and the need and ability of the company to support the hire.

Include a clear position description, mentoring and regular honest evaluations. Even if everyone understands the process, it may not always be conflict-free—but it will be accountable.

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And here is where the family tree can get unruly: Too many ineffective or disruptive family member employees will be a drag on the business.

Trim the family tree—that is, only hire family members who deserve the role they'll have and "counsel out" those who are best in a different career.

"Having directors who represent each family branch and generation, along with at least one who is not a family member, is another best practice."

Finally, there is succession planning. This concerns both the succession of leadership in the company and also how and to whom shares may be left.

Best practices allow the board of directors to select the CEO, who should have an employment agreement spelling out terms such as duties, compensation and retirement. (Having directors who represent each family branch and generation, along with at least one who is not a family member, is another best practice.)

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And best practices also include senior-generation shareholders devising an estate plan that recognizes the extraordinary value and obligation of the family business interest they own. Doing so may not ensure that the family business will continue for another generation, but it will not undermine it, either.

—By Grant Rawdin, special to CNBC.com. Rawdin, a lawyer and certified financial planner, is founder and CEO of Wescott Financial Advisory Group.