How Founders Can Successfully Transition Family Businesses to the Next Generation

Although family businesses can range in size from mom-and-pop grocery stores to global conglomerates, they often face similar challenges and opportunities when the founder must decide whether and how to transfer the business to the second generation.

Household names that are also multigenerational family businesses include Walmart, Ford Motor Company, Koch Industries, Comcast, and Estée Lauder. In each case, subsequent generations continue to own large stakes in these businesses and some heirs have taken active leadership roles in them.

“Family businesses are the economic engine of the world,” says Oscar Paez, a consultant with The Family Business Consulting Group. While their economic impact may vary by country, in the U.S. that impact is enormous. According to a 2021 report from Family Enterprise USA, a nonprofit advocacy group, there are at least 7.2 million family businesses in the U.S. They represent at least 19% of business tax returns and 14% of private sector GDP, or $2 trillion. These businesses account for at least 14% of the U.S. workforce, or 20 million jobs.

In light of their contributions to the economy, transition and continuity for family businesses are not just family matters. To learn more about how founders can successfully transfer their business to the second generation and effectively establish a family business legacy, This Is Capitalism spoke with three experts who have worked with family businesses that have made the transition.

Three-Circle Model

Paez says that successfully transitioning a business requires the founder to clarify “the higher purpose of the family” and for the second generation to share that belief. “That way, as a family, they have an end goal. As an individual, the family member who joins the business must feel that their purpose is aligned with the family, and that they are able to be part of the family business in their own particular way.”

Paez says the transition from the first generation to the second generation can be difficult. Often, the company has one founder who also is the owner, but the second-generation family members rarely are taught to be partners with the founder, according to Paez.

He urges the development of a proper education plan early on to start teaching the next generation about ownership, the business, and family dynamics. This concept, called the Three-Circle Model, was created in 1978 by Harvard Business School professors Renato Tagiuri and John Davis. Working with the Three-Circle Model, Paez incorporates the concepts of governance, strategy, structures, systems, and culture during his conversations with family business clients.

“Ultimately, when families stay together in business, they generate more value,” Paez says. “Families are more conscious about how they work with all the stakeholders, because it’s their name behind everything.”

Corporate governance and family governance are related yet distinct considerations. The former addresses how the business operates, and can closely resemble governance practices at non-family businesses. The latter addresses how family members interact with each other regarding the business, charitable initiatives, inheritances, and so on.

Strategy addresses the mechanics of how the family transfers wealth (i.e. business and non-business assets) across generations. Sometimes the second generation will become partial owners of the business without actually ever working in the business. In these cases, adult children still would benefit from learning good communication skills, corporate finances, and fundamentals of the business.

Structures may include a corporate board of directors, and a family board or family council. Systems can be educational plans to teach the second generation, as well as rules about when and where family members are allowed to discuss business. For example, some families do not discuss business at the dinner table, Paez says.

Culture is about the intersection of family values and business values, which generally occurs in the first generation and continues into the second generation, informing interactions with employees, customers, and business partners.

Generational Stages

“I don’t believe in so-called best practices. At best, they are anecdotal, so better to call them common practices,” says Doug Baumoel, founder of Continuity Family Business Consulting. “I prefer to ask what is likely to go wrong in each individual family and to address those issues. If you can guard against specific pitfalls and conflicts, you give the family a chance to write their own best practice.” He cites poorly managed conflict as the major threat to family businesses.

Conflict can arise from a variety of factors. Frequent culprits include different communication styles, work ethics, clashing values, long-simmering family drama that spills into the workplace, and perceptions of fairness around business ownership, compensation, and inheritance. 

Baumoel lays out a typical evolutionary path for family enterprises. Each developmental stage presents a challenge that some families navigate well, while others either get stuck and thus are destined to repeat that stage, or fall into conflict. 

The first developmental stage is the Entrepreneurial Stage. During this stage, if successful, the founder or founders (G1) have started something from nothing and created a foundation that can be built upon. 

Next is the Professionalization Stage. The business leader’s job now is to professionalize and scale the business. If the second generation (G2) has appropriate business education and experience, they may be the best possible leaders at this stage. But G1 also needs to be ready to transition leadership. Founders typically want to see some spark of entrepreneurial drive in the second generation before handing over the reins.

The third stage, the Governance Stage, can be especially tricky for family businesses. These companies have grown to considerable size and complexity, and the ownership group has most likely transitioned to a larger group of cousins (G3). With a more complex business and ownership system, developing corporate governance becomes the critical success factor.

It is less likely that a family member would qualify for leading a company of this complexity, but serving as a director and learning about governance can be fulfilling and important roles for family members. Family employment policies may provide paths for family to contribute appropriately as employees as well. 

Once corporate governance is established, the family (G4 and beyond) can then enter the Regeneration Stage. A secure business fuels the family so that stakeholders can diversify and create new value. This can include the creation of a family office, family venture funding, direct investing, and shared philanthropy. 

Developing family governance – structures and practices that enable families to stay connected and make decisions together – becomes the most important critical success factor. These families typically hold annual family retreats that incorporate business and personal finance education and have secure family websites and newsletters to facilitate family connectedness.

“At each stage of development, families typically consider the importance of the business leader being a family member. One might argue, if a business is looking for the best CEO, why not hire someone who’s run a similar size company before? Why hire a family member?” Baumoel says. “In fact, a family member may be the best choice.”

He argues that family member CEOs are more likely to stay and work to improve the business during tough times, rather than seek to exit and find another job, because their name and history are so closely intertwined with the business. If the family member is a first-time CEO, he recommends building a strong C-suite and an experienced board of directors to support them.

Financial Considerations

Gifting a business often is the most economical way to transfer it to the next generation, as opposed to selling either the entire business or equity stakes to family, according to Jared Johnson, president, North America of Capitaliz. He oversees the American side of a business valuation and exit planning platform that uses software and human analysis to explore factors such as profit margins, management structure, competitive dynamics, client concentration, and employee costs.

During their lifetime, founders may prefer to give a significant portion of the business to heirs due to lifetime gift tax exemptions available and estate tax exemptions that kick in upon death. Other tax-advantaged structures for founders to consider include grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs). Advisors, accountants, attorneys, and trust specialists can offer guidance to founders, Johnson notes.

Yet, when the second generation consists of multiple heirs, there are fundamental questions around how much and which assets to give each heir. The answers are especially pertinent when one heir has qualifications, such as a business degree and/or experience working in the business, that others lack.

“Fair isn’t always equal,” Johnson says, noting that heirs who do not work in the business could receive more liquid, non-business assets while heirs working in the business could receive greater stakes in the business. However, there is no guarantee which type of assets will perform better in the long-term.

One of the crucial factors that can affect business valuation in the long-term is management structure. For instance, if a founder generates the majority of sales for a business through personal relationships, and the second generation takes over without either securing those same relationships or bringing in equally valuable new relationships, sales and ultimately business valuation can suffer when the founder leaves.

A similar problem can arise if experienced senior management consists of non-family members who are loyal to the founder but not to the second generation. If those key personnel exit soon after the founder departs, the business can suffer due to lack of strategic guidance, Johnson warns. This is why it is important for both founders and their heirs to work with all stakeholders and gain buy-in well before the transition.

“There are a lot of things that family businesses should be doing that are just common sense and good business planning,” Johnson says. “If founders and heirs take those steps, the business will be in good hands in the second generation.”