How to grow a thriving family business

An interview with Harvard Professor John A. Davis
Friday, 20. February 2015 - 11:45

Professor John A. Davis

Professor Davis is a professor at Harvard Business School, where he has taught for 18 years, leading the Family Business area programs and research. He is also the founder of the 25-year-old Cambridge Family Enterprise Group, which has worked with family businesses from more than 60 countries. Professor Davis is one of the pioneers of the field. He spoke to Felicity Carter.

Where do you see family businesses in the context of the whole economy?

Family business is the world’s most prevalent type of business organisation. A family company is one where a single family has ownership control and two or more family members significantly influence its direction and policies. These companies account for about two thirds of the world’s companies, including over half of the largest ones and more than half of the publicly traded companies. One might say this is the most important sector in any market economy.

It’s not surprising then that most vineyards are family owned, including most of the most prestigious ones. Family vineyards are a special kind of family business, part farming, part marketing. For most of these companies, the owning family treats it as a real business and they work hard to make it a success and to pass it to the next generation. I haven’t seen particular studies on family owned vineyards but I expect these perform well on average. The family owners of some vineyards, however, treat them as a hobby—as a way to get away from the rat race, and also as a status symbol. Everybody is entitled to hobbies; it’s just that vineyards are very expensive ones. I expect that these vineyards perform less well.

Add to that, many studies have shown that family companies perform better than non-family businesses, although you don’t hear that much. Family companies do get in the news occasionally, but almost never for the reasons I’ve just talked about. They’re almost always in the news because something goes wrong. When things go wrong in the family business, invariably the family is seen as the culprit. When things go right, the family is rarely pointed out as a reason it’s doing so well. There is clearly a bias in the public’s perception of family enterprise—family and business don’t mix.

It’s said that the first generation creates the business, the second generation grows it, and the third generation loses it. What is different about families in businesses that escape that trap?

Every culture in the world seems to have a similar “Three-Generation Rule,” which described the rise and fall of family wealth and success. My latest research examining multigenerational family success suggests that many, and probably most, families follow this rule. But some families crash sooner than three generations and some continue to be successful after three generations. How some families remain successful over generations is an important lesson for business families. There are three important things that have to happen:

Number one, a family needs to grow its assets faster than the family and its business can consume them. (This is mathematically obvious but this axiom reminds us that good investing and maintaining affordable consumption levels are both key to long-term financial success.) Your business will consume some of your assets because not all investments pay off and we waste some resources with unproductive spending. Likewise a family consumes assets. It grows in number over time, family lifestyle expenditures go up, and many family members become at least somewhat financially dependent on their company and other family investments. In most of the cases I’ve researched, within a couple of generations, family consumption of their assets exceeds the growth of their assets.  

Second, you have to produce enough of the right kind of family talent to guide the activities of the family. The family benefits from wise advisors but the family can’t just be passive owners and allow others to make their important decisions for them. In each generation, a family needs to ask, what roles can family members best fill and where do we need non-family talent. For example, families in business have to develop good owners of the business, good board members, perhaps managers of their business, and perhaps someone to lead the family’s philanthropic efforts. If I had to rank priorities in order of importance, the number one thing would be developing a talented next generation. If you have plenty of assets but no talent in the next generation, you’re probably going to waste those assets. If you don’t have abundant assets but have talented next generation members, the family still has a good shot at surviving and being successful.

Finally, you have to keep the family united around the family’s mission and it’s approach (or values) to being in business—how you’re going to manage the business, what kinds of risks you’re going to take, how you will treat employees, customers, the community. Over generations, families become impressively diverse in almost every dimension you can imagine, but they still have to be united in these ways.

Growth, talent and unityis the mantra of families who create and also regenerate their wealth in later generations.

Most people love their families, but many would struggle to work or own something with them. How do you get people with a strong emotional connection to one another to be successful in business with one another?

Besides having family members with talent and good intentions, families in business learn from experience that they need to maintain a united and contributing family, capable, loyal owners, and capable managers. Good governance helps produce these elements of success. And generally, families discover the need for good governance by bumping into problems and then seeing that a board, a shareholder agreement, rules and policies for the family are needed.

For the family itself, you need a mechanism in place where the family—small or large—has a way of talking about its interests, goals and issues. These discussions can occur informally as well, but scheduling regular meetings with agendas is a more reliable way to ensure you will get the right issues and interests on the table, make decisions, and be able to address and resolve problems. A family also needs to have a family rule book—often called a family constitution, which includes policies that specify, for example, under what conditions family members can be employed in the family company, how family employees will be compensated, developed and promoted, and on other themes that can be problems if not regulated.

Family owners need a legally binding ownership or shareholder agreement. These can specify how ownership decisions are made, the decisions owners and the board each make, how the business leader is chosen, and the qualifications to be an owner. If you want out of ownership, then we’ve got a policy for that too; here’s how we’re going to price the shares of the company and conduct a buyout. These family and ownership policies maintain a sense of fairness, discipline and order. Families that create and use these mechanisms have a greater chance of survival.

Some business leaders pooh-pooh boards, but I have found them to be very helpful to a family business and the family itself—as long as they are well composed and well run. Later generations definitely discover their usefulness. A board of five to eight members that have useful experience and perspectives can really help a management team unlock problems. They can also increase a sense of direction, professionalism and accountability in the management. Business leaders should feel empowered to make many decisions, but there has to be some mechanism that also makes them feels accountable to the owners and others. Most founders, understandably, aren’t interested in having a formal board, but the smart ones have an advisory board with a few independent members that provide good advice and ask you good questions.

Speaking of founders, how do you get the founder to step down when it’s their business, but it’s clear they need to go?

You have to turn over the reins in a timely way to maintain the momentum of your company. People are remaining vital longer, but industries are changing faster and the next generation wants to be influential sooner. That generally means a leader has to turn over the reins before they feel ready to do it. One of the most important reasons second-generation businesses fail is because the founder stayed on too long.

In many cases, slow transitions are due to business leaders seeing their job only as running a successful business, and not also developing next generation talent. I don’t know where they expect it to come from. Often these founders will say: "I would step aside, but no one can do this job but me." Four out of five times that’s a self-fulfilling prophecy. No one’s prepared to be the next leader because one person has made all the decisions and even discouraged other people from voicing their views. The art of developing people is challenging them, testing them and empowering them, giving them responsibility in a timely way, letting them take some risks and succeeding and failing. When they fail, it will hopefully be on a small scale, and they will learn important lessons early.

Given what you’ve just said, it sounds like Queen Elizabeth II of England should have abdicated a while ago.

I’d say she should have gone 15 years ago.

Queen Elizabeth is still doing a good job, but her staying around is a problem for the next person in line. How do you convince people it’s time to go and how do you manage the handover?

Yes, Queen Elizabeth is a great monarch but she has virtually killed momentum in her family. It’s a typical problem. Many older leaders I know are still very good at their jobs. Some of them are extraordinarily vital into their 70s and 80s. These are not over-the-hill, depleted leaders. So, what do you do?

One, make sure they’ve got a good board in place that can talk to them in a sympathetic way and nudge them towards a transition. Number two, they need to give more freedom of decision making to their family and other leaders in the business. Sometimes that means spinning out a company where a successor can get hands on control and the older leader can observe the person and help get them ready.

Third, we need to do some emergency planning, because at some point we’re going to get a call that says you’ve got to come to the office because Dad’s gone. I try to do this with business leaders. If I can’t get a leader’s attention, I try and get his permission to get the next generation ready without his participation.

Sometimes, we’ve got a founder who professes wanting to give this company to his kids, but I know in my heart he is never going to let up. In this case it’s often best to encourage some in the next generation to leave and start their own companies.