All in the Family Business? Not Without Education and Information

Tim, a second-generation leader of a family business, recently said to me: “It really bothers me that I have to pay a dividend to my brothers and cousins when they don’t contribute to the success of the business.”

His brother, a non-active shareholder and successful dentist in Baltimore, had a different opinion: “I don’t understand why the dividends of this company are so inconsistent. Even when paid, they seem small compared to the large management bonuses paid out to my brother and our cousin.”

The implied tension is a classic one facing family businesses with shareholders not actively managing the business. Many advisors will tell family business owners to “NEVER” allow family members not active in management to become shareholders. From their perspective, non-active shareholders are a pain in the active shareholder’s balance sheet. In economic terms, non-active shareholders create “agency inefficiencies”— situations in which the interests of the owner-managers are not aligned with the interests of the non-active shareholders.

Advisors and colleagues we work with constitute a diverse opinion base with viewpoints invaluable to this discussion since they are all exemplary family business leaders themselves.  So I asked them:  Should all shareholders be active in the family business?

Walt Legenstein, Chairman of Certified Carpet in Lancaster and an executive-in-residence since 2007, had this to say: “For smaller businesses in particular, having non-active shareholders leads to complications that can have negative impacts on the business and the family.” For Legenstein and his family, the risk of misaligned interests led to a decision that only those active in the business can purchase company shares.

Certainly, limiting ownership to those involved makes management of the ownership, board, and management relationship easier in the short term. However, in the long-term the family will still have to make some difficult ownership-level decisions. For example, what happens when one of the owner-managers retires? Is he/she required to sell shares back to the company - and how will the company pay for this buyback? If there are no successor generation leaders working in the company, the implication of this policy is that the last working shareholder inherits 100 percent of the business.

Tim struggles with the fact that his non-active shareholders do not understand the business well enough to make informed decisions. As Tim has said, “My brother is a smart guy who’s great at pulling teeth, but he does not understand the operations of our family business or why we need to reinvest so much.”  Tim’s father and his uncle, the founders of the business, never worried about this issue since they where the only two shareholders, the Board of Directors, and the top management team—all in one. Since they loved their kids equally, the brothers wanted them all to share in the legacy of what they had created. 

Given his current situation, Tim needs to change his mind set.  Rather than view his non-active shareholders as a pain, he needs to view them as a key constituency.  This starts with education about the roles and responsibilities of shareholders and how those roles are different than management. I often say to family business leaders that they need to give shareholders the roles and responsibilities they should have, so that you can take away those responsibilities that they should not have. 

Tim also needs to to educate his brother and cousins about why dividends are inconsistent, explaining how cash flow of the business varies from year to year . . . and why. He needs to explain why the business requires reinvestment. As we often explain to leaders in Tim’s position, entrepreneurship is a roller coaster ride. If you want your fellow shareholders to ride it with you, they’ll need lots of information.  If you want shareholders to be patient with the capital they have invested in the business, you had better provide them lots of information about where you are headed. In short, treat them like shareholders of a public company. 

Occasionally, all the information in the world is not enough to make shareholders happy - they don’t want to be partners in the business. Perhaps their risk profile just does not match with the risk-return profile of the business. Therefore, it is important that Tim provide his fellow shareholders a way to exit the business. A buy-sell agreement provides this “out” and ensures family members are not trapped in the business. A trapped shareholder—one who is unhappy and has no way of exiting—will eventually call a lawyer to get “unstuck.”

So when is allowing non-active shareholders to become shareholders the best course of action? Phil Clemens, CEO of the Clemens Family Corporation and the Center’s newest executive-in-residence, feel strongly that his family enterprise is a legacy business to be shared with all of their children, regardless of their profession. Having non-active shareholders accomplishes that.

One of several hundred shareholders in his family’s fifth generation food business, Clemens said that his family shifted in position on this issue over the generations:  “For the first 60 years of our business, only family members employed in the business could own stock. However, as we started to gift stock to the third generation and beyond, we changed our policy. 

“First, we have an extremely large family and to have all of them be employed that want to own stock would be almost impossible. Second, we see ownership and management/employment as two very different issues.”

Clemens believes family members don't need to be owners to be manager/employees nor do they need to be manager/employees to be owners, reiterating the two main concerns of owners of the Clemens Family Corporation:

1) Is what I own giving me a fair return on my investment; and

2) Is the business being run in a way that follows the vision?

In Clemens experience, a policy limiting ownership to those involved in management can limit growth of a firm as the requirement to buy out non-active shareholders can be a drain on company resources. “I have even seen companies that are forced to sell when they really didn’t want to because of it.”

The key, per Clemens, is training shareholders to be good stewards of the business: “We view our business as a family heirloom— something that you steward and make better (or more valuable) for future generations.”  Instilling this kind of mindset in shareholders requires a clearly designed and well respected set of family ownership and business governance structures, transparency about business direction and performance, management accountability, and consistent education of shareholders.

S. Dale High, Chairman of The High Companies, believes different models may work depending on the size and age of the family business.  “Each business and family situation is different,” High said. “As a general observation, in smaller companies, when value is created by a few family members, it’s probably a good idea to limit stock ownership to active family members.  In larger companies, where value is created by a pool of professional managers, it’s easier to separate ownership roles from management roles.”

Ultimately, whether to allow or disallow non-active shareholders is a decision that should be made in dialogue with everyone whose life will be impacted.  Bill Alexander, a faculty member at the Wharton School and third-generation principal and CEO of H.B. Alexander.  He explained the decision this way, “It is wrong if you allow stock to be broadly held without a commitment by the family members in the business to educate and keep current non-active family members as to the status of the business. It is also wrong for a family member to hold stock without working in the business while failing to learn about the rights and responsibilities as owners.”

As Phil Clemens’ family business history illustrated, ownership status of family business may change over time, once a business extends into two or three generations, and the potential of developing future generations emerges.

The keys to having broad family business ownership include committing to constant education and information sharing. Strive to clarify roles and responsibilities of shareholders. Put management oversight in place (such as a board) to hold the management team’s performance accountable to non-active shareholders.  

Educate. Inform. Include. Or be prepared to write a big fat check.