Owning a family business, and planning the succession of your family business, is as much a part of the American dream as white picket fences and two cars in every garage. But is handing your business down to the next generation a good idea or just ideal? You see, there’s been a long-standing stigma around family businesses. The three-generation rule, as it’s come to be known, suggests that family businesses rarely make it to the third generation. But let’s take a closer look.
According to the SC Johnson College of Business at Cornell University, only about 40% of family-owned businesses transition to the second generation. Meanwhile, just 13% are passed down successfully to a third generation, while 3% survive to a fourth or beyond. So, it seems that the three-generation rule is accurate, right? Perhaps, but the reality may not be as bleak as these numbers indicate.
The three-generation rule is actually based on a single study conducted in the 1980s. In the study, researchers examined manufacturing companies that operated in Illinois during a predetermined period. They then grouped these companies into 30-year blocks to represent generations. While the study provided some valuable insight, the findings could be skewed by flaws in the way the findings have been presented over the years.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
A Lack of Comparable Data in Family Business Study
The first major flaw in this study is the lack of a control group. The researchers failed to compare their findings to other types of companies. According to Josh Baron, co-founder and partner at BanyanGlobal Family Business Advisors, and Rob Lachenauer, co-founder and managing partner of BanyanGlobal, family businesses hold up quite well when compared to their counterparts.
The duo cites a study of 25,000 publicly traded companies from 1950 to 2009 that found that the businesses lasted an average of 15 years. That's not even a single generation. Meanwhile, the SC Johnson College of Business study found that the average life-span of a family-owned business is 24 years.
Failing to Describe the Findings Accurately
Since the original study took place, it has been cited in countless white papers, research documents and business columns. However, the findings are often described inaccurately. Subtle changes to the verbiage used when describing the findings can drastically change the truth of what was uncovered.
For instance, it's often said that only a third of family-owned companies make it to the second generation. However, the study actually states that one-third make it through the end of the second generation. In the context of the study, that’s 60 years. That is a huge difference!
Why Did the Businesses Close?
Another failure in the 1980s study is the lack of insight into business closures. The researchers didn’t investigate the individual reasons that the companies shut down. This might seem like nitpicking, but if some of the businesses sold, freeing the business owners to start new companies, that isn't the same as failing.
When we look at the flaws in this study, it becomes clear that the three-generation rule isn’t quite as dire as it has been packaged over the years. So, with that, how can you prepare your business (and your family) for an eventual transfer to a family member?
1. Be Mindful of Time and Finances
On average, it takes much longer to receive the full sale price when transferring a business to family members. Longer return times can increase your risk and leave you susceptible to sustained exposure. This can be exacerbated by transferring the business to an unprepared or unqualified family member. The wrong choice could destroy the business and your financial security.
You can avoid this blind spot by properly training and vetting the family members who will be succeeding you. A lengthy and involved, hands-on training period should be built into your exit plan.
2. Choose the Right Successor
Choosing the correct family member is crucial to continuing success. As part of the vetting process, you should ask yourself the following questions:
- Does their vision for the future of the business align with your own?
- Will the rest of the family be happy with who you've chosen? If not, what's your backup plan?
- Are they as passionate about the business and brand as you are?
- Do they have the skill set to at least be as successful as you've been?
- Will they be able to run the business without getting bogged down by family squabbles or disagreements?
The answers to these questions are vital to the sustainability of the business and to the satisfaction of your clientele. Remember, this decision affects far more people than just you and your family.
3. Don’t Overlook the Importance of Tax Planning
Begin working with your tax adviser/planner now to prevent being blindsided by negative tax implications associated with transferring to family members. Depending on how your business is transferred, it could leave you on the hook for various taxes, including income, estate, gift and capital gains taxes. Therefore, it’s important to work with your advisers to create a succession plan that is as tax-sensitive as possible.
In conclusion…
Transferring a business to a family member is an emotional and stressful time. Without comprehensive exit planning and seamless implementation, the experience could cause division. Because families are so closely connected, communications can become much more emotional during the transfer than they would in a third-party sale.
Although it presents unique challenges, owning a family business can be a rich and rewarding experience. However, family dynamics require an extra level of planning and consideration.
With the right attitude, proper planning and even a little luck, you could leave a legacy that extends well beyond the three-generation rule.
-
The '8-Year Rule of Social Security' — A Retirement RuleThe '8-Year Rule of Social Security' holds that it's best to be like Ike — Eisenhower, that is. The five-star General knew a thing or two about good timing.
-
Should I Buy Stocks or Should I Buy Bonds Right Now?Generally speaking, stocks provide reasonable growth while bonds provide stable income. Each play important roles in diversified portfolios.
-
You Were Planning to Retire This Year: Should You Go Ahead?If the economic climate is making you doubt whether you should retire this year, these three questions will help you make up your mind.
-
Are You Owed Money Thanks to the SSFA? You Might Need to Do Something to Get ItThe Social Security Fairness Act removed restrictions on benefits for people with government pensions. If you're one of them, don't leave money on the table. Here's how you can be proactive in claiming what you're due.
-
From Wills to Wishes: An Expert Guide to Your Estate Planning PlaybookConsider supplementing your traditional legal documents with this essential road map to guide your loved ones through the emotional and logistical details that will follow your loss.
-
Your Home + Your IRA = Your Long-Term Care SolutionIf you're worried that long-term care costs will drain your retirement savings, consider a personalized retirement plan that could solve your problem.
-
I'm a Financial Planner: Retirees Should Never Do These Four Things in a RecessionRecessions are scary business, especially for retirees. They can scare even the most prepared folks into making bad moves — like these.
-
A Retirement Planner's Advice for Taking the Guesswork Out of Income PlanningOnce you've saved for retirement, you'll need your nest egg to support you for as many as 30 years. For that, you need a clear income strategy, not guesswork.
-
Why Smart Retirees Are Ditching Traditional Financial PlansFinancial plans based purely on growth, like the 60/40 portfolio, are built for a different era. Today’s retirees need plans based on real-life risks and goals and that feature these four elements.
-
To My Small Business: Well, I've Been Afraid of Changin', 'Cause I've Built My Life Around YouWhile thinking about succession planning might feel like anticipating a landslide (here's to you, Fleetwood Mac), there are strategies you can implement to manage the uncertainty and the transition.
