Business Continuity is the Prize of Succession (Part I)

Legacies Newsletter
by Ernesto J. Poza

Three brothers run a retail chain catering to a well-defined market niche. The business is people intensive, and customer service is very important. Competition is fierce in their industry. As a rule, profit margins are low. New products and product/service combinations do offer opportunities for healthier profit margins. The brothers have grown the business four-fold in their twenty years of leadership and are now preparing for the transition to a third generation of owner-managers.

The next generation is better educated and has worked outside the family business in well-regarded Fortune 500 companies. Motivation to professionalize the firm, update its managerial practices and ramp-up the growth curve is high. The third generation is ready to use organizational and human resource systems to support increased teamwork, delegation with accountability as well as a more strategic approach to the business’ market niche.

The family is now larger. Each of the brothers has three children, expanding the potential pool of successors to nine. To prune the owning family tree, the brothers entered into a buy-sell agreement funded by life insurance. It specifically states that next generation family members need to be full-time employee/managers to qualify for ownership. This is, briefly, the business and family context in which succession is presently taking place in many family-owned businesses.

The Context of Succession in the Family-Owned Business

Transitions of any significance exact a high emotional cost. Most people are unwilling to bring precisely that which has been a success, a source of pride, income and self-esteem to an end. Endings and new beginnings are tough business. For many founder/CEOs, succession and the planning it entails is equivalent to planning their own wake and funeral. It results in denial, anger, depression, and often all the above at different times in the process (See Correll, “Helping the Hero Say Farewell,” Private Business Advisor, Spring, 1993).

The fact is that the transfer of power from the first to the second generation seldom happens while the founder is alive and still on the scene. And regardless of which generations are involved, the succession transition is the most agonizing change I have ever seen CEO’s and top management teams confront. Resistance comes from many quarters: the CEO, their spouse, the children and the next generation leaders, other key executives, suppliers, key customers and friends. Is it any wonder then that anxiety, ambivalence and paralysis through inaction (or perfectly contradictory actions) are prevalent during the succession transition?

We have had, in the European and American tradition, a long history of hierarchy and primogeniture pre-ordaining or at least “helping” us select likely successors. While this practice continues in some families and ethnic groups, it is not a predominant feature of the succession landscape anymore. Many families now appreciate the waste of valuable knowledge capital represented by daughters and younger sons who are barred from leadership because of gender or birth-order.

Primogeniture is much like union seniority rules. It makes the decision about who stays and who goes, simple and objective: birth order and perhaps gender, in the case of primogeniture; years of service in the case of seniority rules. In either case, emotionally difficult evaluation and judgment are traded for simplicity and numerical objectivity, while forfeiting a better decision and a more inclusive approach to all successors who can make a contribution to the business.

Fully 50% of family business owners, involved in a recent U.S. survey, said they would prefer the next generation to manage and jointly own the family’s business. This means that what a “lone ranger” used to be able to dream-up, create and grow into a business, will now be fair game for task forces, councils, retreats and meetings!

These successors, the new family business partners, soon discover that they are interdependent; that “I-word.” There is no escaping their need to manage this interdependence, if they are going to insure business continuity and family harmony.

The Competitive Environment Challenging Family Business Today

The nimble, customer-oriented, often smaller business organization that is a family business is perfectly suited for the global competitive dynamics of the nineties. Businesses serving market niches of $50 million or less realize a 28.1% rate of return on their investment. Similarly those in niches of $50 to $100 million realize rates of return of 26.8%. Businesses serving markets over $1 billion, like General Motors and IBM, achieve only 10.9% returns (Strategic Planning Institute, PIMS Database). Profitability is on the side of the defined, focused, small niche player.

Small market niches have traditionally constituted the preferred strategic target of entrepreneurial and family-owned businesses. Total quality management (TQM) is in vogue among Fortune 500 companies. We hear and read about TQM today as often as we hear the term national deficit. It is no coincidence that many benchmark companies whose stories are often quoted are family-owned and closely-held. After all, the name is on the door. Whether it is Marriott in services, Levi-Strauss in garments, Wallace Co. in distribution, or Milliken in textiles and fabrics, these names mean quality. And have for generations.

Companies whose product quality is high relative to competing products achieve investment returns of 27.1%. Those with low relative product quality settle for a meager 16.8% return, fully 38% less (Strategic Planning Institute, PIMS Database). Again, profits belong to those providing superior quality products and services. Quality too, has historically been a preferred strategic approach of family-owned businesses.

In the nineties, economies of scale are being replaced by economies of flexibility and commitment in competitive advantage comparisons all over the world. Businesses capable of making money in small batches or short production runs are showing a much greater ability to generate profits in ever-changing marketplaces than those reliant upon capital-intensive long-runs. Inventory, carrying and quality costs associated with long runs dampen the earlier economic advantages of scale.

Simultaneously, the increasing flexibility of manufacturing technology reduces set-up times, allows the production of an entire family of parts or products on the same machine and thus increases the economic advantages of flexibility. Manufacturers need not think big when they think low-cost anymore. Service and retail firms are experiencing similar economies with the advent of inexpensive networked PC’s. A clothing and apparel store in Virginia, for example, can enter tailoring specifications for a custom-made suit into a store PC. This information is then transmitted to a factory in Ohio where the pattern and fabric are automatically cut resulting in a one-of-a-kind suit sold at “off the rack” prices.

Given ever-shortening product life-cycles and consumer fickleness, flexibility will remain a distinct competitive advantage that results in higher profitability. This flexibility is an advantage traditionally enjoyed by entrepreneurial and family-owned businesses.

The recent books and articles on innovative Fortune 500 companies indicate that the traditional core competencies of entrepreneurial and family-owned businesses are turning out to be the core competencies larger public corporations are trying to emulate in the nineties: a focus on narrow market niches; quality of product or service; speed and quick response time; product innovation; customer service that results from long-term investments in the skills and knowledge of employees; and commitment or caring about all the people in the value-added chain (whether they are suppliers, customers, employees or relatives/co-owners in the business).

Squandering Competitive Advantage During Succession

Can this advantage family-owned businesses enjoy in the global marketplace of the nineties be squandered? You bet! Just have family members forget that they are interdependent (that I-word again). The moment they forget this has to be a win-win game of everybody loses, the business and the family get mired in conflict, internal divisiveness and self-imposed handicaps. This is a highly probable and dangerous occurrence during succession, because past rules, influence patterns and practices often come under scrutiny by next generation members in the business. Into the vacuum created by a departing hero (and the rules and roles this individual instituted) rush assumptions, greed and a thousand hidden agendas.

Do sibling partners emphasize growth or profitability? Different personal objectives may lead to different strategic orientations vying for prominence in the next generation. Conflict around these differences may erode the commitment of the next generation members to the business. I have seen these conflicts work their way to the boardroom and result in shareholder fights.

Differences in day-to-day operating matters, even when only differences in managerial style, may be perceived by employees as differences in priorities between the owners. For example, when all is said and done, is it better to err on the side of quality or on the side of number of units shipped? Such differences, often more visible than shareholder disagreements, create conflict confusing employees and customers alike.