We the Family: The Benefits of Creating a Family Constitution

Sustaining a family business for generations is an incredibly challenging task. Indeed, just 12% of family businesses survive into the third generation.1 One of the most trying and emotionally charged issues a family business faces is balancing the evolving liquidity needs of the family with the growing capital needs of the company. For family businesses that want to thrive across generations, finding this balance is a key component of success.

In the early years of a business, the founder draws a salary and typically redeploys all earnings back into the company to support its growth. As the business scales and stabilizes, owners gradually feel more comfortable extracting liquidity for themselves through a higher salary and/or distributions. Over time, when the business is passed from the founding generation to subsequent generations, the composition of shareholders becomes increasingly diverse, each with unique lifestyle needs and liquidity expectations. At the same time, the larger business requires more capital to continue its growth trajectory. These competing forces make it a challenge to find the right balance between the business and family.

The Need for Patient Capital

A cornerstone to success in achieving balance between these competing demands is the cultivation of the family’s “patient capital.” While many people think of patient capital simply as long-term capital, there is an emotional component to it as well in successful multigenerational family businesses. This emotional connection and sense of pride helps family members to recognize that the family business is more than its current tangible financial value, and it encourages connectivity to the business built through shared values and heritage. When effectively nurtured, patient capital is a key competitive advantage that enables owners to think and act for the long run, not just the next quarter. Family businesses that have patient capital are resilient and willing to reinvest capital during good times in order to increase their odds of survival during adverse times. Patient capital can and should serve to motivate and guide future generations of owners.

Patient capital resides in a business from the beginning. Founders must take a long-term view when starting a company, and there is typically a strong emotional connection given the sweat equity contributed. However, the necessity of patient capital often comes to light once a family expands and attempts to transition the family business to the next generation. As ownership extends to multiple generations, liquidity needs diverge. For instance, the elder generation that has accumulated significant wealth may prefer to reinvest cash flow in the company to perpetuate the family legacy, while younger family shareholders may have substantial expenses such as mortgages and school tuition that require healthy distributions. Reinvesting in the business and providing liquidity to shareholders are not mutually exclusive options – both are necessary for success. But the opposing pull of these demands all too often creates a level of conflict that results in a downward spiral and/or sale of the business. Providing liquidity is akin to enjoying fruit that has been harvested over time; it supplies family members the sustenance to maintain patient capital across generations.

The Importance of Liquidity Mechanisms

As founder-owned businesses scale and generate surplus cash flow, and liquidity demands increase with each generation, many owners pay modest regular dividends to shareholders and establish share redemption programs in order to protect their patient capital. The size of the dividend or the share redemption should depend upon the sustainability of earnings balanced with the outlay required for capital expenditures and strategic initiatives. Implementing share buyback and redemption programs provides more significant liquidity opportunities for shareholders while avoiding starving the business of the capital required to thrive. In fact, the very act of developing and communicating these programs to shareholders can help to manage their expectations and establish trust.

The lack of a liquidity mechanism can result in family members feeling constrained, especially those who are not actively involved in the business and do not draw salaries. Without a tangible way to participate in the business’s success, shareholders are likely to have difficulty focusing on enhancing the long-term value of the company, since the value of their shares can seemingly never be realized. Liquidity programs allow all family shareholders to access the company’s value and appreciation over time.

Liquidity mechanisms prevent capital from being trapped, but cultivating the intangible aspects of patient capital is equally, if not more, important. Dedication to developing family systems and reinforcing family values creates a powerful force that few businesses can match.

The Cultivation of Patient Capital

Family business owners must of course be diligent and focused on business performance over the long term. But the long-term achievements they strive for rely on the family’s support – not just the financial investment in the company. As the business grows and family ownership becomes dispersed, it is important that family members understand how they contribute to the success of the family and company, regardless if they are an employee or not. Shared family values provide the glue required to hold together the business and family, particularly through times of change and upheaval, and are at the heart of patient capital. They inspire family members to make commitments that require discipline, to behave unselfishly and to remain steadfast over the long haul even under moments of personal adversity. An enduring commitment to shared values is one of the greatest strengths and competitive advantages family ownership can bring to a company.

Successful multigenerational family businesses typically develop governance structures to create a clear separation between the roles and responsibilities of the family relative to the business. While there is no one-size-fits-all approach to governance, developing protocols and structure – for instance, a family constitution or a family council – can define the role of the family and provide processes to resolve issues that arise. They are also effective vehicles for transparent communication and engagement with all shareholders (both employee and non-employee). Shareholders who are informed about the business and have confidence in management’s long-term goals are less likely to seek excess liquidity in the short term and instead are unwavering in their ownership commitment. It is important that family shareholders have insight into the company and a true sense of ownership even if they do not work in the business. Regularly scheduled family meetings to review business results and discuss strategy and the state of the industry will encourage shareholder engagement.

When the non-financial reasons for being a family business owner – such as tradition and family pride – dissipate, the family’s patient capital erodes. Family members are then likely to view their ownership in the business as simply a financial asset and push for liquidity through increased distributions or a sale in order to diversify their portfolio. Do not leave the legacy of the family or the business to chance – plan and prepare for future generations by investing in the family early to cultivate patient capital.

Conclusion

Developing a successful multigenerational family business does not happen overnight. It requires careful planning, skillful management and the cultivation of a family culture that prioritizes stewardship and a family legacy. For a family-owned business to thrive through the generations, it must plan for the provision of both adequate shareholder liquidity and sufficient capital for the business. The ability to balance these competing needs will determine the health of the business and the family. While there is no single approach to managing this ever-present tension in family businesses, nurturing patient capital by implementing effective liquidity mechanisms, fostering shared family values and embracing the family heritage will go a long way to striking the right balance.

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1 Source: “Family Business in Transition.” Family Business Institute. 2016.