Keeping the family in business Heinz-Peter Elstrodt Very few large family-owned enterprises thrive beyond the third generation. Those that do find ways to run themselves professionally while making the family happy. I n advanced economies, as well as in emerging markets, most compa- nies start out as family-owned businesses. From their humble beginnings, driven by entreprencurial vision and energy, some have grown to become major forces in their economies. Indeed, this still happens not only in emerg- ing markets, with their chaebols in South Korea and grupos in Latin America, ‘but also in North America and Europe, where relatively young family-ownedbusinesses such as Wal-Mart Stores, Bertelsmann, and Bombardier, to name just a few, have become front-runners. But family-owned businesses —companies in which a family has a control- ling stake—face a sobering reality: the statistical odds on their long-term success are bleak. In fact, a number of studies, taken together, suggest that only 5 percent continue to create shareholder value beyond the third genera~ tion. This statistic should come as no surprise, given the business challenges any company faces in increasingly competitive markets, to say nothing of the difficulty of keeping growing numbers of family shareholders committed to continued ownership. One kind of risk for these businesses comes from the generations that follow the founder, whose drive and business acumen they might not match, though they may insist on managing the company. By the time the third generation takes over, the scene is set for squabbles among members and branches of the ever-expanding family. Rather than looking after the interests of the business, they may fight over the size of the dividend payouts, the composition of the board, or who gets to be chief executive officer. ‘Nevertheless, a few family-owned businesses defy the odds and continue to thrive generation after generation. To gain a better understanding of how toos | THE MekiNSeY QUARTERLY 2099 NUMBER 4 build and manage family businesses that last, McKinsey conducted inter views with the family leaders—either the chair of the board or the leader of the family holding—of 11 family-owned businesses. Of these, 9 were in the United States and Europe and 2 in emerging markets, where such busi- nesses make up a much larger part of the economy but are mostly quite young. All of the companies are at least 100 years old —the youngest in its 4th generation, the oldest, founded more than 250 years ago, in its 11th. These survivors are ZB i iN not only venerable but also large and successful. Of the 11, T have revenues of more than $10 billion, and the families IAN fA that own 6 boast a net worth of more than $5 billion each. All have delivered growth and profits over recent decades, and are financially solid, with low debt-to-equity ratios. “The companies in our sample—a few of them public—have made it through economic depression, war, and other forms of turmoil, with the families remaining in control. Their experience has great value for younger family businesses whose owners face a generational transition and must decide whether and how to embrace the challenge of creating an enduring business under family control. For the companies in the sample, the key to survival and success was strong governance in its broadest sense: a powerful commitment to values passed down through the generations and a keen awareness of what ownership means. Ownership is both a blessing and a curse, giving the family the power to destroy the business as well as to shape it and enjoy its returns, The fami- lies that own the businesses in the study recognized this danger and estab- lished systems of checks and balances for carrying out the family’s roles in the three vital dimensions of governance: ownership, board supervision, and management. In what is usually a patchwork of oral and written agreements—some legally binding, some not—the family addresses issues such as the composi- tion of the company board and how it should be elected; which key board decisions require a consensus, a qualified majority, or interaction with the shareholder assembly; the appointment of the CEQ; the conditions in which family members can (and cannot) work in the business; how shares can (and cannot) be traded inside and outside the family; and some of the boundaries for corporate and financial strategy. These arrangements, typically developed over many decades, help defuse the often highly charged issue of the succes- sion of power from one generation to the next and lay the foundation for fulfilling the two main conditions for the long-term success of any family- owned business: professional management and the family’s ongoing commit- ment to carry on as the owner.KEEeING THE FawaLy IN ausiness | 97 Running the business well With a set of clear rules and guidelines as an anchor, and with family con- flicts comfortably at bay, family-owned enterprises can get on with their strategies for long-term success. Some key factors show up over and over again: strong boards and uncompromising standards of meritocracy in per- sonnel decisions, risk diversification and business renewal through active management of the business portfolio, and long-term financial policies. Powerful boards Strong boards are particularly important in family-owned enterprises to complement the family’s business skills with the fresh strategic perspectives of qualified outsiders. As a fourth-generation family leader said, “We must not be managers. We must be experts in corporate governance.” Indeed, the corporate-governance practices of most family businesses in the study surpassed those of average public As a family leader said, ‘We mus companies. not be managers. We must be experts in corporate governance! Even when the family holds all of the equity in the company, its board will most likely include a significant proportion of outside directors. One family has a rule that half of the seats on the board should be occupied by outside CEOs who run businesses at least three times larger than the family busi- ness. Another private family business set up an independent institution solely to nominate and elect one-third of the board members. But in most of the companies, the family nominates and elects the outside board members. The procedures—for all nominations to the board, not just nominations of outsiders —differ from company to company. One board perpetuates itself it selects new members and then secks approval by an inner family commit- tec of around 30 members and formal approval by an assembly of share- holders. In another company, board members are elected, on the principle of one share, one vote, from a list of candidates at a meeting of all share- holders, A more common approach is for a limited number of family branches to pool their holdings and elect a block of board members. The formal mechanisms differ; what counts most is that the family must under- stand the importance of a strong board. All of these boards become deeply involved in top-executive matters and. manage the business portfolio actively. Many have meetings stretching over several days to discuss corporate strategy in detail. In most of the com- panies, the chair and the vice chair typically spend at least half of their timeoe | THE MekINSEY QUARTERLY 2099 NUMBER 4 interacting with other board members, top management, and the family, which is kept informed about the business through newsletters, informal gatherings, and regular reports. ‘True meritocracy Nepotism is the obvious way to destroy a family-owned business in a single generation—and this happens, all the time and all over the world. To control the natural human desire to favor your own kin, family-owned businesses that want to last for generations must establish a true meritocracy, as all the companies in the survey did. Half of the families had decided not to have their members involved in man- agement at all. “You cannot expect the family to consistently generate com- petent top managers,” one family leader said. Another noted, “My uncle, who had been appointed chief executive, died early. Otherwise, he would have ruined the business.” A third leader said, “Our key factor of success is that we hire the best people in the market, and if they turn out not to be the best, we fire them. We would not be able to do that if we had family "You cannot expect the family to members in management.” consistently generate competent lop managers,’ said one leader In the remaining companies, family ——_ members who have proved their competence are welcome to serve as managers. Twwo of the companies require family members to start work outside the family business. After they have had 10 to 15 years of highly successful experience, its board may invite them to hold top-management positions. Said one family CEO: “Twas surprised to be invited to run the company, but I guess the family found me competent. Ac the other companies, family members can enter the business after gradua- tion and work their way up. Their performance and career prospects are usually evaluated every year, often by competent outsiders reporting directly to the board. If such family members lack the potential to become top man- agers in the long term, they leave the company. “Our policy is up or out,” one family leader said. “Nobody gets promoted because he or she is family—rather, the opposite.” ‘One family member and CEO of a privately held company explained in great detail how he was put through a two-year process of outside evaluation and coaching before a board committee appointed him to the position. Another company uses a recruiting firm to find alternative, outside candidates for