“Financial families” and “The high wealth market.” Both terms are used to describe families with substantial investment portfolios who enjoy life styles made possible by seemingly endless streams of income. The tantalizing fact that somewhere in their histories that wealth was created by a family business that was built and sold to non-family interests – including, in some cases, the public equities market. These families have reached Stage Four – the final stage in the evolution of family business and wealth.

At the other end of the spectrum are the Stage One family businesses that do well, but often for only one generation. These businesses provide well above average incomes for their owners, but never quite realize the potential the founders thought they had. Along the way, members of the next generation come into the business, usually under the assumption that the business will be theirs some day. Then the founder decides to retire and finds – to everyone’s surprise – that he/she cannot afford to keep the business in family ownership. The business is sold, the founder uses the proceeds as a source of retirement income, and the second generation members who were in the business scurry around making mid-life career change.

Setting the Trap

The above scenario of a Stage One family business is not a pretty picture. Can it be avoided? The answer is ‘yes.” The next question is “How can it be avoided?” The answer to “how” makes more sense if one first understands the nature of the Stage One family business.

Every business starts at Stage One. It is an informal, often scary, but always exciting place to be – at least at first. The founder usually has all the ownership and all the control. Nobody else has much authority, particularly other family members who might work there. The initial challenge is survival so everyone does whatever it takes in a very fluid, informal, undocumented organization. Policies and procedures are understood, not written.

Entrepreneurs thrive in this kind of environment. They enjoy the risk, the power and the informality. They take out of the business the money they need to live, and plow every other dollar back into the business for working capital and to fund growth. After all, institutions that will lend to such a business are hard to come by, the cost of accessing debt is high and most founders don’t like to borrow in the first place.

Then the business gets past the volatile start-up phase and the survival challenge is replaced by the challenges associated with growth. Managers are brought in to support the founder; family members (youngsters when the business was founded) grow up and come on board. More employees are hired and the organization becomes more complex. In most cases, however, the founder’s love of power and informality doesn’t go away, and he/she continues to plow every available penny back into the business.

Fast-forward to the day the founder decides to slow down, spend less time in the business and enjoy some of the fruits of his/her labor. Look around at the income producing assets to support this change and you will find only one meaningful source – the business itself. The founder would like to pass the business to the next generation, but can’t gift it because he/she needs earning assets. The kids can’t buy it – they don’t have the cash and can’t borrow that amount of money from the bank. A note to the founder sounds good, the business doesn’t produce enough cash to simultaneously support itself and service the debt. They are in a trap that often results in the sale of the business to outside interests and the hopes and dreams of the family unfulfilled.

Avoiding the Trap

The best approach to ensure family business continuity is to move the business into Stage Two in the evolution of family business and wealth long before the founder starts to slow down. The table below demonstrates some of the key differences between Stage One and Stage Two. It provides guidance about where to put your energies.

As the business takes on Stage Two characteristics, it is more able to create enough “extra” cash for the founder to start investing in income-producing assets that are independent of the business. As a result, when the time comes to retire, the founder’s wealth portfolio has evolved to a point that he/she is no longer totally dependent on the business for asset and income security in retirement. That puts less financial pressure on the business and opens up opportunities for a successful transfer into next generation ownership open up that wouldn’t be there for a Stage One business.