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Family business

Evolution from a family-owned company to a family-owned investment portfolio

Published 10 May 2022 in Family business • 7 min read

When deciding whether to sell your family-owned business, the choice for many families comes down to a number of factors – some of which will be uncontrollable. Peter Lorange, Emeritus Professor of Strategy and Honorary President of IMD, weighs up the pros and cons.

 

Many families have built their wealth over time based on owning a particular company. With the success of this company, the fortunes of the owning family have also grown. While this evolutionary path certainly represents a way for a family to accumulate wealth, there may also be potential problems.

One major challenge would be that the owning family might become too heavily exposed to the firm’s ups and downs. Should the firm run into difficult times, for instance, the wealth of the owning family would also diminish.

Many families have been facing this dilemma of being over-dependent of the firm they own. For some families, the “solution” might be that their firm is sold, or at least their ownership share in the firm is reduced, with proceeds going towards building a more diversified portfolio of investments. This means that the eggs are no longer in one basket, i.e., that the clustered investment risk the family is exposed to would be reduced. In my view, the various permutations of middle-ground positions offer the most attractive possibilities for augmenting and protecting long-term wealth.

But how might such a transition from a company-based focus to a diversified portfolio of investments take place?

Diversification is a strategy that mixes various investments within a portfolio to reduce the risks.

The process

It is, of course, a key pre-requisite that a suitable buyer for the firm can be found, and that the price is right. We shall not have to discuss this further here; rather, we shall raise some other issues that typically might come up during the sales process, such as:

  • Resistance from employees. A sale might represent a source of uncertainty for employees, who may be concerned that it will impact their jobs. So, to ameliorate at least some of this resistance, it may be useful to incentivize the top management and employees to conclude the transaction.
  • Payment in cash. It should be kept in mind that the main purpose of a sale would be to build up a more diversified portfolio. Hence, it is important that the firm would be sold for cash and not for shares, nor based on some sort of earn-out scheme. In this way, the risk for the selling family would also be more manageable.
  • Stakeholders and others in the company network might not appreciate the far-sweeping changes a sale could mean. Critical voices are typical. The sellers should be prepared for this and be ready to accept that others might describe them as incompetent, or even as idiots.
  • With a considerable amount of cash in hand, there may be a temptation to rush into new investments. This should be avoided. It is key to avoid suboptimal decisions due to money burning in one’s pocket.

 

So, why sell the family company?

There are three major reasons to sell the family firm. These are:

  1. Too large a share of ones assets are tied up in the family firm. Many such firms would need to generate funds for expansion and development, therefore the owning families are usually strapped for cash. Furthermore, there may be quite heavy taxes to be paid by family members as a fraction of the value of the firm. While many countries have abandoned such wealth tax, it is still the norm in some countries, e.g., Norway. In general, the cash requirements of many firms, as they are growing, may be such that private family owners may simply not be able to come up with the additional capital needed. As a result, the family company may have to go public or be sold. For some family-owned companies, however, where relatively large dividend payouts may be sustained, there might be an opportunity for the owners to diversify into other areas, i.e., develop a diversified portfolio while still maintaining the ownership of the family’s firm. This, however, is not the most common situation.
  2. To enjoy the power” of diversification. A diversified portfolio is typically much more liquid than when the bulk of one’s values are tied up in a single entity. Thus, one might be in a better position to enter new existing growth prospects, i.e., to be much more flexible and opportunistic. In addition, one might be able to exit relatively easily from less attractive businesses. It would be easier to “cut the losses”.
  3. To reduce the risk of critical success factors that are largely outside the owning familys control. Examples of this might be, say, ship owning, where the uncontrollable freight-rate movements may significantly impact a firm’s value; tobacco companies, where unforeseen legislations might adversely impact sales; or cement manufacturing, where heavy CO2 emission may represent further adverse environmental exposure. The bottom line here is that non-controllable factors might significantly impact the value of a family-owned firm.
Selling the family firm too early can also entail a massive opportunity cost for one’s family

So, why keep the family firm?

There are, of course, also strong reasons for maintaining family ownership, such as:

  1. Family-owned firms benefit from the commitment of the family members involved. This very commitment and experience, often stemming from generations of involvement, often leads to stronger and more robust organizations. Furthermore, the family members themselves may also attach a high personal value to their involvement. Their involvement might even be worth more than security or higher monetary reward to them, in which case any sale would entail loss of purpose, and of social and personal identity.
  2. It may be too early to sell. Mark Zuckerberg was famously offered $1bn USD to sell Facebook at one point, an offer he obviously refused. While this is perhaps not a typical example, selling the family firm too early can also entail a massive opportunity cost for one’s family. Furthermore, if your family firm has survived the first few generations, it has most likely become a highly effective business. As the research of and others demonstrates, family firms outperform publicly listed firms on important criteria such as innovation, therefore there is no reason to believe that a portfolio of blue chips should outperform a well-functioning family firm in absolute terms.

When relatively large dividends might be paid out over time, then a more diversified portfolio might be developed in parallel with owning the family firm – as already discussed. However, it is typically not easy to find circumstances that allow for such sizable dividends over time.

If you have sold, please remember…

The following key points need to be kept in mind:

  • The importance of maintaining entrepreneurial capabilities in the family. This would typically be enhanced by members of an owning family being involved as active board members in various direct private equity investments and ventures. Ownership positions in such companies would be important, and a more active involvement than from simply owning stocks or bonds would be called for.
  • The owning family members must be comfortable with change. For example, going from a situation where they would typically manage a relatively large group of employees with an element of hierarchy, to managing relatively few people, often relatively detached (i.e., the portfolio) and networked.
  • Being open-minded and analytical is key. The search for new elements in one’s portfolio calls for this. To develop a basic understanding of what might be critical success factors in a particular niche is also important. Learning new skills will increasingly be called for, in addition to leveraging one’s experience. It follows that a degree of focus would be key also at the portfolio stage. Strategy means choice!

In conclusion

Navigating the evolution from owning a firm to owning a portfolio is doable, but difficult. There are no easy answers. The transition process in itself can lead to quite significant value losses for the owning family – or it may save the family from long-term value destruction, even ruin.

Authors

Peter Lorange

Peter Lorange

Emeritus Professor of Strategy and Honorary President of IMD. 

Peter Lorange is Emeritus Professor of Strategy and Honorary President of IMD. He served as the President and Professor of Strategy for IMD and has held the Nestlé Chair for Strategy and the Kristian Gerhard Jebsen Chair for International Shipping. His areas of interest includes global strategic management, strategic planning, and entrepreneurship for growth. He has written or edited more than 30 books and 120 articles on multinational management, planning processes, and internally generated growth processes.

 

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