PHOTO CREDIT ©Neal Hamberg for Harvard Business School

Avoiding the Three-Generation Rule
By John Davis

Since the start of the field of family business in the mid-1980’s, academics and consultants have largely focused on how the actions and attitudes of the family, the family ownership group, and the leaders and employees of the business influence…the performance and survival of the family business. This orientation emphasizing the support and continuity of the family business is obvious in the academic journal and magazine articles in the field. The name for the field, after all, is family business. We didn’t call it the business family field. But maybe we should have.

The emphasis on supporting the family business was a natural way to start the field and has generated useful findings. But this focus is also limiting. It seems to imply that a family should try to keep its family business going and in the family’s control. Most business families, themselves, have this attitude. In fact, most seem to regard the sale of their healthy business, not just the failure of the business, as a sign of family failure. Jonathan Pellegrin will cure you of that misconception.

For almost 20 of the nearly 40 years I have spent as an academic and an advisor in this field, I, too, was largely focused on understanding long-term family company success. But then my focus shifted to the success and survival of the family. I came to see that we academics and advisors should be most focused on studying and helping business families to survive as economically productive and socially responsible groups. And business families should understand that to be their goal too. Jonathan Pellegrin called that one correctly long before I reached that conclusion.

Like most of my life learnings and shifts in orientation, I needed to be convinced by the data. And I was. If you observe family companies that survive generations, you will see that over time the industries these companies participate in change considerably, often abruptly, and sometimes the industries just go away. Some family companies have the resources, talent and interest to stay in the game as an industry changes, matures. Company size, relative size (compared to competitors), a strong balance sheet, and an innovative company culture, all backed by a persistent and loyal family ownership group, help a family company weather industry change and disruption. But there are a far more losers than winners when industries change and you have to know if you have what it takes to stay in the game and to prosper. Most families are slow in making this call, most overestimate their ability to compete well in the new environment, and some are delusional.

At the root of much of this poor decision-making is the noble attachment families have for their companies. Most families in business strongly prefer to stay in the industry game they know and to keep the company they have grown to love and are identified with. It’s not easy but certainly easier to exit a particular industry if the family company has more than one line of business and participates in other industries as well. Then, the family can exit a particular business where they can’t win, and stay in other businesses where they can compete, and their overall company can go on. For family companies that are focused on one line of business, the decision to exit an industry is usually excruciating because it usually means that the whole family company would go away. Their identity as caretakers of this jewel, their image in the community, and the welfare of people they care about, all threatened.

Timely sales of companies are also compromised by opposing interests in the family ownership group. One could choose to mediate these conflicting interests but most families choose not to.

If a family truly loses interest in the family company, it is emotionally easier to sell it. But very often a loss of interest in the company is accompanied by a lack of attention to it and the industry that it’s in. if an industry is changing rapidly, or if the family has not been persistent in reinvesting in its company, when the family is motivated to sell the company, there might be very little value in it.

These dynamics all play out in the movement of family wealth over generations. We all recognize the so-called Three-Generation Rule, expressed in many ways in different languages, that a family that becomes wealthy will lose its wealth in three generations. I have studied “family wealth paths” for over a decade, to test the above rule. According to my research, the Three-Generation Rule captures the experience of about 70 percent of all families. Some families lost their wealth faster than three generations. And some—perhaps 15 percent of all families—regenerate their wealth beyond the third generation. If you want to be on the Regeneration Path, you will follow this prescription.

Recognize that businesses come and go and you must shift the lines of business you are invested in if you want your overall family company to survive or if you want to survive as a business family. The more successful families I have studied shift from businesses that were declining (or they didn’t have the resources, talent or interest to continue them) to business that had growth potential and were a better fit for the family. Sometimes, families that stayed successful financially would sell their entire family company altogether, and reemerge in another company. Especially in today’s environment of quickly changing industries and shifting interests in families, you need to be prepared to sell at least one of your businesses, if not your entire family company. Pellegrin’s book will tell you how to do this.

What you do with the capital you earn by selling your family business also matters in many ways. Families that maintain their financial success mostly invest their capital together (as opposed to dividing it up among the owners to invest separately), they invest in business activities they understand, and they grow family talent to guide and improve their new business activities. Ultimately, they stay a family in business with a different kind of business.

Some people feel this advice—focusing on the growth of family wealth—encourages business families to be too financially oriented and not loyal enough to the work of the family. In response, I would try to persuade you that you can’t do good work of any kind without the financial resources or assets to support those activities. You also can’t keep families united and loyal to whatever the family builds without sufficient financial resources to motivate the family owners. You simply must keep a wealth perspective if you are going to sustain the good work you want to do.

But I would add the following: creating anything of lasting value involves being passionate about and attached to whatever you are building. You simply won’t invest the time, energy, and creativity into something if you are not attached to it.

I admit there is more than a touch of irony in my advice. But here is how you resolve this understanding of value creation: Attach to and nurture activities that deserve your attention and that will grow and return adequate rewards for your efforts. Then be able to detach from these same activities when you can no longer give them what they need or when your returns no longer warrant your good efforts. If you own a family business, there will come a time when you need to let it go. This fine book by Jonathan Pellegrin will explain how you do that.

Martha’s Vineyard
February 25, 2017