Family business: Moving beyond myths to best practices

Founded in 578, Kongo Gumi in Osaka, Japan, is the oldest known family business in the world. The family was of Korean origin, brought to Japan by Prince Shotoku more than 1,400 years ago to build the Buddhist Shitennoji Temple, which still stands. Since then, Kongo Gumi has constructed many famous buildings, including the 16th-century Osaka castle.

Today, the family continues in the general contracting business, with a special fondness for the niche market of building and repairing temples. Toshitaka Kongo, the 40th-generation leader, stated his intent is to name his son Masakazu Kongo as the next president.

What makes an “entrepreneurial family”? Being raised by entrepreneurs is the best predictor of success in an entrepreneurial venture. Of successful U.S. business owners, 67% were raised in families that owned business. Today, however, very few family businesses (only 12%) make it into the third generation, so if longevity isn’t the gold standard of a successful family business, what is? To help identify best practices, let’s pull together statistics from top research houses, including PricewaterhouseCoopers, to dispel five popular family business myths:

Myth 1: Family businesses typically are microbusinesses

In fact, about 90% of U.S. businesses are family-owned, and 20% exceed $25 million annually in sales, with 44% bringing in $10 million in revenue or more. Only 2% have annual sales of less than $1 million. If success is measured by return on assets, family businesses are significantly more successful than non-family businesses, with a 6.65% higher average return than that shown by non-family firms.

The top-performing family businesses share four traits:

  • Belief in ongoing strategic planning
  • Formulation of boards of directors or advisory boards
  • Willingness to embrace advanced technology
  • Commitment to continuing business education programs

At the heart of family business success is the wisdom to adopt best practices and put them to work.

Myth 2: Compensation packages for family members are higher than for other employees

As a general rule, in U.S. family businesses, compensation contracts and long-term bonus opportunities are standard, regardless of family affiliation. Cash bonus opportunities also show negligible differences. Where there is a bias, however, is in disability protection: 27% of family members may be covered versus 21% of key employees or general employees. The largest difference would be in salary continuation contracts, with 6% of key employees having a written policy offering coverage versus 12% of family members.

Myth 3: Owners plunder family businesses to serve family needs

Within the C corporation structure, which is what 55% of family businesses decide to form, 32% are able to pay dividends quarterly or at year-end. If there are retained earnings of $10,000 (for simple analysis), this is an average annual breakdown: 54% goes to profit, 25% goes to annual expected payouts, 18% is reserved for cash flow, and only 3% goes toward family needs. In S corporations or LLC formulations, 53% typically is held back for taxes, with 13% reserved for cash flow. An average of 5% is held for constant payments due, 24% is claimed as profit, and 5% goes toward family needs. However, those tend to be smaller companies than C-Corps, and 5% of $1,000 is far less than 3% of $10,000. There is always a minimum expectation of return on family investment.

The most successful family business owners don’t take a dime out of their businesses, even to compensate for work completed by a partner, until hitting a set earnings/retention formula that guarantees the business will continue to operate debt-free for six months, with adequate cash flow to meet all payables on time. That’s one measure of success.

The second is a formula for the owner’s worth. For 63% of U.S. business owners, at least 50% of their net worth is tied to the business via personal guarantees or loans to the company, which should be paid at the time of dissolution or transfer. If you can maintain a lower margin, given the recent recession, then that healthier margin will signal when or how much of a cash disbursement to take. Consult a tax expert to maximize retained earnings.

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Myth 4: Health care is the hardest challenge for family business owners

Nope. Corporate and personal tax law is the most onerous burden, with a whopping 68% of family business owners citing it as their greatest headache. Following that are the cost of health insurance (55%), potential employment lawsuits (50%), environmental codes (49%), increasing competition in a global market (48%), compliance with government regulations (46%), labor and wage costs (31%), and a lack of qualified employees (29% but rising sharply, and it may even hit 50% this year).

If you are worried about tax law, be proactive. Best practice: Have your bookkeeper scan all invoices, deposit slips, and receipts and attach them to your entries. Use QuickBooks or another standard accounting software system also used by auditors, and have your transactions monitored monthly by a tax specialist.

Myth 5: Most business owners have a formal succession plan

Here’s a look at business succession plans now in place for U.S. family business owners: Never retire (11%); semi-retire into perpetuity (23%); retire with potential co-CEO named in next generation of family (26%); retire, but no designated leader in ongoing business (40%).

An encouraging 91% of family business owners expect their businesses to remain in the family for at least the next five years, though only 44% have a formalized, written succession plan. And of those 44% who do have a formal plan, only 65% have shared that vision with company management. Reflecting the difficulty of maintaining a family business across generations, 34% of companies expect to bypass their families altogether for succession and sell to key employees or outsiders.

Regardless of the succession intention, for the optimal transition, you should plan early and in an orderly and open way. If possible, entrust selection of your successor to a truly independent and knowledgeable outsider who knows the company and has observed the candidates at work. Likewise, pick an outsider with no axe to grind so that the ultimate decision can be fully respected and honored by all.

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