Five Tips for Family Business Shareholders

Thunderbird Professor Ernesto Poza

By Ernesto Poza

In terms of wealth management, and in sharp contrast to the extremes that portfolio theory’s intellectual dominance has created in the definition of risk, the entrepreneur and family business owner will tend to keep many eggs in one basket – the firm. Family shareholders thus often depend significantly on their equity in the firm, much more so than shareholders who own heavily traded shares of management-controlled companies. And if they are not “in the know” because they are not involved in management, this dependence turns to a heightened sense of risk. Healthy adults resist blind dependence on people or things they do not understand and trust. But what can family business shareholders do about their dependence on an undiversified asset?

Financial literacy and committed ownership

Family shareholders expecting to fulfill their responsibility of aligning management interests with shareholder priorities and holding management accountable need a thorough understanding of financial statements. They must be able to make sense of what the numbers say about the firm and its competitiveness. Financial literacy is essential for every shareholder, not just those active in company management. Without it, family business shareholders can easily become just as indifferent or impatient, fickle and greedy as hedge fund managers and investors on Wall Street.

Family shareholders inactive in the business, with little understanding of management and the time cycles involved in new strategies or new investments, can hamper the company’s effective operation. They can bring about significant erosion of the founding entrepreneurial culture, which valued the role of hard work and patient capital and tacitly understood the benefits of owner–manager alignment. If family unity suffers as a result of this pressure by some family members for high financial returns and/or short time frames, a loss of will and vision may result.

Unless family owners can understand and accept what their returns will be in both economic (dividends, capital gains and career opportunities, for example) and noneconomic (purpose, status, family unity and philanthropic opportunies, for example) terms, a family business may lose one of its precious sources of competitive advantage. In the longer term, family-business continuity may be abandoned in favor of immediately recapturing, via sale of the company, the value created by previous generations. Sounds like hedge funds and Wall Street, doesn’t it?

What responsible shareholders do for a company

1. Define what constitutes reasonable financial and nonfinancial returns on shareholder equity or invested assets and then demand those returns of top management. Define the rest of the owning family’s strategy (separate from the company’s strategy) and communicate all owning-family priorities to management and the board of directors.

2. Act as co-architects of family unity and a win-win, trusting family culture. This represents a significant contribution to the preservation of patient family capital.

3. Provide the values and principles of doing business and ensure they remain instilled in the company. Values might include independence through low debt-to-equity ratios, continuing entrepreneurship and a strong work ethic.

4. Develop, pre-emptively, approaches to shareholder liquidity through buy-sell agreements and an internal stock market. Responsible and loyal shareholders are more likely to remain so when they know they could exit under agreed-upon circumstances. And those who prefer liquity options will exercise them and not erode the commitment of others through resentment of their forced loyalty.

5. Design and execute an ownership structure that preserves speed, agility and customer orientation. Shareholders can recapture some of the value created in the form of good shareholder returns only when businesses are capable of creating value for customers by delivering better and faster products and services while maintaining a closer relationship with them.

Ernesto Poza is a clinical professor of global entrepreneurship at the Walker Center for Global Entrepreneurship at Thunderbird School of Global Management in Glendale, Arizona.