The Challenge of the Third Generation

By Peter Davis

"Three generations from shirtsleeves to shirtsleeves," Andrew Carnegie commented on the tendency of families to squander their wealth in a relatively short span of time. There's a message in that for business owners.

One of the most difficult transitions that a family business must make is from the second to the third generation. It's not just that the third generation, accustomed to wealth and privilege, is likely to spend the business into bankruptcy. They also have a very difficult time getting their acts together and providing the leadership necessary for the business to survive.

In the third generation, there are typically many more family members who would like to work in the company. The cousins have grown up in different households and may have far different styles and points of view. There may be extremes of personality and huge disparities in competency as well as in financial need. There may also be lingering feelings of competitiveness or memories of past injustices carried over from the second generation.

The seeds for a successful transition to a third generation are sown early in the company's history. As he builds the business, the founder sets a tone for family involvement that is usually well established by the time his children take over. The tone in most businesses usually falls somewhere between two extremes: the family-first culture and business-first culture.

In "family-first" businesses, family needs are primary. Business decisions that might generate family conflict are avoided. Members of the second generation are paid equally and share in all key decisions. Family ownership is zealously guarded and nonfamily managers tend to be regarded as "the help." If the company has a board of directors, it is likely to consist of family members who gather informally, perhaps with an attorney or accountant.

At the other extreme are "business-first" family businesses, which let children who want to work in it know that they must measure up to company norms and values that are above the needs of the family. The children may be told that they can't work in the business unless they are at least as good as professional managers, and that they will be paid for the job they do rather than who they are. In a business-first company, nonfamily members have considerable power and influence. The company is likely to have a board of directors with people from outside the company on it that meets regularly in formal sessions.

The family-first businesses in the United States are common among certain ethnic groups — Jewish, Lebanese, Italian, Greek, Latin American — that give the family a central place. They tend to be small, personalized businesses — like real estate concerns, jewelry stores, and restaurants — that depend for their success on the family's hard work and entrepreneurial energies.

By contrast, business-first companies are more often found in Calvinistic cultures that place a high value on institutions and the free enterprise system. The most successful large companies that are still family owned, such as Cargill and Bechtel, are all business-first companies.

The tilt toward one or the other end of this spectrum shapes the survivability of the business. In the family-first business, the kids in the second generation are set up as active partners. They trust one another, communicate easily on business matters, and generally have more drive and savvy than anyone they can recruit in the job market. Early on they get the message from parents that they must work together and resolve their conflicts.

Typically, the family-first enterprise is a brilliant success in the initial phase of second-generation management. The business is still growing and the excitement about that growth sustains the partnership. Mother may still be around to moderate any conflicts that arise. The spirit of "all for one and one for all" is so deeply ingrained that it would be embarrassing and painful for any of the partners to cut out of the business.

The difficulty with these partnerships is that it is hard to keep them alive once the glory days are over. After a honeymoon period, the partners enter a more realistic phase in which they may realize that one or more of their group has serious shortcomings. They may be stuck with a lazy brother or another who is a loudmouth. At about the same time, spouses may begin to assert themselves. As the in-laws insist on larger roles for the spouses in the business, they may drive a wedge between the partners.

In the next phase, the deficiencies have become ever more real and aggravating. Disillusionment sets in. The partners spend much time apart from one another and have difficulties in coordinating their business activities. Their willingness to discuss and negotiate is limited. The partnership is held together more by the fear of an embarrassing breakup than by the desire to work as a team.

As the older generation's differences grow, the children now enter the picture and become an even greater force propelling the partnership toward breakdown. One partner can't stand his brother's son, who thinks he's a big shot and doesn't have to work. Another resents having to train a partner's incompetent daughter. In some businesses, the partners can manage anything but the entry of the children into the business.

Besides their own differences, the third generation may bring with them the unresolved problems from the second. One partner may have felt that he was always treated as an inferior by his brother. As a result, his son may carry the grudge into the next generation and be overly aggressive on issues involving power and responsibility in the company. He says, in effect: "I'm not going to be treated like dirt as my father was."

So in the worst of all possible worlds, the old partnership is dying just when the third generation is struggling to build a foundation for their own working relationship. They can seldom work it out by themselves. Their parents get embroiled in their disputes and an intergenerational tug of war ensues. At that point, a large percentage of these businesses fall apart.

If family-first businesses are to survive, each generation must negotiate the terms of its partnership separately. The second generation must revitalize their partnership and reach the accommodations necessary to launch the third. Members of the third must reach their own understandings on decision-making authority, pay, and methods of resolving conflicts — but, again, that may not be possible unless their parents cooperate in planning succession.

In the business-first firm, thesuccession process is morereliable and more structured. The basic rules are put inplace when the companymoves from the first generation to the second. Ownershipis separated from management. The board of directorsparticipates along with familymembers in defining and developing the rules of passage.

Business-first companiesmay be somewhat more bureaucratic than other family businesses,but they are more stable and usually do abetter job of managing succession. Themajor challenge for these companies isdealing with the family problems thatoccur because of the priority given tobusiness considerations.

Children who are not qualified to work in the company and are denied jobs will suffer from feelings of rejection. Even if they share in ownership, they may feel cheated. When the business is growing, any surplus may be reinvested in the company rather than distributed as dividends. Family members in the business have an opportunity to earn higher salaries as the company grows, which may create envy among those who do not work in it. Moreover, in a business that promotes people on merit, one sibling may be taking orders from another, even from a younger brother or sister.

The stresses created by these differences in status and wealth are justified only if the goals and traditions of the business seem worth it. If the family feels that perpetuation of the business is important for reasons other than money — to maintain jobs for loyal employees or to enhance the family's reputation and influence — they have an extra incentive for working out their difficulties. But if the business creates too much friction in the family, some members may choose the simpler way of securing their futures selling their shares; or, if enough of them are fed up, they may sell the company.

According to one study, only about 10 percent of all family businesses will make it into a third generation. With the exception of a few types of smaller entrepreneurial businesses, those that succeed in making the leap usually adopt a business-first philosophy during the transition.

It is up to the second generation to see that a viable set of operating rules and procedures are worked out during the process for managing the company and employing family members. They must establish a board of directors to oversee the business according to agreed-upon criteria and codes of conduct. To maintain unity, they must see to it that all branches of the family feel they have an opportunity to participate fully.

Without a good plan and a clear goal toguide the family's participation, furthersuccess may be impossible — and somefamily members, faced with decliningfortunes, may return to the founder'sshirtsleeve beginnings.

Peter Davis, chairman of the Family Business advisory board, is director and founder of the Division of Family Business Studies at the Wharton School, University of Pennsylvania, where he and his staff educate and advise family firms on critical issues.

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March 1990

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