Diversifying your family business helps to insulate you from risks

By James B. Wood

Many well-established family firms are seeking ways to generate new streams of income independent of the core business. Despite the longevity or success of the family enterprise, inherent risk is typically tied to the legacy business—which also happens to be where most of the family's wealth resides. What if there is a catastrophic business interruption? What if the supply shuts down? What if new technology or global competitors upend a once-defensible position? Your family may very well run a tight ship, but there are many real-world possibilities for disruption that are simply beyond anyone's control.

This is a common conversation among successful family businesses, especially from those who are thinking several generations ahead. There are many benefits to diversifying a legacy business and providing alternative streams of cash flow. Risk management is typically the driving force, but there are other reasons, too: preservation of long-term wealth, offsetting a cyclical industry, extending the enterprising legacy of the family, capitalizing on the family's unique ability to innovate.

Privately held firms actually have an advantage in innovation because of their long-term perspective on capital efficiency, which allows for the "patient capital" attitude of owners to tolerate longer return cycles. Public companies, on the other hand, are pressured by short-term investors to focus on projects that maximize quick returns while demanding high hurdle rates. These "tourist" shareholders (a term coined by Clayton M. Christensen and Derek van Bever in their article "The Capitalist's Dilemma," published in the June 2014 issue of Harvard Business Review) have no patience for investments that may be good but take a bit longer to become established.

If family businesses have such an advantage in long-term investing, why do we not see more active diversification playing out? What is holding back families from capitalizing on their own success? For many, it is simply a lack of expertise and direction in getting started. Looming questions arise: How do we evaluate industries or businesses we have no experience with? What kind of return expectations should we have? How much capital should we allocate?

The answers require some level of investment strategy, process and accountability, which most family businesses simply haven't developed because, well, they're far too busy running their existing business. While the core businesses may be firing on all cylinders, the risk of venturing into new territory can appear greater than the risk of sticking to what they know (which has plenty of its own challenges to deal with, thank you very much).

The fact is, diversifying into new business ventures is fraught with peril. Therefore, family leadership must have a clear, compelling and objective framework to ensure they are making good long-term decisions in the best interest of their current and future shareholders. Some families bypass this complication by parking their non-core investments in a third-party family office or private equity fund, leaving it to the experts to manage those choices. Many families, however, are uncomfortable with the passive nature of this option, preferring hands-on control, security and a sense of ownership over their new endeavors. All the more reason to take a systematic approach to ensure you get it right.

Diversifying your family business is certainly not an easy task, but it can be successfully accomplished if the following steps are applied.

1. Establish a clear and compelling vision for diversifying the business. Does your family vision statement tie the business to a single industry, or leave it open to grow from various sources? Despite your emotional attachment to the family business, it is nothing more than an asset representing a source of income and value creation. When families treat their business this way, they are more likely to acknowledge there may come a day when competitive pressures or capital requirements dictate the asset could create more value if it were liquidated and redeployed into higher-return opportunities. This may sound blasphemous to certain family members, but when you stop and think about it, your family business legacy is likely to be more about growing wealth than clinging to a specific company or industry, especially if it is struggling to maintain relevance, or is losing value.

Articulating a clear statement of long-term intent cements your family's commitment to enterprising beyond your core business, even if you are not sure what it might look like one or two generations from now. By raising the concept of "diversified enterprises" as a purposeful direction for the family business, you also gain enthusiasm and buy-in from shareholders who will now publicly stand behind it, even expect it. Something powerful happens by agreeing on a future aspiration, writing it down and then providing frequent exposure to that message. You will eventually make it happen.

2. Set the strategic framework and criteria. Once a vision is established, the next step is to fill in details around a strategy, which informs the type of industries and approaches you will take toward diversification. Start by casting a wide net around your playing field. What are you good at? What assets are currently underleveraged? What core competencies might be transferable to other markets or customers? This process taps into your unique capabilities to generate new, profitable sources of growth.

Next, layer in a filter of risk correlation. For example, would you prefer to focus on synergistic businesses, or counter-cyclical ones? Will you consider businesses related to your core enterprise, or do you want completely independent industries? An agribusiness firm historically dependent on one product driven by commodity markets decided to venture into alternative commodities that were historically uncorrelated to its core product. A newspaper publisher entered the travel and tourism industry with niche consumer resource publications. You could also go horizontally forward or backward in your supply chain, but generally that only ties the risk further into your existing industry. Obviously, the less correlated an industry is with your core business, the more you are truly diversifying risk.

Additional criteria to consider should include expected returns, industry growth rate, build vs. buy, geographic limitations and capital constraints. As you develop a strategic framework, get as specific as you can while leaving plenty of room for iteration. In the end, you should be able to look at it and see how it makes sense strategically. An example might look something like this: "We will pursue regional businesses in adjacent but counter-cyclical industries within the Northeast region that will provide returns similar to or greater than those from the legacy business."

3. Appoint a dedicated leader reporting directly to the CEO. Many diversification attempts either sputter or produce spotty results because they lack dedicated, focused, accountable leadership to see the mission through. A diversification initiative cannot be approached as a part-time gig with a "let's see how it goes" attitude. The pitfalls of approaching diversification as a side project of current management are two-fold: Either the core business sucks management back in, leaving insufficient energy for the diversification initiatives; or the shiny new diversification projects become a distraction, drawing management's attention away from the core enterprise.

Putting an objective leader in place can allow the business to cut through emotionally driven decision making—a weakness that family businesses are prone to that often leads to a hodgepodge of starts and stops that may or may not be consistent with the strategy. Once your investment criteria have been agreed upon, a designated leader operating separately from the core business can provide objective analysis of new opportunities and ensure that the family is focused on achieving outcomes rather than dabbling. If you are serious about it, put a competent individual in charge, and then structure the new initiatives to operate separate and apart from the core business.

4. Apply a process to narrow down the best choices. Now that a strategy and criteria have been set, a process is needed to evaluate new opportunities. All ideas should be considered from a variety of sources, as if they are being thrown into a large funnel, except now there is a screening methodology for evaluating the strength of each proposition. The more aligned with strategic criteria, the further down the funnel the business idea will go. There should be just a few gems coming out the other side. My initial work with a food manufacturing company generated a wide range of ideas: restaurants, trucking, machine fabrication, refrigerated warehousing and grocery retail stores, to name a few. After the process was applied, the only idea left standing was the refrigerated warehouse, which went on to become a substantial success for the family.

Despite the straightforward nature of this process, it is also where the family dynamics can get in the way, requiring management to remain disciplined. Does Uncle Charlie's friend's investment project meet the criteria? If not, no offense to Uncle Charlie, but toss it out. During this phase, one should expend enough attention to validate a fit with criteria, but no more than a first-pass level. An internal review board is helpful to vet ideas that make it through to more advanced stages, forcing justification and validation of the most promising proposals.

5. Develop the best ideas into a full-scale business plan. Here is where the viability of the business investment can be fully validated in great detail. This is no time for shortcuts or reliance on anecdotal information. Spend the time and energy necessary to develop a robust, data-heavy business plan with compelling market and financial justification, as if it were being pitched to an outside investment group. The business plan should cover typical components such as marketplace feedback, industry growth rates, prospective customers, competitive landscape and a financial pro forma. Ultimately, the business plan should clearly depict its unique strategic differentiator—why will you win? What makes it a compelling investment?

Finally, get outside feedback from a third-party expert in the industry who can provide an unbiased perspective on your plan's integrity and a critical view on its probability of success. A designated devil's advocate can provide a reality check on your assumptions around operations, market, customer, pricing and competitors. Even the most promising ventures will present challenges, so make sure you understand the minefields that will be faced.

6. Provide visibility and accountability. Once the new business plan has been vetted, critiqued and approved, now it's time to take the leap and launch. The business plan should provide a set of milestones for tracking progress, which also becomes an accountability mechanism to ensure appropriate oversight and course-correction when necessary.

Be prepared to evolve and iterate. Admit what you don't know and bring in expertise to help operationalize when necessary. Diversification can be a risky proposition, but given the right commitment, process and discipline, it can de-risk your business—and that is something your grandchildren will thank you for.

James B. Wood (jrwood9@verizon.net) has worked with middle-market family businesses for more than 25 years as executive, management consultant and board member. He is the author of The Next Level: Essential Strategies for Breakthrough Growth.

Copyright 2016 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permission from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.

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September/October 2016

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