A new book, just released by Harvard Business School Press, contributes substantially to our understanding of how the family business grows and changes over time. “Generation to Generation: Life Cycles of the Family Business” provides models for the transformations that occur in a business-owning family as well as in the business structure itself, as both age and mature and plan successions in leadership. The authors—John A. Davis, Kelin E. Gersick, Marion McCollom Hampton, and Ivan Lansberg—are leading figures in the field and frequent collaborators in their consulting.
One section of “Generation to Generation” analyzes three stages in the growth of a family business, from start-up, to the expansion/formalization phase, and on to the mature business. We present here a case study from the book (based on a real company, but with fictionalized names) about a music company that is wrestling with all of the issues and choices in the expansion/formalization stage. This is the critical phase during which the business is hiring outside professionals to help the family manage a growing organization and seeking infusions of capital to take advantage of new opportunities.
Sarah Greenberg had been passionate about music her whole life. It was a strange choice for the daughter of an accountant and a tone-deaf real estate broker, but her focus had been unwavering—through childhood piano lessons, an undergraduate degree at Oberlin, several jobs at record stores, her own radio show, a stint as music reviewer for a city newspaper, and, later in life, a master's degree in music theory and composition at Columbia. Stimulated in her master's program by more academic perspectives, Sarah decided to combine her interest in music with her long-term entrepreneurial inclination to start a business. Her firm, ProMusic, would be a resource for composers, teachers, and performers, with several lines of business: providing rare recordings by direct mail, offering online research on composers and compositions, creating and distributing software to allow composers to score and orchestrate their compositions via computer, and (her real dream) operating a small recording studio.
Upon researching the opportunity, Sarah found no competitors in her niche except for music stores and libraries, which were unresponsive to customers' needs for speed and specialized expertise. She put together a business plan and talked to family and friends, raising some initial capital to create the first business line: a direct mail catalogue for rare recordings. Sarah, her husband, Aaron, and a graphic artist worked for several months to design a vehicle to let their target market know about ProMusic services (which did not yet exist) and order specialized recordings, each of which was reviewed briefly in the catalogue by a specialist. At this point, they also had no inventory. Sarah's plan was to fill orders through a special rush arrangement with distributors she had located, who were willing to provide this service at a discount price to ProMusic in exchange for what they saw as free marketing and potential higher sales volume for their merchandise.
Sarah spent most of her $50,000 start-up money on the catalog, then crossed her fingers and waited. The orders rolled in, and over the next two years, the company made a small profit on sales of about $250,000. They opened an office, developed an information system, and began to stock inventory. During this start-up stage, Sarah felt busy all the time with the company. Aaron picked up the slack with their two young sons, and Sarah waited for things to calm down. She had no idea that the stress would get worse, not better, as the company grew.
When it was clear that ProMusic was a going concern, Sarah moved quickly to grow the business. The family moved back to the New Jersey suburb where Sarah had grown up. She opened a retail record store, created a consulting and information service via online links to publishers and distributors for specialized services, and bought a small recording studio. Each of these new divisions had its own general manager, but none of them made important decisions without checking with Sarah first. Sarah intended to have weekly meetings of her executive team, but travel and work demands made that very difficult. She hired office, research, retail, software development, and studio production staff. They were growing; however, costs were also growing, and because they still weren't making much money, the company's balance sheet performance was declining. Every two years, Sarah would put together yet another business plan that laid out the need for several million dollars of capital investment. Each time she would make a connection with a publisher or venture capitalist with deep pockets, and each time she would come away from the deal with $200,000 or $300,000 instead of the several million she needed.
What Sarah found was that the potential investors wanted control, which she was not yet willing to give up. She also found that the projects that she liked—the retail store and the recording studio—were not projects that thrilled potential investors, because of their low margins. So she kept turning to her and Aaron's family for short-term operating loans, and the business bumped along without sufficient capital.
After 10 years Sarah was becoming discouraged and worn out. She closed the consulting business, which had never found its market and only broke even in its best years. The record store was about to be the next closure, until the manager convinced Sarah to move to a smaller location with a much more specialized jazz inventory, and focus on supporting the mail order catalogue.
Then ProMusic had a sudden and unexpected breakthrough. Sarah's software designers developed a product which was a major improvement on the programs currently in use. Before she had to worry about production, she received an offer from a major company to buy out that division at a very generous price. Sarah took the proceeds from that sale and purchased three recording studios in the metropolitan New York area. In the course of six months, ProMusic's cash flow doubled, Sarah could retire most of her debt to nonfamily members, and the prospects for the future looked much improved. Sarah immediately began considering new ventures, like producing CDs of local talent at the studios or sponsoring major musical events.
ProMusic is still in business, but in a form significantly different from that of its start-up years. Sarah has turned most aspects of the company over to professional managers. The retail store and mail order service have been combined into a separate subsidiary company with its own president. Sarah is chair of the board and continues to run the original recording studio. This decision reflected a fundamental change in her approach to the business. Initially, she made the decision to do what she wanted, rather than to please investors, and was happy to work hard for relatively low returns. She did not start the business to get rich, after all, and they were living a comfortable lifestyle in a place they loved.
After several years, though, she had become burned out. Each of the five product lines of the business required huge amounts of time and effort to develop. Sarah needed time to see her family and to have a life of her own. With the buyout of the software division, she was tempted to try again to run things herself, in all three directions at once. But with Aaron's help, she recognized instead that neither the company nor she could survive if she did not formalize the structure, hire senior managers, and begin to act more like the owner of a complex enterprise and less like a hands-on entrepreneur.
Especially in its early years, ProMusic did not sound like the typical example of a company in the expansion/formalization stage. What about all those high-tech companies that double sales each year? Some companies do grow that fast, but most family companies do not. The difference lies in financing and ownership. Start-ups headed for the fast track often go public to raise capital; after the initial public offering, the founders may retain a significant ownership interest, but the company is publicly traded. Family businesses must either rely on family investment or gain access to outside sources of capital. This puts many family companies in the position of ProMusic—ready to grow but constrained by the absence of investors who are willing to take a minority position. Thus growth proceeds much more slowly and is driven as much by reinvestment of the cash that the business generates as by significant outside capital.
ProMusic leapt quickly through the start-up stage, and then remained in the expansion/formalization stage for almost a decade. Sarah’s experience raises the interesting question that many owner-managers have to answer: What constitutes success? Is it sufficient that the business just supports the family? Is it sufficient that it satisfy the owner's professional self-image? Or is it necessary that the business bring significant positive change to the economic status of the family? Sarah was certainly hoping for the latter when they started, but she was happy to have the first and second criteria met. Let's consider the key challenges.
Modifying the owner-manager’s role and professionalizing the business. In the expansion/formalization stage, businesses typically evolve from a founder-centered structure to a more formal hierarchy with differentiated functions. At ProMusic, Sarah hired professionals in each business line—direct marketing (a graphic designer), consulting, retailing, and software development. The realities of diversification gave her little choice, even though she was uneasy with the way that decentralization diminished her direct control. Her challenge was to gain a strategic advantage in the specialty music services business—to establish a strong foothold in that market—by virtue of providing many products and services at once.
Ambivalence about delegating authority in the expansion/formalization stage often leads to some confusion or conflict, so that the professionalizing process happens in a “start-stop” pattern: hiring new managers, reassuming control, delegating again, and so forth, until the owner-manager gets used to the new role. In addition, the company must develop sufficient product quality and availability to meet customer needs and satisfy the growing customer base. Relationships with suppliers and customers are under stress, as cash needs have multiplied and products or services cannot always be delivered when promised. Accounting, information, and communication systems may not be sophisticated or fast enough to keep up with the company's increasing complexity. In this case, ProMusic had all the costs and operational needs of a retail enterprise, a software R&D firm, a production studio, and a direct marketing business.
Often, as was the case here, all this development must be done with insufficient funds. The owner-manager, who is watching the funds drain out of the account every month, is also spending a great deal of time and energy revising the business plan, locating potential investors, and trying to secure the funding that will allow more unencumbered growth. The time and attention of the owner-manager, therefore, is one of the key bottlenecks of the expansion/formalization stage.
Strategic planning. ProMusic exists because the Greenbergs' first line of business, the catalog, was a moderate success for the first seven years. This means that Sarah successfully identified a market and a service that the market would buy. She also had good ideas about other, complementary lines of business; however, her strategy consisted mainly of developing a presence in all the areas where products and services for music makers intersected. She did not consider the competitive advantages of ProMusic in the strategic environment of each business line separately, nor the benefits of a staged entry plan, nor the impact on the company of trying to develop all those business lines at the same time. Two of the five lines proved unsustainable in the long term, but for very different reasons: the retail store, because the margins were too thin, and the consulting business, because they could not develop a cost-effective marketing plan to target a specific customer base. Arguably, either of these businesses might have succeeded had Sarah been able to focus her management time and capital exclusively on them.
There are many opportunities for strategy formation in the expansion/formalization stage. Since the 1960s, a major theme in management science has been exploring the complex relationship between strategy and structure as companies grow and age. The key issue here is not which strategy is chosen (high volume, specialty market, cost or quality focus) or what type of expansion predominates (functional, multidivisional, decentralized), but rather that these are challenges that must be addressed much more fully than in the start-up stage. Owner-managers who restrict information gathering and analysis, and who resist critical reflection on the personal vision that sustained them in the earlier stage, will be working with a truncated range of options. This may well lead to a mismatch of resource investment with strategic opportunity or, even more likely, to a failure to see the new opportunities that are available in the expansion/formalization stage.
Organizational systems and policies. True to form, Sarah did everything herself in the early days. However, she moved very quickly to hire outside expertise for the specialized, value-adding touches that made the catalogue work—the graphic design, the short album reviews in the catalogue text, and the consultants for specific problems. The Greenbergs also built a computerized accounting and inventory system early in ProMusic's life. Thus Sarah began to move away from the hands-on management mode earlier than most founders do.
However, it took her almost a decade to move fully into a functional organizational structure and to set up integrative systems and policies. As the key resource allocator among the five enterprises, Sarah could not move out of the center until there were enough resources to permit full delegation. Unfortunately, neither internal nor external sources of revenue were sufficient to grow all the businesses comfortably, until the software company was sold off. The resulting cash supported a major jump in business system development, as the organization finally caught up with the needs of its diverse operations.
Cash management. ProMusic clearly acquired funds sufficient to make the business go in the start-up phase. Sarah invested her original stake wisely, and the first business provided enough cash to move the company into expansion in just a few years. However, Sarah still had to spend months of her time in the first 10 years trying to “sell” the company to outside investors. Had she been willing to make the company more commercially attractive by traditional business standards, Sarah might well have been successful earlier and at a grander scale than has been the case so far. However, she felt strongly about keeping control and was committed to a diversification growth strategy.
As a result, ProMusic had to weather continuous cash flow crises. She could never invest in people or systems fully enough and always had to fend off her family's needs for cash because of the constant need for reinvestment in the company. In the end, Sarah may conclude that it was her faith in the range of services that led to the software success and the dramatic improvement in her company's cash position. But Sarah is also a seasoned enough businesswoman to realize that this is no ultimate resolution. She has only moved up the line of business development, and ProMusic still faces critical choices on strategy and cash management at this point in the expansion/formalization stage.
Business development in expansion/formalization affects the family in a variety of ways. During the early part of this stage, Sarah continued to live the life of the entrepreneur, even though she didn't quite accept this identity and had a significantly expanded cadre of managers. She worked long hours, traveled away from her family, worried about the business all the time, went through periods when she did not sleep well, and, most painfully for her, did not have time to do other things she loves—rafting trips, camping, and extended periods in the wilderness. ProMusic took a heavy toll on her.
The demands of the company have also consumed Aaron. He is an active participant in the company—hardly a silent partner, as he sits on the board—but he works only part time. And he works, one feels, as much to stay connected to Sarah and her passion as to satisfy his own needs and interests. Early on, of course, he was working for free; now he is paid. An observer would speculate that the business has intruded into their marriage; they are connected now through the business, especially as the children grow close to college age. Members of Aaron's family of origin are still key investors, so his own and his sons' financial security is inextricably caught up in the company. It is tempting to wonder what kind of business Aaron would choose to run, if the pair had followed his dream instead of Sarah's.
The challenge for this couple, then, is how to maintain the marriage enterprise that they have chosen in the face of the entrepreneur's urgent passion for the business and the business's overwhelming need for cash and attention.
Sarah and Aaron are about to confront another family issue that sometimes appears when a company is growing—the potential entry of the children into the business. So far, neither of their sons has expressed an interest in joining Sarah, and she has not given much thought to the idea of passing the business along. After all, it is her dream, and one that she has not yet fully realized.
Still, the boys will be in college within two years, and she knows that they will all need to sit down and talk about whether there is room for either of them in the business. And the vision of her sons in college has also provoked a new round of anxiety about tuition. Although the boys will probably go to state schools, Sarah recognizes that her family is also facing significant financial needs, at the same time that the business has reaccelerated its growth and requires a cash infusion. She knows that she and Aaron must make major estate planning decisions, which she has avoided until now, in order to be sure that their family will be secure financially if she should die prematurely.
She is now more realistic about her own role and more optimistic about the prospects for the business. ProMusic has found a surprisingly solid niche in its current businesses, and has the opportunity to leverage modest, continued growth in the coming years.
-- J.D., K.G., M.M.H, & I.L.