1. Estimate What Portion of the Family’s Overall Wealth Is Represented by the Family Business
As we discussed in last week’s post, attitudes toward the benefits of diversification depend on whether one takes a “business” or “shareholder” perspective. When evaluating diversification opportunities, directors should have a clear understanding of which perspective they are taking and why. If the family’s wealth is concentrated in the family business, the “business” perspective will likely be appropriate. If, on the other hand, family shareholders have significant assets and sources of income outside the family business, the “shareholder” perspective is probably preferable. It is not unusual for larger families to have a mix of diversified and undiversified shareholders, in which case directors need to develop strategies for simultaneously managing the different shareholder “clienteles” within the family. Family shareholders may chafe at disclosing personal financial information, so this needs to be approached with some tact. First, keep in mind that this is not an accounting exercise that needs to tie to the penny: broad percentages are acceptable. Second, family shareholders may be more willing to be transparent with a trusted third-party intermediary who can collect, analyze, and present aggregate shareholder data on a confidential basis.2. Identify the Primary Long-Term Strategic Threats to the Sustainability of the Existing Family Business Operations
What are the risks of failing to diversify? Assessing the strategic threats to the family business can help directors evaluate the most fruitful avenues of diversification for the family business. We find the Porter framework to be a helpful way to think systematically about the strategic position of your family business. The Porter framework organizes strategy under the headings of five basic competitive forces.
- Threat of New Entrants. How easy is it for new firms to enter your markets? What protects your family business from competition by new industry players?
- Supplier Bargaining Power. Where does your family business sit along the value chain from raw material inputs to consumers? Is your family business susceptible to supply disruptions? How well could your family business absorb or manage a price hike from your key suppliers?
- Rivalry Among Existing Competitors. What factors determine market share in your industry? Why do customers choose your family business over competitors?
- Threat of Substitutes.Is your family business selling steak or sizzle? What are other (existing or future) alternatives for your customers to get their sizzle?
- Customer Bargaining Power.How diverse is your customer list? What does your family business provide that customers cannot get elsewhere and are, therefore, willing to pay for?
3. Establish a Family LLC or Partnership to Hold a Portfolio of Diversifying Assets (Real Estate, Marketable Securities, Etc.)
Depending on family dynamics, it may be desirable to set up a mechanism for diversifying inside the family, but outside the family business. A family holding company structure can deliver both family governance and estate planning benefits. Directors should understand that, from an estate planning perspective, one of the principal benefits of such entities is the ability to transfer wealth at the fair market value of an illiquid minority interest in the family holding entity, which is generally determined net of discounts for the lack of control and lack of marketability inherent in such interests. The use of such discounts for estate planning transactions is potentially at risk under the Biden administration, so it may be beneficial to move quickly.
4. Create Opportunities to Provide Seed Funding to Family Members with Compelling Ideas for New Business Ventures
Established families may be in a position to make seed investments in start-up ventures as a way to both reap diversification benefits and promote engagement on the part of rising next generation family members. This should not involve providing a blank check for every harebrained-scheme your shiftless nephew hatches. Venture investing won’t be right for every family. Moreover, successful venture investing is a disciplined, and occasionally ruthless, process of identifying, funding, nurturing, harvesting, and – often – pulling the plug on unsuccessful ventures. Not every family has the characteristics needed to manage an in-house venture fund, but for those who do, the rewards can be substantial.
Conclusion
Diversification is too important to keep putting off until next quarter or next year. Give one of our professionals a call to help you get started on knocking out your to-do list today.
