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The company had a reputation of being progressive and hard charging. They were dominant in their markets. Unfortunately, I soon discovered the reputation had tarnished. The company was undergoing tremendous growth challenges due to acquisitions, operations restructuring, and adapting to a significant change in size and complexity. They were crossing the 100 million in sales threshold. Their problems, to me, were not unique as I was coming from a Fortune 100 corporation where dealing with size and earnings issues was well understood. For the family, however, the problems were new and different and quite taxing.
As a new member in a new function, I rolled up my sleeves and helped wherever I could. After a short time of getting to know the organization, I assembled a team and went to work on areas of gain that were obvious to me but not to the existing family management. Over the next few years, I and my team contributed significantly to the corporation’s bottom line. Our contribution was documented and presented to executive management at the end of each fiscal year. In one year, we were responsible for over a third of the rebound in operating earnings. Because of this, I was confident of my ability to get substantial salary and bonus increases for myself and my team.
My confidence was short-lived, however, when I found that the existing family ownership was content to reward with cost-of-living adjustments and bonuses based on past formulas. In short, the pay did not match the performance and that is where my trouble started. What began as an optimistic relationship with great promise deteriorated and eventually led to my resignation.
During my exit interview, I discovered two immutable facts of the family-owned enterprise. First, I was flatly told that my salary and bonus were “more than several family members.” And second, I learned that the family was greatly embarrassed that an outsider, with limited experience, could come into the organization and succeed where many family members had been unable to achieve similar performance.
Over the years, in my consulting across some four dozen distinct durable goods channels, I have discovered similar stories. That is, the professional manager comes into a family business, makes changes that drive performance, and resigns in a few years due to lack of authority and pay commensurate with accomplishments. Many positive things can be said about family-owned businesses, but this phenomenon owes to some of the less attractive traits of family ownership, i.e., preferential treatment for family and lack of desire by family execs to maximize earnings. My overall impression is that many family-owned business – certainly not all -- suffer poor earnings because of a priority to protect family members who are less qualified than they ought to be in their positions. This was a significant reason for my migration into consulting. I couldn’t fathom why a professionally trained manager would want to work for a family-owned enterprise where income potential, career progression and pace of growth was limited.
My opinions about family management, however, has taken a new turn that was catalyzed in large part by two different studies that have recently been released to the management public. The first study, done by faculty at Harvard Business School and several leading business schools in Europe, is titled, “Matching Firms, Managers and Incentives.” It is a working paper studying the relationship between compensation and managers at public versus private firms.[i] The other study, “Outside and Inside hired CEOs: A Performance Surprise,” was published last year by two faculty members at Florida State and Mississippi State, respectively.[ii]
The Need for ControlIt is generally accepted that in a family business the family gets the largest chunk of compensation and non-family employees get something less. The HBS study contends that the primary reason family firms pay lower salaries to non-family members and sometimes hire less talented managers is that they “…attach a higher value to control at the expense of profits while managers only value profits…”[iii]
In essence, the family firm often opts for control over top quartile profitability. Why? Experience says that the family firm, especially after several generations, has many family shareholder interests that create a desire for steady growth versus more risky but greater profits. This “need for control” and compensation disparity hampers the ability to hire and keep outside managers. It also penalizes closely-held firms that outgrow the ability of family to manage the organization.
It has been our observation that somewhere around the $100 million sales level, the family distributorship begins to struggle with the size and complexity of the business. Our observation also is that by $200 million in sales, there are often many functions manned by talented outsiders with specialized skills. The issue of size and complexity drives the family-staffed firm to seek managers with more advanced educations and demonstrated abilities from more complex and higher growth firms.
To get outside managers, family firms must change their attitude toward compensation. From the HBS study, “the power of incentives is positively correlated with managers’ risk tolerance and measured ability and where incentives are more powerful managers exert more effort, are paid more, and are more satisfied…”[iv] This is commonly accepted logic. However, it is important to realize that there is little hard empirical evidence that would support the statement. The upshot for family-owned distribution businesses that are growing in size and complexity is clear.
If the desire of family shareholders is to grow the firm and deliver superior earnings, the family will need to temper their need for control, hire outside managers who are demonstrated performers, and pay them according to their compensation expectations in non-closely held businesses.
Sadly, it has been our experience that many families run the business too long with family members who do not have the skill sets to manage complexity. Thus, the business, over the course of time begins to weaken. Top line sales may grow but the ability of the firm to fend off aggressive competition, drive superior profits, and develop efficient growth plans suffers. While hiring functional managers from the outside is often the best way for the family to grow the distribution firm, there is a real challenge in filling the top slot of the CEO that requires careful planning and selection unlike that of functional managers.
Picking the CEO for the Large DistributorSeveral years back, I was called to review performance issues of a $500 million distributor of industrial and construction supplies. There were noted weaknesses in the firm but most evident was the lack of a strong President/CEO. The existing family member who occupied the position was over his head and it was obvious to the Board that a change had to be made.
The Board reviewed internal candidates and, not satisfied with their options, recruited and landed a candidate from outside the industry. The new CEO lasted 18 months and drove the performance to new lows. What happened? There were simply too many employees who distrusted the CEO and felt his ideas and plans were not founded on common industry practice. The new CEO began a campaign to replace the managers who would not support him and, in hiring professionals who thought as he did, he further undermined support of the rank and file, eventually leading to his ouster.
The working paper, “Outside and Inside Hired CEOs,” gives a fascinating comparison of hiring the top slot from outside or inside the company. The study viewed public firms over close to a 20-year period and their performance in hiring the top spot from the outside or from the inside. The results were a surprise to many. Internally selected CEOs were responsible for a 25% greater financial performance than outside hires.[v] Furthermore, the study found that external candidates delivered comparable performance with internal candidates only when they were hired from the same four-digit SIC codes of the business in question. Hiring from the same two-digit SIC code resulted in lower performance. It is important to remember that the research regarded the top slot in the company and not other managerial positions.
Implications for the Large Distribution CompanyAs the distribution firm exceeds $100 million in sales, the complexity of managing the business often exceeds the ability of family members. Generational family businesses often have a need for control and measured growth and tend to hire managers who are competent but not necessarily capable of running a large organization. At the point where the organization becomes a struggle for family members, the firm will need to carefully select outside professionals who are leaders in their position(s). Also, the family shareholders will need to pay these managers commensurate with what they can earn in outside positions at companies that are not closely held.
For the top spot in the organization, family shareholders should, if at all possible, carefully groom a CEO from the same industry and within the firm. Hiring a CEO from the outside and not in the same industry typically results in significantly less financial performance. Outside hires within the four-digit SIC code are found to be most effective. The careful planning of the CEO position is a responsibility of the Board and, for a large distributor with numerous shareholders and obligations, there should be a well-defined backup plan for developing an internal candidate.
As the family distribution firm grows, challenges to existing pay scales and planning for transition of the top spot are crucial for the family to maintain controlling ownership of the firm. Many families end up selling the business because of failure to understand these transition issues. With a proper understanding of how to pick and reward professional managers and groom the CEO position, it is possible for closely-held firms to perpetuate their ownership and drive superior performance.
References[i] Bandiera, O., Guiso, L., Prat, A. and Sadun, R. “Matching Firms, Managers, and Incentives” Working Paper 10-073, HBS, 2010.
[ii] Ang, J., Nagel, G. “Outside and inside hired CEO’s: A Performance Surprise,” Working Paper Series, November 2009.
[iii] Bandiera, O., Guiso, L., Prat, A. and Sadun, R. “Matching Firms, Managers, and Incentives” Working Paper 10-073, HBS, 2010, ppg. 32-33.
[iv] Ibid, page 33.
[v] Ang, J., Nagel, G. “Outside and inside hired CEO’s: A Performance Surprise,” Working Paper Series, November 2009, page 6.