Many
years ago, I worked in a sizable family-owned distributorship. My goal was to
gain experience in helping the company go to market using modern principles of
sales and marketing. The position and
its duties were unique and I was afforded the opportunity by a progressive
family member who wanted to use advanced marketing theory and practice to drive
the firm.
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 Control
It
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 Distributor
Several
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 Company
As
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.
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