Working with family-owned businesses is deeply rewarding and challenging. What makes it so special is the unique blend of economic and emotional factors affecting decisions made by the owners. To be successful, advisers must be able to offer both a rational, economically sound approach to decision making and empathize with owners' complex motivations.
Perhaps the most difficult business decision that the owners ever have to make is whether to sell the business. We see situations often in which the family has an opportunity to sell a successful but plateauing business, or to exit a struggling one, but hangs on instead. By the time the owners finally decide to get out of the business, value has dissipated, confidence in management is lost and relationships are in crisis.
So why are family executives, and even family members not directly involved with the struggling business, so slow to make decisions? And what can advisers do?
First, advisers can help owners develop and implement an effective performance measurement system. Too often, operating income is the primary — or the only — measure of the business unit's performance. Even if income and cash flow are trending downward, as long as operating income is positive, the business often is left alone. The problem, sometimes years in the making, becomes apparent only when operating income turns negative. By this time, it may be too late or too costly to take corrective action, but the executives, feeling both surprised and guilty, resolve to fight an uphill battle.
Statistically, their chances are not good. Therefore, some basic quantitative measures — for example, return on invested capital — must be available to the family owners on a continuous basis so they can monitor the health of the businesses. An effective business performance system reveals a problem early on, pointing to probable causes and possible solutions.
Second, advisers need to offer the family an objective decision-making framework. Without this, the family cannot distinguish between a strong turnaround candidate and a business that has become a liability.
Finally, advisers need to help the family owners sort out their emotions about the business. Some motivations — e.g., loyalty to non-family employees or executive employment opportunities for current and future family members — may not appear economically sound from an emotionally detached, value-maximization perspective, yet they are crucial and must be respected.
While emotions play a key role in the selling decision, owners and executives often cannot articulate the tangible or intangible benefits sup- posedly outweighing the financial losses associated with the struggling business. What we hear is: “This business deserves another chance.” Or simply: “We need to try harder.” These answers reflect a belief, deeply rooted with many business families, that an exit — in any form — would be an admission of failure.
LOSS AVERSION BIAS
Advisers must recognize that there's a bias at work here that's well-known in the field of behavioral finance — the loss aversion bias.
Daniel Kahneman, the Nobel-winning economist, and his colleague, Amos Tversky, convincingly demonstrated in their research that people are more motivated by the prospect of loss than by the promise of gain and thus are willing to accept an ever greater amount of risk in the hopes of “getting even.” This explains, to some extent, why people commonly hold underperforming investments far too long, in the misguided expectation (or hope) that they will rebound.
There is a second bias at work. Family executives tend to think of themselves as smart and experienced. Certainly, they have succeeded where others have failed. If they become overconfident, however, they develop a distorted perspective, allocating to the business more resources than it deserves.
Both biases are deeply rooted in human nature. Unfortunately, they also lead to decisions that are suboptimal. As trusted advisers, we must try to help business families overcome these biases so they can make the best decision.
Obviously, exiting the business is not always the right solution, and there are businesses that stay in the same family for generations. Yet in some cases, to preserve the value for the family and open up new growth opportunities, timely exiting could be the right strategy. If done in the spirit of stewardship, an exit is not a failure, but should be celebrated as an enduring achievement.
Ari Axelrod is a partner at Banyan Family Business Advisors LLC.