Only 30% of family businesses survive the transition from first- to second-generation ownership, and of those that do, only about half make it to the third generation, according to researchers at Baylor University’s Institute for Family Business.

There can be many reasons behind the failure of a family business to make it from one generation to the next, including a lack of viability of the business itself or the reluctance of offspring to join the company. However, the most common reason is the failure of current management to formulate a succession plan.

To be sure, lack of succession planning is a problem not exclusive to family-owned businesses, but its repercussions can be greater there than in other types of businesses. The demise of a family business can result not only in financial failure but in damage — sometimes irreparable — to family relationships as well.

In a classic work on family businesses for the U.S. Small Business Administration (“Transferring Management in the Family-Owned Business (PDF¹)“), Nancy Bowman-Upton described a family business as a “complex, dual system consisting of the family and the business; family members involved in the business are part of a task system (the business) and part of a family system.”

Because each system has its own rules, roles and requirements — the family system is emotional and stresses relationships and loyalty, while the business system is unemotional and contractually based — conflict may occur where they overlap. The most common flashpoint is the transfer of ownership/management.

While there is no guaranteed formula to prevent such a conflict, the most important thing a family business can do to stack the odds in its favor is to formulate a comprehensive transition plan, which is not always an easy task. It’s a unique management challenge because it deals with business, family, tax and estate issues while planning for the succession of both management and ownership.

Because transition must preserve the continuity of a business’s leadership, it is critical that the succession of ownership and management be structured as a process rather than a discrete event, and that approach must be clearly communicated to all affected members of the organization.

The owner of a family business contemplating an exit strategy has three main options (other than simply closing its doors):

• retain family ownership and management control;
• retain family ownership but not management control; or
• sell to a third party.

Ensuring the greatest likelihood of a successful transition plan under this option requires the formulation of four distinct plans:

• Business strategic plan — Allows each generation an opportunity to chart a course for the business and provides a clear picture of its future.
• Family strategic plan — Establishes policies for the family’s role in the business and addresses issues important to the family.
• Succession plan — Outlines how succession will occur and how to know when the successor is ready.
• Estate plan — This is critical for both the family and business to avoid paying higher-than-necessary estate taxes and to make sure the estate goes primarily to the designated heirs.

The succession plan is often the most problematic of the four. Among obstacles it may have to overcome are reluctance by the founder/owner to relinquish power and control, reluctance by family members to discuss issues related to siblings’ positions and their parents’ death, fear and uncertainty on the part of non-family employees, and over-dependence of clients on the founder/owner.

Overcoming those obstacles is best done through a four-phase process, according to Bowman-Upton:

• Initiation — A period of time during which the children learn about the family business, which should begin from the time the children are born, but can occur later.
• Selection — The process of choosing who will be the company’s leader in the next generation, which is often the most difficult step.
• Education — Training or education of the successor by a trainer (not necessarily the founder/owner) who is logical, committed to the task, credible and action-oriented, using a program that is mission-aligned, results-oriented, reality-driven, learner-centered and risk-sensitive.
• Transition — The actual transfer of power to the successor, which can be gradual or abrupt, but should always be timely and final.

If the transition plan calls for the family to retain ownership of the business, but pass management responsibility to a non-family member, much of the above process applies. Family members should be included in the formulation and updating of the business and family strategic plans, and an estate plan is still required. The main difference is in the selection and grooming of the successor.

In a study of career path definition and succession planning at 35 companies — including industry leaders such as Microsoft, Merck, John Hancock, General Electric and Motorola — Best Practices LLC, a leader in benchmarking research, identified aspects of the most successful approaches taken by those companies:

• Responsibility for career path definition and succession planning process design, execution and refinement is distributed rather than resting in a single individual (founder/owner) — Benefits of a multi-level approach include cross-checking of results, shared responsibility for results, sense of ownership of process at all levels, improved employee acceptance of process results and perception that employee development is positive and succession planning is fair.
• Set of key leadership criteria is established — These standards assist in identification of employees/candidates with greatest potential and are critical in the succession planning process.
• Screening to identify high-potential candidates and concentration of resources on future leaders — Formal succession planning reviews should be conducted at least annually, with informal feedback taking place on a continual basis.
• Measure results of career path and succession planning processes for both individuals and the company — This helps ensure alignment with goals.
• Educate employees about career planning and development opportunities. This promotes communication about career options and aids in identification of potential successors.

Opting to sell a family business to a third party eliminates most of the issues associated with succession planning, but it introduces other issues in the transition planning process. Chief among them are:

• Defining priorities — What do you want to get out of the deal, and what’s most important to you? Considerations might include all-cash vs. seller-financing deal, clean break vs. continued involvement (perhaps on a limited basis as a consultant), future treatment of existing employees, etc.
• Choosing the right time to sell — Points to consider include general economic conditions and conditions specific to your industry sector, current state of business, expiration dates of leases and key contracts, opportunities for tax savings, etc. It generally takes at least a year to sell a business once it is on the market, so planning should start early.
• Assembling a sales team — Members might include an accountant, attorney, business broker, appraiser, tax specialist and banker or other financier, depending on the size and nature of the business.
• Business valuation — Engaging the services of business appraiser or valuation expert is the best way to determine a fair and accurate value for your business.
• Finding a buyer — Finding and working with a business broker, creating a selling memorandum, marketing concerns, legal and ethical considerations are among the issues that might apply.
• Structuring the deal — Items that might be considerations include Letter of Intent, due diligence, buy/sell agreement, financing and closing.