Avoiding entrapment in the family business

With an estimated 65 per cent of all family businesses having two or more generations working in them, it is vital to ensure that the older generation avoids entrapping younger family members in the business.

Andrew Mattner of Adelaide accounting firm Hattam McCarthy Reeves warns that in any generational transfer of a family business, there are numerous factors that create barriers to success and conflict between individuals. These include:

1. The need to balance family concerns and business interests.
2. Adequate compensation of family members working in the business.
3. The ability of the business to generate adequate financial returns to support the family.
4. The level of trust in the ability of potential successors to run the business.

However, in his experience, the issue that causes the greatest level of conflict - and which is perhaps the greatest barrier to success - is the third issue.

“When this occurs one of the common results is a symptom that we define in our office as ‘entrapment’,” he says.

“Entrapment in a family business occurs when the older generation employs family members in the business at lower than market rates on a promise that one day the family business will be theirs. Normally this occurs in underperforming businesses that are unable to financially support multiple generations or have not generated sufficient return to enable the older generation to step away in the comfort that they have sufficient ‘off-business’ assets to retire.

“Unfortunately, in a lot of circumstances, entrapment not only leads to the destruction of the business, but also to the destruction of the family.”

Mattner says this is because entrapment has the potential to:

• Create significant conflict between generations working in the business.
• Create conflict between siblings (between those working in the business versus those that are not when an untimely death occurs).
• Create a “lazy” business that ultimately becomes financially unsustainable.
• Create a knowledge “black hole” where the entrapped children are unable to financially support the educational needs of their children.
• Lead to further generations walking away from the family business because they do not want to do what their parents did. (There is significant evidence of this in the rural sector as evidenced by the diminishing number of children electing to stay on the farm).

“There are countless examples of families that have managed this situation well and just as many that have not. Unfortunately for those that have not managed it well, so much damage is often done that it is difficult to repair,” says Mattner.

However, he says good family governance can help to help resolve this problem as it generally creates better communications. “This could include having a formal board or advisory board for the family business, obviously depending on size,” he says.

He also suggests introducing the following:

• An agreed and adhered to meeting structure.
• A family constitution. While not legally binding, it outlines how family members agree to work with each other in business.
• Open communications. Because this does not always come easily, some external facilitation may be required.
• Formal job descriptions and employment contracts for family members.

Mattner adds that the family needs to clearly set the rules at the outset of any arrangement and to have clear business strategies and financial plans in place. It should also ensure there is a clear transition plan in place that is agreed to and communicated to all.