The G2G goal frequently fails, and this article explores the challenging mathematics underlying the failure. Understanding the inevitable challenges results in better planning, more realistic expectations, and more likely G2G success.
Research indicates that the G2G transition risk is one of the biggest risks facing a family business. Management is certainly part of the challenge but another barrier faces multigenerational family businesses. The rate of annual growth is simply not sufficient to fund distributions and reinvestment over many years.
“Only 31% of businesses survive to the third generation. Other studies estimate that only 30% of family firms survive the shift to the second generation, 12% in the third generation, and only 3% make it to the fourth generation or beyond.”
Many business owners remain active well past 70, placing additional challenges on multigenerational success. They tend to have larger families and their children tend to have children earlier. For these reasons, maintaining a family business over many generations requires astutely managed operations, prudent distribution management, and careful personal budgeting for each generation’s spending.
Many Cooks in the Kitchen
Running any business is complex. As new family members take active roles, complexity increases. Each generation exponentially increases the number of children and consequently the number of owners of the company. With three children per family, the business will have nine third generation owners. Owners from the previous generation and each owner’s partner will be direct or indirect contributors to the decision making process, increasing the number of owner decision makers to 24 people. The coordination of important business matters among 24 decision makers will lead to slower and less effective decision making, which has a negative effect on company growth.
How Much Growth is Enough
What rate of growth is required to fund multigenerational family businesses? We need to make a few assumptions about retirement age, average number of children, average age to have children, inflation rate, and retained earnings. We also assume that subsequent generations will spend an equivalent per capita as the founding generation.
Retirement, children, growth, and distributions are interrelated. An average retirement age of 70, coupled with an average age of first childbirth of 30, means each generation will have 40 years to grow the business so the subsequent generation can enjoy an equivalent spending power. For three children, the business profits in today’s dollars will have to triple each generation or every 30 years. After adjusting for inflation, the business must grow at a compound annual growth rate (“CAGR”) of 7.7% to sustain each generation.
This baseline growth requires significant investments in assets to expand the company. A typical reinvestment rate of 50% of earnings is most commonly observed, but an analysis unique to the business is needed to establish more concrete asset investment requirements.
Assuming a starting net income of $200,000, it must grow to over $17 million by the second to third generation transition and $158 million by the third to fourth generation transition. Most businesses by then will have reached stable operations, leaving children and grandchildren with relatively lower wealth and income.