Take a lesson from the Rockefellers...

“Fortunes are made through concentration and are kept through diversification,” goes an old family business adage. The Rockefellers made their fortune from Standard Oil and kept it in ventures like Chase Manhattan Bank, Eastern Airlines and McDonnell Douglas. The Pitcairns went from Pittsburgh Plate Glass to real estate, airlines and their family-run Pitcairn Trust Company. The Phippses of U.S. Steel transformed their family office into a financial advisory business.

But how many other family companies actually follow that sage advice? From the Fords to Bill Gates, a brilliant idea has often spawned a vast family empire. As the business passes from the founder to the sibling generation and then to a cousins’ coalition, most families have continued to concentrate their wealth in the original family business.

Why is “diversification” such an alien word in many business family circles? To many families it’s tantamount to rejecting the family’s heritage. Diversification requires sacrificing precious cash flow from the family business to be invested in building other assets. In some cases, it may even require sacrificing a slice of ownership to outsiders in order to free up funds. Business-owning families tend to want to preserve the family business to the detriment of preserving or growing the family wealth. The family business has been the “baby” for many generations. It required so many sacrifices, so many efforts, so many risks to evolve into the family’s primary “cash cow.”

But the bottom line is this: The family grows faster than the business does. And succession, liquidity needs of shareholders and wealth return expectations can often prevent the smooth passage of a single business through the generations.

So consider some compelling arguments for spreading the family wealth beyond the family business:

“Stay rich to get rich,” goes another old saying. The stock market slump during the last two years has provided a rude lesson for many families with all their eggs in one basket. Even owners of private companies have seen the value of their businesses diminish commensurately with the decline in public-market value.

Contrary to the false lessons of the high-tech ’90s, building family wealth is a long-term process. It requires vision, heritage and long-term strategic investment decisions. Any large fluctuations of value can jeopardize the long-term investment strategy or even the very rationale for investing together as a business-owning family.

The need for steady wealth building is particularly true with multi-generation families whose risk tolerance is relatively limited. Shareholders depend on the family wealth for income and for asset growth. A large decline in the value of family wealth, in or outside the business, can negatively impact inactive shareholders’ patient capital, resulting in defections and sometimes, in the worst circumstances, sale of the entire business. Proper diversification and allocation of family assets helps the family build wealth and ultimately control the timing and the price of future value realization.

But where and how should you diversify your assets? Obviously, proper diversification requires judicious investment allocation. Typically, a family would place its “diversification assets” in classes of assets whose value doesn’t fluctuate with the value of the business: real estate, say, or private equity, and in some cases public stocks.

If financial considerations were the only reason to diversify, that should be sufficient motivation to run out and do it. But there’s another important advantage: Diversification can also help you pass wealth from one generation to another.

One of the greatest impediments to orderly succession is to reconcile goals of active and inactive shareholders. Active shareholders typically feel entitled to market-based salaries and benefits and want to reinvest much of the company’s cash flow to expand the business. Inactive shareholders often prefer that the company provide them with liquidity in the form of dividends and other benefits, which limits the capital available for the company’s growth.

Diversification can be a very powerful tool to avoid such conflicts and allow the family business to stay in the family’s hands. By passing on shares of the business to active shareholders and non-business assets of equivalent value to inactive shareholders, you avoid this common collision of goals.

Consider a Swedish family business that had diversified and built up considerable wealth outside the business over the years. By the time the third generation came along, only one family member remained in the business. He inherited 100% ownership, while his siblings and cousins inherited real estate and financial assets of equal value.

One of the critical hurdles of diversifying family wealth is the need to pass on a business family heritage, not just a family business. A business family heritage goes beyond the bricks and mortar of the family business. It is the heritage of the wealth built over generations. Even at the founder generation, some visionary patriarchs understood this well and focused on “total family wealth.” In his own lifetime Matthew G. Norton, a founder of Weyerhaeuser Corp., diversified into construction materials, real estate and financial management through Laird Norton Trust Company.

Another hurdle is persuading business owners that not all siblings or family members need to inherit the same assets. The emotional obstacle here is often based on the strong attachment family members may feel to the business. If they no longer own shares of the company, how can they remain connected and identified with that important aspect of the family legacy and identity?

How much should you diversify?
Just how much should family businesses diversify? That depends on the number of generations and inactive shareholders.

There are no exact ideal numbers, but in general a new business usually requires all available capital, just to stay afloat. As the accompanying graph illustrates, by the second generation, when one or more siblings may have inherited shares, the family should consider diversifying as much as 30% of the company’s value into other assets, which could include real estate, other business ventures or a family foundation. By the third generation, when multiple cousins may have inherited shares, the family might diversify another 10% to 25% of the company’s value into outside assets.

As a business passes from the founder to the next generation, the owners’ first responsibility is not necessarily to save and build the family business, but to save and build the wealth—by diversifying—so that wealth can perpetuate throughout future generations. In the process, you could be saving the family business as well.

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