If Handing Off a Family Business to the Next Generation, What’s the Key Thing to Avoid?

What’s the difference in performance between a family business where the CEO hands off leadership to a member of the family versus an outside CEO? That’s one of the questions our latest podcast, “The Church of Scionology,” tries to answer. (You can download/subscribe at iTunes, get the RSS feed, or read the transcript here.)

Stanford economist Francisco Pérez-González has looked at the data to try to figure this out. (His paper “Inherited Control and Firm Performance” can be found here). He compiled data from 335 management transitions across a number of industries with concentrated ownership or founding family involvement. He compared 112 blood-related successions to 213 unrelated ones. Here, first, is a breakdown of successions by industry, and by family-handoff within industries:

Pérez-González then measured operating return on assets (OROA) for these firms, since “OROA is a measure of current profitability, and arguably, the simplest measurement of overall firm performance.” He found that family firms that transition to family CEOs did experience a decline in unadjusted OROA, but very little difference in overall profitability.

Here’s his most significant finding (with a little bolding to highlight the a-ha moment):

A closer test of the nepotism hypothesis is to compare the performance of family CEOs when sorted by the colleges they attended. Under nepotism, family successors are more likely to be promoted to the CEO-post irrespective of merit. As a result, firms with family heirs who exhibit high motivation or talent might experience superior performance relative to those family firms in which the family CEO lacked them. Firms that promote unrelated CEOs, in contrast, are better placed to avoid this extreme lower tail in the performance distribution by promoting CEOs with a proven track record, and whose post-graduation professional experience before being appointed a CEO would likely outweigh the informational content of the college they attended.

The results are startling. Family CEOs who attended less selective colleges (LSC) account for the entire decline in performance observed by the group of firms that promote family CEOs. For them, OROA falls by 4.31 percentage points (27.7 percent decline relative to own pre-transition levels), significant at the one-percent level. More revealing, 40 out of the 54 observations in this group of family LSC CEOs or 74 percent are negative. In contrast, firms that promote family CEOs who attended selective colleges (SC) do not exhibit significant differences in operating profitability around successions.

Here’s what Pérez-González’s finding looks like:

 

And here’s the relevant portion of the podcast transcript:

PEREZ-GONZALEZ: The underperformance of family CEOs was basically explained by those family CEOs that do not attend, you know — forget about the most selective colleges in the U.S. If you’re in the top 30 college pool, you do fine. If you’re in the top 50 colleges, again you do fine. Or top 100, you do fine. It’s that in 40 percent of the cases in my sample were people who attended colleges outside the top 189 colleges in the U.S. despite having substantial wealth. So, these people that, say, maybe did not have the ability, or did not have the effort because they might be able, but they’re not encouraged to make huge effort. These were the ones that were driving, or dragging, the performance of the family CEO pool.

DUBNER: So, if you throw out the family firms who hand off the CEO position to a family member who went to a non-selective school, if you throw out those companies, then you find that family firms do as well as family firms who hand off to a non-family CEO, yes?

PEREZ-GONZALEZ: Statistically there’s no difference in performance.

DUBNER: So there you have it. The entire effect can be explained by a handful of family CEOs who just aren’t very good, or very smart, or very motivated. In other words: Junior isn’t necessarily cut from the same timber as dear old Dad – hard-working, self-effacing, up-from-the-bootstraps dad. Now, it should be said: This is hardly a new insight. Remember Max Weber? He wrote The Protestant Ethic and the Spirit of Capitalism – which you read, or pretended to read, when you were young. In 1904, Weber wrote that capitalism requires, and I quote, “a more individualistic form of entrepreneurship and the absence of nepotism.” Modern scholars have a name for this:

Vikas MEHROTRA: So this is called the Carnegie Conjecture.

DUBNER: That’s Vikas Mehrotra. He’s a finance professor at the University of Alberta in Edmonton. The Carnegie Conjecture goes back to Andrew Carnegie, who made a huge fortune in steel in the 19th century.

MEHROTRA: Right, so in his idea, he’s actually very clear on this, he did not mince words at all. In his idea, the inheritance of a fortune for the second generation, the heirs who inherited fortunes in his opinion it deadened their talents. And therefore it was incumbent upon rich tycoons and entrepreneurs and so on to distribute their wealth prior to their departure from this earth.

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  1. nobody.really says:

    But … but … but what about George Bailey? He was smart! He was motivated! And he was gonna go to collage, but gave up that plan — precisely in order to carry on the family business!

    (Honestly, you economists. If only you spent less time studying and more time at the movies you’d understand these things….)

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  2. Ezzie says:

    Isn’t this a remarkable reply to those who complain that many “rich people” are undeserving of XYZ because they never had to work for it, and a rather strong case for more free-market capitalism?

    It basically says that rich people who are simply handed the keys to the kingdom will eventually fail, while those who work their way up will typically succeed.

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  3. Caleb b says:

    George Bailey was dealing in Sub-Prime! He made loans to people with shaky credit and did so lerveraged to the hilt. His whole operation crumbled because of his forgetful, probably alcoholic uncle Billy….then he got bailout from the tax payers!

    AND look at all those fun looking bars that were in Pottersville!

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  4. robyn ann goldstein says:

    The key thing to avoid- giving it to them. They have to earn it on their chosen terms particularly here in America. Family is abstract anyway- brother, sister, father, son are used as symbols and can mean blood as in continuity of thought, knowledge, tradition. From that standpoint, my father was Comte, my mother was Martineau and I have a son.

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  5. Joman says:

    Before all the libertarians start cheering this as some sort of personal vindication I’d like to point out ANYONE with the slightest shred of motivation can easily get into a top 189 college (if they have the money to pay for tuition) when you consider that US New and World Report only ranks around 200 colleges. In other words, using the same metric, of the 112 blood-successions in the study, there exists several million college students with the same educational background who should have been just as likely to succeed if given the chance to run those businesses.
    What this says to me is how little skill/merit it takes to simply _maintain_ the wealth someone inherits, and the arguably marginal amount of additional skill needed to at least grow that wealth slightly faster than inflation.
    A fool and his money may be easily seperated, but it doesn’t take a genius to keep it.

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  6. Ira Bryck says:

    I don’t believe that all successors who are not scholars will undermine the family company- there are many other traits besides intelligence; and other studies have shown that moderate intelligence and high energy are the winning combo. But I do think that family businesses should have affirmative action for family: that is a search for a key position yields equally qualified finalists, the family member gets it. A good search will first identify the talents and criteria desired, and the search committee should be blind to family membership. I also think families in business should be very frank about their business only offering openings to family members who are passionate, talented and can add to the business’s success. And that family members be told up front that if they discover the business is not a fit, that leaving doesn’t also mean dismissal from the family. Ira Bryck, UMass Family Business Center umassfbc.com

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