Is Your Family Business on the Path to Growth?

For many years, Bethany didn’t ask a lot of questions about her family business, a successful third-generation technology company.* Bethany had pursued a career as an educator outside of the family business, but she was proud of how the business had grown rapidly and profitably under her uncle’s leadership. She trusted him to make the right decisions for both the business and the family. Historically, the business had created a lot of value on paper for the owners but had distributed relatively small dividends.

When her uncle decided to turn over the reins to the first non-family CEO, Bethany knew it was time for her to be more engaged as an owner, but she was unsure of how to go about it. The business was thriving and had begun to generate cash — a lot of cash. Now the board and new CEO were asking for guidance on the most fundamental question for any business: What do the owners want from their business?

When Bethany asked the CFO to get her up to speed on the financials, he brought her a thick binder filled with reports in tiny font and proceeded to rattle off financial terms, numbers, and “KPIs” that were hard to follow. “Financial gobbledygook,” she later told us. Bethany didn’t understand how those numbers could help her, as an owner, influence decisions. She knew she needed a way to cut through the financial clutter and find a handhold to start her journey.

Bethany’s experience is common among family owners who do not work in their business but still want to be engaged owners. The good news is they don’t have to get up to speed on those voluminous reports. We believe owners can start by focusing on a single number: reinvestment rate. By “reinvestment rate,” we mean the percentage of all the profits that are reinvested in the legacy business or new ventures, instead of distributed to owners. We’ve seen families use different names for “reinvestment rate,” such as DCF (distributable cash flow). And we’ve seen slight variations in how reinvestment rate is calculated. But they measure essentially the same thing — the critically important decision that owners make of how much to reinvest and how much to distribute.

No other number is a better expression of owners’ intent. Reinvestment rate is the answer — explicitly or implicitly — to the question of: How committed are we, as owners, to reinvesting our capital in this business together? When family businesses start focusing on reinvestment rate, rather than on profits or dividends, it focuses them on purpose (“Why do we own these assets together?”) and return on investment (“How could the business use these funds?”), rather than a cash cow for dividends (“What do I get?”). Reinvestment rate can signal whether your family business is on a sustainable path for growth or at risk of bleeding itself dry. And best of all, you don’t need to be involved in day-to-day operations or have a corporate finance degree to understand reinvestment rate.

Why Reinvestment Rate Matters So Much

In many first-generation businesses where a founder is trying to build a legacy for their family, we often see reinvestment rates of 95% or more. Nearly all available cash is reinvested in the business. Early on, such owners reinvest heavily to grow a big, thriving business.

In an extreme case, we know a successful founder of a New York City real estate company who, despite growing a business worth more than $30 million in value, lived in a two-room flat in Queens, never took a dividend, and rarely took a salary. They largely lived off of his spouse’s income. He wanted to reinvest all he could, and he did. In a non-family business analogy, many high-growth tech firms do not pay dividends for many years during their high-growth phase. Their reinvestment rate is often 100%. Like the founder from Queens, their intent is to prioritize growth.

At the other extreme, we’ve seen some family businesses with a nearly 0% reinvestment rate. We had a client who owned a fabulous consumer services brand with great growth prospects. The owners (siblings who had grown the business that their father had started), however, were stuck in constant and destructive family conflict. After years of trying to work in and own this business together, they eventually made the choice to take out all the funds they could to diversify away from each other. They set their reinvestment rate to near zero. They believed that if they owned the company together, they’d end up in destructive lawsuits (several of which were threatened) risking the future of their jointly-owned business. They turned their business into a “cash cow” that they milked, placing themselves on the path to the eventual sale of the business to other owners. This decision meant that they prioritized growing their personal wealth instead of the company.

Most later-stage owners don’t live in these extremes. But where they set the reinvestment rate is still the best signal of their intentions for the business in the long-term. We often see a natural tension emerge in later-stage multi-generational family businesses between owner-operators and management (who typically prefer that more be reinvested in the business) and owners who are not involved in the day-to-day business (who may want more cashflow from the business, either for income or to reinvest it elsewhere).

It’s not uncommon for third-generation beneficiaries to receive zero or low dividends because the owners are trying to respect the founder’s intent or trust structures which flow most of the profits back to the company. For example, we know owners of a family business worth more than $100 million who receive near zero annual financial benefit. Setting too high of a reinvestment rate can cause owners to wonder “What’s the point of owning this family business anyway?” They’re wealthy on paper, but not in day-to-day life, and they begin to feel little psychological ownership of their family business. We have often seen this lead to requests to sell the business or for individual exits.

In the long term, neither extreme is healthy for most family businesses.

How to Set the Right Reinvestment Rate for Your Family Business

So how do you determine the right reinvestment rate for your family business? Many owner groups feel the tension to keep dividends low. They often want to pass at least as much wealth per person to the next generation as they have experienced. To do so, most family businesses need to grow 5% per year in real terms for the duration (depending on the number of children in the next generation). Such growth typically requires sustained and substantial reinvestment.

In our client base, we have found that healthy, multi-generational family businesses typically set a reinvestment rate between 75% and 90%, balancing the goals of continued growth and allowing owners to enjoy some of the wealth they are creating. In other words, the owners are committed to supplying the business with plenty of “oxygen” for long-term growth while also allowing for the growth of differentiated family wealth outside of the business. If the owners set a reinvestment rate lower than 75%, it usually signals an intention towards diversifying away from their family business, rather than reinvesting in its future.

Reinvestment rate is at the center of what we call “owner strategy” — the expression of your purpose and goals as owners. Effective owners decide together how to balance the trade-offs between their goals for growth in the business, liquidity for themselves, and the desire to retain control of how the business reflects the values of their family. Unlike public companies that must focus on maximizing the growth in the value of their shares, privately-held family businesses can choose to define success on their own terms. The reinvestment rate is central to the owners’ strategy: Here is what we prioritize and here are the tradeoffs we’re willing to make.

Of course, every business has a de facto reinvestment rate — you can track how much they have reinvested in the business after the fact. But failing to focus on and make a deliberate choice about how much should be reinvested in the business to reflect the family owners’ priorities can bring some unwanted results.

Using this strategic handhold, you can have productive discussions among the owners — and then with the board and management team — about what your intentions are for the business. Here are the questions business owners should be asking:

1. What is our historical reinvestment rate? You may not have consciously set this, but you have one. What does this number say about the former intentions of the owners?
2. What are the implications of the number as it is set now? Is your current reinvestment rate leading to disaffected owners? Business underinvestment? Wasted business investment?
3. What do we want as owners? A discussion of your owner strategy and what tradeoffs you are willing to make is essential to determining the right reinvestment rate for your business. Are the owners aligned? Does the rate reflect a shared agreement about owners’ goals?
4. What would be involved in changing the reinvestment rate? Reinvestment rate is typically a decision reserved for owner groups. Don’t expect all owners to align quickly, as you will likely have different goals and experiences. Can you get a majority or even a super majority of owners to agree with you?

Once you have worked through these questions as owners, you can begin to share your thinking with the board and the management team. Determine their reaction to changing the reinvestment rate — ask what they would do with a higher rate to get a feel for how and where they would guide the company’s long-term growth. And finally, when you’ve made your decision about the reinvestment rate, set up a tracking and learning cycle. Review the decision annually with both the owners and the board.

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Originally published on HBR.org, 15 March 2024.