Strategy

Does evolutionary science offer clues to family businesses survival?

Image: Wikimedia

Image: Wikimedia

The biggest cliché about family-owned businesses is that they go from shirtsleeves to shirtsleeves in three generations. So common is the phenomenon, supposedly, that some people talk about it as if it is a law of nature, citing the “30/13/3” formula - that 30% pass to the second generation, 13% to the third and just 3% beyond that. But this is not some sort of universal truth, however widely accepted it is. The formula comes from work by Harvard professor John L Ward, who discovered this pattern when studying a small sample of American family firms. He never said that the same numbers would apply to family businesses in other countries, or at other times. In Japan for instance, where there are 50,000 businesses aged 100 years older or more, the stats would probably stack up differently.

Why are people so attracted by the 30/13/3 idea? Perhaps because it seems to reinforce the saying “from shirtsleeves to shirtsleeves in three generations”, which has equivalents in several cultures - in China “from rice bowl to rice bowl", in Scotland, "from the stable to the stars and back again" and so on. 

There is nothing mysterious about this phenomenon, however. It is very unlikely that the combination of timing, luck, personality, availability of capital etc etc that allow one person to amass a fortune will also present itself to his or her offspring. Sometimes it happens, but rarely. Hence the small number of multigenerational family firms. As a third generation business family member recently told me, “the first generation makes the money, the second spends it, and there is nothing left for the third”. It's that simple. 

SEDUCED BY METAPHORS

But is it true that businesses tend to die out quickly? On the face of it, yes and what's more it is getting even harder for businesses to survive long periods because of disruption to markets caused by technology and competition from other countries. A good example was a recent article in the Harvard Business Review by Martin Reeves, Simon Levin, and Daichi Ueda which argued:

Businesses are disappearing faster than ever before. Public companies have a one in three chance of being delisted in the next five years, whether because of bankruptcy, liquidation, M&A, or other causes. That’s six times the delisting rate of companies 40 years ago. Although we may perceive corporations as enduring institutions, they now die, on average, at a younger age than their employees. And the rise in mortality applies regardless of size, age, or sector. Neither scale nor experience guards against an early demise.

This is the graphic they used to illustrate their point:

Average age at which US firms delisted, by year. 

Screenshot 2016-01-05 at 16.35.02
Screenshot 2016-01-05 at 16.35.02

Others have made similar claims. Professor Richard Foster from Yale University has said that the average lifespan of a company listed in the S&P 500 index of leading US companies has decreased by more than 50 years in the last century, from 67 years in the 1920s to just 15 years today.

However, other research shows that short life-spans are nothing new. Research by Madeleine I. G.Daepp, Marcus J.Hamilton, Geoffrey B.West, Luís M. A.Bettencourt from the Santa Fe Institute found that the average life-span for an American business over the past 60 years has been about 10 years.

They studied Standard and Poor’s Compustat database of over 25,000 publicly traded North American companies from a wide spectrum of sectors over the period 1950–2009, and discovered that, as Hamilton said, “it doesn’t matter if you’re selling bananas, airplanes, or whatever,” a decade was the usual life-span for a business. And this is the important point: this has not changed.

So, whatever measure you use, firms do seen to die at a surprisingly young age. At first glance, that is a bad thing for family businesses and suggests that if you want to pass on a business you are fighting against some fairly strong forces.

EVOLUTIONARY DEAD-ENDS?

But if you look more deeply, things are more complicated. These ideas are openly influenced by biology. Reeves, Levin, and Ueda article was called The Biology of Corporate Survival (Levin is a professor of biology at Princeton) and they describe their research as being "at the intersection of business strategy, biology, and complex systems focuses on what makes such systems - from tropical forests to stock markets to companies themselves - robust". They go on:

Some business thinkers have argued that companies are like biological species and have tried to extract business lessons from biology, with uneven success. We stress that companies are identical to biological species in an important respect: Both are what’s known as complex adaptive systems.

The Santa Fe researchers also cite biological models, and say their methods come from "organizational ecology", arguing that "organizations that vary in their structure and relationships are modelled as competing for finite resources within a complex ecology of economic interactions". They also talk about firm "births" and "deaths", "lifespans" and "mortality" and say they are studying "the way that publicly traded companies live or die".

Have they been unduly influenced by biological concepts? Is biology really a good guide to firm survival? Perhaps, in some respects, but the results suggest that firm survival is somewhat different to the survival of organisms, or species. And the "business environment" has very different properties to the ecological one.

The Santa Fe research discovered that the most common reason for a firm's "death" was a merger or acquisition. Other types of "death" included leveraged buyouts, re-formatting and reverse acquisitions. Bankruptcy and liquidation, which I imagine most of us would say were closest to real "death" for a firm, were not uncommon but by no means dominated the statistics. An M&A is a funny kind of death, and it's not obvious to me what the equivalent in biological evolution would be.

This graph shows the causes of "death" of businesses. The main graph shows firm deaths when "normalised" by the size of their sector - note that there are more pink and light green dots beneath the diagonal line - ie, they are less common - than the purple M&A dot. The smaller inset graph shows the total of exits - note the prevalence of purple for M&A in the top part, showing that this is the most frequent cause of "death".

Screenshot 2016-01-05 at 16.11.13
Screenshot 2016-01-05 at 16.11.13

The HBR article also talked about "de-listing", which also covers a range of possibilities including M&A, a private sale and so on. It is tempting to say that firms "evolve" and "die", and probably some insight can be gained from using ideas from evolutionary biology, but businesses or business families are not organisms or species, and the similarities are limited. Business families shouldn't get too carried away with the idea that businesses "die", or that they do so faster than they used to.

FOLLOW THE MONEY

How relevant is all this discussion of individual businesses to business families, anyway? Most have interests in several ventures at one time, either ones they manage or ones they invest in. So perhaps a better way to understand the fate of business families is to look at their wealth. The "shirtsleeves-to-shirtsleeves" phenomenon hints that this also tends to "die out". Is that true?

A recent report by investment bank UBS and consultancy firm PWC said that of those who were dollar billionaires in 1995, just 44% remained so today. This, they said, shows "the volatility of billionaire fortunes", the "precariousness" and the "fleeting" nature of wealth. Fortunes, just like firms, come and go, are born and die out.

But a deeper look shows that the truth is more complicated. Of the 289 billionaires in 1995, 66 have died (in the old-fashioned sense), 24 fortunes have been "lost" through family dilution and a further 73 have disappeared due to business problems and other reasons.

So, assuming that those who died passed on at least some of their wealth, and paid death tax, it is fair to say that those fortunes dissipated, rather than disappeared. Just 73 of the 289 - about a quarter - lost their wealth. But it is hard to imagine that many lost it all. Although not longer billionaires most are presumably still wealthy by most standards.

And those who are still alive and haven't gone out of business have done very well. As the report says:

This exceptional group of billionaires has not only been able to remain in this elite class, they have grown their average wealth by a factor of 3.8 in the last two decades, boosting their average wealth from US$ 2.9 billion to US$ 11 billion in 2014.

This graphic shows the growth in more detail:

Screenshot 2016-01-06 at 10.05.12
Screenshot 2016-01-06 at 10.05.12

So many billionaires did not in fact lose their wealth - they increased it massively. Even when they do "lose" their billionaire status, in many cases this is because of "generational algebra", as the report puts it: if a billionaire has three children then - even excluding inheritance taxes - each would inherit just a third. Assuming they do not increase it, the wealth then dissipates further through the generations.

Some billionaires give their money away in philanthropy, and would not consider the loss of billionaire status as a failure. Passing on a third of a billion dollars to three children can hardly be seen as a failure either, unless you are obsessed with possessing an (arbitrary) amount of wealth.

Also, how is this wealth measured anyway? How much of it is liquid, or dependent on currency fluctuations, not to mention regulatory and political situations? Most wealthy families talk about what the wealth is "for". It is hard to think of anything they could do with a billion dollar that they couldn't do with half as much. Are we really looking at "fleeting" fortunes that die out?

(The dominant metaphor here doesn't seem to be from evolutionary science, but from physics, the idea of entropy, which states that energy dissipates over time, for example your coffee's heat spreads through the room. Does something similar happen to money?)

Whether you look at the fate of individual firms, or fortunes, it is tempting to think in terms that are influenced by evolutionary science - these ideas are ubiquitous and they stress the effect of the environment on individual organisms. We are constantly told that we live in a world of disruption and innovation, and so it is natural that we look to evolutionary science to understand it. In other cases, we might be influenced by other ideas from science. But the parallels are limited, and the realities are more complex. Don't be seduced by metaphors.

© Business Family 2016