Are you interested in creating a family legacy while encouraging entrepreneurial spirit, accountability, self-sufficiency and good governance, all within the context of your family's core values?
A family bank—a family-funded entity that offers financing only to family members or family-owned assets—is a mechanism for achieving those goals. It puts family resources to good use for the benefit of all participating family members. Senior family members provide funds to the family bank, which finances next-generation members' interests, business ventures, education, homes and other assets. Junior family members should also be encouraged to invest, even a small amount.
If it is designed and managed in a professional and democratized way, this structure can empower next-generation members to build wealth responsibly while pursuing their own interests and passions.
Developing the next generation
A family bank is a family business. While it is not a commercial, regulated entity like a savings and loan, it should be formed as a legal entity with properly constructed agreements, good governance structures and a board of directors. All participating members must understand, and be comfortable with, the bank's policies and processes. It is also important to clearly articulate the bank's mission, vision, objectives and financing criteria.
Why is it preferable to use a family bank to finance the next generation's activities, instead of outside sources of funding or outright gifts of money?
• Supporting entrepreneurship. Business-owning families typically want to instill in the next generation the entrepreneurial mindset that made the founding generation successful and fiscally responsible. External funding sources may not be as willing to take the risk or be flexible and patient investors. A family bank encourages hard work and rewards calculated risks while providing a system of support and accountability that may not exist when Mom or Dad makes an outright gift or a quick, casual loan. This is why the family bank should require a business plan with a financing proposal and other funding prerequisites. Encouraging entrepreneurial endeavors while holding the borrowers accountable provides experiences that will serve them well as future family business stakeholders.
• Professionalizing intrafamily financing. All too often, intrafamily loans are informal, emotional decisions that ultimately result in tax liabilities and upset family harmony. The professionalism of a family bank can help prevent tax missteps, take emotion out of the transaction and sidestep potentially unhealthy family dynamics.
• Offering flexible terms. Within tax code limits, the family bank can provide more flexible terms than a commercial bank; however, the interest rate must be at or above the Applicable Federal Rate (AFR). The terms of the loan should be aligned with bank values, mission, objectives and policies. All policies and financings should be reviewed by a tax and estate-planning adviser and be well documented.
• Transferring wealth. The family bank can also be a good source of funds to buy out bank debt or interests in an employee stock ownership plan (ESOP). The bank can even be used to transfer wealth by purchasing interests in the family business. An added bonus: Loan interest and other returns on investment stay in the family.
• Fostering good governance. As the next generation develops its own sound governance relating to the family bank, they will be preparing for eventual group decision making and effective oversight of other jointly held family enterprises. Independent directors can assist with this process by providing experience, fresh perspectives and objectivity.
• Developing fiscal responsibility. A family bank can help members of the next generation to develop mature, disciplined approaches to dealing with money. Rather than paying outright for college tuition, imagine requiring young family members to apply for a loan for at least half the amount and then to work during weekends and summers to make loan payments. How would that change their attitude about the value of their education—and of money?
• Building on family values. Self-sufficiency, independent thinking, entrepreneurship, innovation, perseverance, accountability, collaboration and social responsibility—these are just a few of the qualities that families attempt to pass on to their children and grandchildren. By requiring that financed ventures uphold family values, the family bank can protect the family's brand and its legacy.
Three principles
A successful family bank is built upon three key principles:
Professionalize. Treat the family bank as a professional family business by formalizing the financing process and incorporating the independent oversight of non-family board members. Experienced outside advisers can help facilitate training and mentoring of next-generation entrepreneurs.
Democratize. A family bank should give the next generation a chance for full participation and responsible ownership. It should empower the next-generation members by giving them a voice in decision making while supporting their development.
Harmonize. A family bank involves all generations working together (both within and across generations) to create something positive and flexible for the benefit of future generations. All agreements, communications and policies must be carefully developed and customized to meet the family's unique needs, with input from all participating family members.
Why family banks fail
There are several scenarios that can spell trouble for a family bank.
• Engendering a sense of entitlement. If the family fails to demand accountability and responsible wealth management, family members will view the family bank as a “bag of money” that they can dip into at whim.
• Running afoul of the IRS. Bad-debt family loans are a hot area for IRS audits. Without proper documentation, the IRS may consider the loan a gift, therefore disallowing deductions or creating future tax liabilities. The key to avoiding this situation is to operate the bank as a professional business, providing funding at arm's length and observing all debtor-creditor formalities (such as promissory notes and collateral pledges).
• Unhealthy family dynamics. Informal intrafamily loans hold the potential for misaligned expectations and miscommunication that can lead to emotion ruling over reason. Independent board members, sound policies and processes, good governance, accountability and open communications all contribute to keeping emotions in check.
• Lack of flexibility. The family bank should be flexible enough to accommodate the interests of subsequent generations; otherwise, it will decline in relevance and usefulness.
Creating a positive legacy
A family bank that is professional, democratized and harmonious can help future generations become more entrepreneurial, responsible stewards of the family enterprise and the family's wealth. With good governance systems in place, a family bank can be a powerful, sustainable entity that will encourage members of the next generation to work together and support one another. Wouldn't that be a legacy worth leaving?
Warner King Babcock (wkb@aminet.com) is chairman and CEO of AM Private Enterprises Inc., a registered investment adviser that provides strategic planning to help family enterprises deploy assets for the benefit of the next generation. A trustee, board member and former family business CEO, he also teaches an MBA course on boards, governance and leadership within entrepreneurial and family firms at the Zicklin School of Business at Baruch College.
Getting started
Starting a family bank is similar to starting any other family business. It requires forethought, clear communication and involvement from the right individuals. Here are a few steps to consider.
• Engage and educate family members. Make sure all family members know the advantages, disadvantages, benefits, limitations, opportunities and risks. Participation should be voluntary. Each family member should make his or her own decision about whether to invest in the bank or receive financing (or both) based on interest, needs, feasibility and the family bank's business model.
• Agree on the bank's purpose and scope. What is the mission of your bank? Who or what types of activities will be financed? What are the core values that will direct investment decisions?
• Set a strategy. The bank's strategic plan should be aligned with its mission, vision, objectives and values. Determine specific performance metrics that will be used to measure success.
• Develop appropriate policies. At a minimum, outline requirements for financing and documentation, determine if earnings will be distributed or reinvested, explain how investors can cash out of the bank, define the composition of the board of directors and decide what reports investors will receive. The goal of these policies is to foster a professional and healthy family business system.
• Clarify roles and responsibilities. Clearly articulate who is responsible for making the key decisions.
• Engage independent board members. Objective oversight by non-family directors is essential to creating a family bank that is professional, democratized and harmonious.
• Be mindful of tax and legal consequences. Work with experienced, specialized advisers who can help you stay in compliance with regulations from the IRS and other agencies.
Copyright 2012 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permssion from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.