Why Do Second Generation Businesses Fail

I recently received a call from a client whose employer is on the brink of bankruptcy. It is so bad that they have hired a business consultant (me) to help them start their own small business in the event their employer lays them off and declares bankruptcy. As, she likes to put it “I am preparing myself”.

This is not the first time nor will it be the last time I get asked this question, why do second generation businesses fail?

This is not a simple questions to answer. However, I feel the main reason is, most heirs of business usually take over as managers of the business and they have NO IDEA on how the business operates, makes money or understand basic business fundamentals and this is why I am usually hired by second generation owners. That being said, if the business makes it past the second generation of heirs then generally the business has learned succession planning, and will continue to prosper, so we will focus on the second generation heirs.

Trial and Error

As with most small business people learn through trial and error, they correct, make new policies, procedures and prevent “the mistake” from happening again. As the business grows so does the learning curve for the new heir later down the road, and as a result, the heir usually makes the same mistakes the founder did when they started the business, the problem is instead of those mistakes being small because the business was small, they are usually bigger because the business is bigger and can lead to significant losses.

Lack of Experience

Similar to the above, it boils down to lack of experience in the particular industry. If a business doesn’t have an experienced and well qualified chief, they make the same mistakes, which leads to making rash an unwise decisions (although people mean good), and with any new owner, weather inherited or not, everyone likes to make changes to the way the business is ran to suit them – this can cost BIG if you have little or no experience in that industry.

The Value of Sweat Equity

Heirs do not and will never understand how hard the founder (parent) of the company worked to achieve a certain result. For example, the founder may have worked long hours, made sacrifices, spend years of their life networking and so on. When any one person inherits the business, they don’t appreciate the asset (business) as much as the founder did.

Estate Taxes

This has nothing to do with the heirs of any given business where it has everything to do with taxes. An inheritance tax or estate tax is a levy paid by a person who inherits money or property or a tax on the estate (money and property) of a person who has died. How much tax would you have to pay on a $50 Million dollar inheritance? I have seen many heirs of business who have to sell the family business in order to pay taxes because the founder never planned and paid for a life insurance policy.

Cash Flow Is King

At the end of the day if a business has cash (cash is king) they will continue to operate no matter how bad the management or how significant the losses are. If the company runs out of cash it will be bankrupt. If the new heir has to withdraw cash to pay for mistakes, lawsuits, taxes, and so on, the business will eventually run out money and will cease to exist which is generally the last step before the business ship finally sinks.