What is in this article?:
- How to Properly Structure and Govern a Family Bank
- Family Governance and Family Banks
Warner King Babcock and Barbara R. Hauser highlight the possible advantages a family bank can offer a high-net-worth family.
High-net-worth families and those who own businesses and want to plan for the future encounter several challenges, including:
1. Financially assisting the next generation without causing problems;
2. Inspiring the next generation to build intellectual and financial wealth;
3. Developing accountability, perseverance, responsibility and self-reliance in the next generation; and
4. Inspiring teamwork and building meaningful relationships.
The solution? These families should consider allocating capital to a special family-created entity as a corporate vehicle in addition to a trust. The entity’s purpose is to directly fund and support the development of the next generation through intra-family financing—a family bank.
What’s a Family Bank?
A family bank is a family business that’s specifically formed for the purposes of providing family funds to family members, otherwise known as “intra-family financing.” Financing the next generation can occur in the form of loans, equity or a combination. Family banks aren’t commercial or regulated, so there are no accounts, depositors or funds made available to the public. A family bank can provide a source of funding to family members or their related entities that’s much more flexible and customized than traditional commercial, regulated bank financing. However, the terms need to be within the Internal Revenue Service rules and accompanied by proper documentation for tax purposes.
Use of a family bank can help build the next generation’s human, intellectual and financial capital, as well as their accountability, careers, entrepreneurial spirit, perseverance, responsibility and self-reliance, all while maintaining and building strong family relationships.
Family banks can (and should) start small and provide nominal, simple loans to young family members to instill basic financial responsibilities. A family bank can also offer or require educational sessions for next generations to develop a better understanding of the issues, requirements and practices that will guide them to success. Reducing mistakes can make the experience more enjoyable. Senior and other experienced family members, along with outside mentors and advisors can share their wisdom on an ongoing basis as the next generation plans, proposes and builds their funded projects.
The earlier the next generation is involved with becoming financially educated, the more likely that they’ll be able to build the intellectual capital necessary to manage their own careers and assume greater roles in and grow the family wealth and the family business. The global financial crisis taught many families that they need to pay attention to how their wealth is managed, allocated and spent, as well as the importance of preparing the next generation.
Finally, but in many ways most importantly, a well-run family bank can introduce and promote integrated, healthy governance systems in the wider family. (See “Family Governance and Family Banks,” p. 38.)
Let’s look at the four challenges and opportunities mentioned above and how a properly structured and governed family bank can help address them.
Good family governance with independent judgment and oversight should be used when making funding decisions. Emotion, a single controlling trust or an individual or party with a bias or conflict of interest shouldn’t drive decisionmaking.
Good governance and planning are at the heart of a successful, sustainable family bank and key to building healthy family relationships. The family should work with experts to: (1) determine what the true purpose, size and nature of the family bank should be, (2) create clear governance structures and policies, (3) develop financing criteria, policies and processes, and (4) form an independent governing body, such as a board of directors or advisory board, with or without an investment committee, to review and approve each financing proposal made by the family members.
These independent parties can also provide objective advice without emotion. However, it’s important to involve the next generation in the creation, decisionmaking and democratization of the family bank. If it’s not relevant or of interest to the next generation, the family bank will fail. All criteria, processes and policies for funding should be open and well communicated in advance, based on questions such as: Who can apply for funds? How much funding is available? What funding purposes are allowed? Who will judge the strength of the application? Who will monitor the use of the funds? What general terms might apply, including a repayment schedule? The activities and performance of the family bank should be reported periodically to help all family bank owners and participating members determine the value of their interests and eliminate suspicions. The above steps help build a healthy bank entity and healthy relationships.
By definition, the family’s current wealth has its origins in someone’s entrepreneurial efforts. All families can tell the story of “great-great-grandpa,” who came to the new country with nothing but some cloth to trade. Due to his tremendous hard work, perseverance and entrepreneurship (and some luck), he created the family’s wealth. Now what?
Merely protecting wealth today is to watch it decline. Further, without the continued development of human and financial capital, the wealth or family enterprise that “great-great-grandpa” built won’t be sustainable across generations. At the same time, it’s likely that the number of individuals joining the family is increasing. The result is less wealth and fewer family business jobs to be divided among more people, many of whom may become dependent on or feel entitled to the wealth.
The best way to reverse this downward trend is to re-ignite the flame of entrepreneurship by helping each successive generation in developing meaningful capabilities (intellectual capital), careers, entrepreneurial characteristics and passions to build their own businesses and wealth. Entrepreneurship can play a key role in the development of the next generation. Families owning businesses typically recognize the need to instill the entrepreneurial mindset. Family banks can be more patient and flexible investors with family entrepreneurs, encouraging family members to take some calculated risks, while also having a few advisors educate, mentor and support them.
By providing a dedicated, family-friendly funding vehicle that’s aligned with family core values, a family bank can assist the next generations with growing their confidence, intellects and wealth, while passing along meaningful values and building a strong entrepreneurship legacy.
Encouraging the next generation to actually experience a sense of accountability, perseverance,
responsibility and self-reliance is also key to building human and financial capital in wealthy families. This can start by having a working-age family member submit a basic written proposal to the family bank for a small loan to pay for equipment, clothing, supplies and marketing for a part-time summer business, like a house or boat painting company.
Each proposed project should show a financial plan with the ability to repay the borrowed funds and produce a profit for the family bank (interest and/or gains from funding), as well as what the borrower expects to learn and gain personally from the family bank funding. This way, the proposal can be evaluated in terms of both financial and human expected gains.
This formalized (professionalized) process of requiring a well thought out proposal for review by an independent and objective committee or board, as well as requiring the submission of a monthly update and final report with an analysis at the time of repayment, can go a long way in helping develop financial skills and management capabilities. Having family members invest in the bank and/or actively participate in their project that’s being funded, as “skin in the game,” can also help motivate members. If the borrower struggles to repay or can’t repay the loan, that is itself a valuable learning experience, which should be shared in the report. Not everyone can become an entrepreneur, and not all entrepreneurial endeavors succeed.
A family should decide whether the family bank should emphasize financial or human capital development and results, or balance both, and communicate these expectations clearly. These goals can include building financial literacy, responsibility and acumen, as well as life and career skills. Furthermore, the experience should help develop management skills, joint decisionmaking, problem solving and the ability to work with others outside the family.
The family should openly work together to create the family bank, allowing anyone to contribute or participate in its construction. The family should encourage all members to contribute some capital to the family bank, but this contribution should be voluntary. The more democratic and transparent the process, the greater the participation will be, and the family relationships will be healthier and stronger. Building family relationships should be an ongoing objective for family banks. Families should develop effective, family-friendly governance policies to achieve harmony, continually build relationships and create a sustainable family bank and a healthy family system for the benefit of future generations.
Although family banks can be structured and chartered to maximize a return on investment, minimize taxes, transfer the maximum amount of wealth or exert tight controls over the next generation, family banks should, ultimately, attempt to inspire and assist the next generation in developing human, intellectual and financial capital, while building meaningful, long-term family relationships.