Investing in and Banking on the Family

The Value of the Family Bank

Henry Brandts-Giesen and Stephanie Evans

1. The value of human and intellectual capital

Wealthy families and their advisors will be familiar with the old saying ‘shirtsleeves to shirtsleeves in three generations’. Many families may have this adage at the forefront of their minds when they think about the transfer of their own wealth to the next generation. While that outcome is the unfortunate reality for some families, recent discourse concludes that this theory, which is rooted in fear, is outdated and unhelpful.^[1] The conventional focus on financial capital tends to overlook the importance of human and intellectual capital. Human capital, which concerns the physical and emotional well-being of family members, and intellectual capital, which encompasses the family’s collective knowledge and experience, can significantly enhance financial wealth when properly nurtured. However, neglecting these aspects can have the opposite effect. Families that recognise the value of these assets and implement strategies to bolster them are more likely to achieve lasting success.^[2]

Families generally hope to see their wealth provide for their descendants, taking steps to structure their asset plans in sometimes convoluted ways to maximise financial value, optimise tax and buffer themselves against risk. The traditional approach has largely been to protect the younger generations ‘from themselves’ by over-engineering structures and retaining control of the family assets. After all, control and discipline is often seen as one of the reasons for the senior family members’ historical success.^[3] However, this preoccupation with control and the three-generation myth potentially undervalues the opportunity to cultivate the family’s intellectual and human assets. Consequently, this myth can become a self-fulfilling prophecy.^[4]

The return of the shirtsleeves will often be marked by one or more of these themes:

• a lack of preparedness on the part of the younger generations;
• a breakdown in communication and trust between family members;
• the development of a culture of expectation and entitlement, rather than one of a collective mission rooted in gratitude, participation, and fairness

The greatest intergenerational wealth transfer in history is currently underway. To ensure wealth sustainability through generations, families need to prioritise and promote the development of financial, human, and intellectual capital.

An effective vehicle for this can be a family bank.

A family bank can increase family member accountability and buy-in, improve business and financial literacy and readiness in the younger generations, and mitigate risks posed by external disruptors and family relationship difficulties.

2. What is a family bank?

A family bank is a purpose-built, family-funded entity that operates for the sole purpose of supporting family members to assist with an agreed purpose or project. This concept, known as ‘intra-family-financing’ can be achieved by loans to family members, and/or by equity investment in start-up or other ventures.^[5] Many families have engaged in family lending at some stage, whether it be helping children into their first homes, contributing to the cost of tertiary education or to help a child get back on their feet after a financial hardship event. The family bank goes further by professionalising this financing to achieve multiple goals:^[6] 

1. Financially supporting family members;
2. Fostering the next generation’s financial, human and intellectual capital;
3. Promoting accountability, entrepreneurial spirit and self-reliance; and
4. Cultivating family relationships.

Where the traditional succession planning approach focuses heavily on retaining and growing financial wealth, the family bank is used as a strategy for enhancing wealth and promoting human and intellectual capital across generations at the same time. The family bank is designed to act as the ‘custodian of all aspects of the family’s wealth’,^[7] its ultimate objective being to financially support family members to engage in productive activities, in turn enhancing the wider family and the preservation of all types of assets for future generations.^[8] 

Family banks achieve this by forming a committee of members who are tasked with objectively assessing the merits of a request for financial support, whether it be for further education, a business venture, an investment, or the purchase of property. These committee members are often family, who together with external appointees, serve as members, mentors, experts and advisors. The family bank agrees the terms of any loan via a documented, agreed-upon process which the family have all had a hand in creating.

Once a loan is made, family bank members (whether internal or external) can give guidance to the borrowers, share wisdom, provide financial education and help them to make decisions throughout their entrepreneurial journey, to maximise the chance of the project’s success.^[9]

Arguably one of the most famous examples of the family bank is the arrangement put in place by Mayer Amschel Rothschild for his sons in the late-eighteenth century. After establishing a successful banking house in Germany, Mayer Rothschild provided loans to each of his sons to establish their own banking operation in various capital cities throughout Europe. Lending was provided on agreed terms, including that the sons had to work together, pooling their collective expertise and capabilities.^[10] He also demanded accountability, by requiring each son to report back regularly on the knowledge they had gained within their new marketplace.

Another key element to the structure was the adoption of a family motto, which provided a clearer understanding of the family’s collective values and goals. The family reaffirmed these values consistently across the generations.

The Rothschilds’ success in preserving and enhancing their wealth over generations spanning more than two centuries is credited in large part to the conception of that family bank.^[11]

3. How do Family Banks differ from their commercial counterparts?

Family banks have less stringent application criteria, and assess an applicant based on a broader range of information

Family banks offer a more flexible, bespoke alternative to commercial banks^[12] which usually come with complex application processes, strict regulations, and a focus on profit, seldom ready to gamble on young entrepreneurs with possibly scant financial history.^[13] Commercial banks typically emphasise the need for solid quantitative data, including financial statements, asset valuations, credit scores, and banking history.^[14] While established enterprises can meet these requirements, newcomers may find it challenging to convince lenders based solely on their financial records.

Traditional lenders often underappreciate the applicant’s qualitative, relational qualities^[15] such as their family’s values, regardless of the part those values have played in the senior family’s success, and in turn, are instilled in the next generation from a young age. Family firms also tend to think intergenerationally as opposed to quarterly^[16], and are therefore able to offer a lender the stability that comes from longer-term planning. However, in the case of a younger family member looking to start their first enterprise, ‘soft’ information such as family values, demonstrated work ethic and other personal characteristics may not be valued by a commercial bank.^[17]

Whereas commercial banks have restrictions against lending to minors, family banks also have the flexibility to lend to a borrower at an earlier age.^[18] For example, the family bank could support a teenager to start a small business during their summer holidays, to encourage their development of work ethic, independence and business acumen through real-world experience.^[19]

Family banks can offer preferable lending terms

While a family bank may still be subject to certain rules under the relevant country’s internal revenue service, it should be lightly regulated and able to provide funds to family members or their related businesses or other entities, often at more favourable rates than those offered elsewhere.^[20] They are also typically a more patient lender that can provide funds on more personal terms, usually with less onerous repayment periods and security obligations. Family banks can also forgive loans,^[21]  or insist on personal development milestones, as opposed to requiring strictly financial repayment and interest.

A family bank’s values are not limited to commercial gain

Instead of concentrating only on risk and profit, a family bank’s fundamental values mirror the family’s own, aiming primarily to safeguard the family’s assets.^[22] Its mission extends beyond financial wealth to include the enrichment of human and intellectual capital, thereby providing education, mentorship, and guidance. With such comprehensive support, a family bank not only aids in wealth generation but also nurtures the entrepreneurial spirit that contributed to the founding members’ success. It also motivates younger family members to confidently participate in and contribute to the family’s projects in their distinct manner.

4. Why you should have a family bank

Your succession plan may not be as good as you think

The Exit Planning Institute reports that 50% of businesses collapse due to unforeseen events such as divorce, disagreement, disability, death, and ‘distress’—with ‘distress’ covering issues like legal risks, loss of key employees, economic downturns, and political shifts.^[23] Families that have not adequately discussed and planned ahead for these kinds of disruptors, will find themselves struggling to navigate challenges as they arise.^[24]

There are several common reasons families do not sufficiently prepare for intergenerational wealth transfers. Some family leaders simply do not turn their minds to their succession plan. Those running family businesses are usually preoccupied with the immediate requirements of the business. Succession planning is often seen to be complex and demanding of time, leading many to believe their efforts are better devoted to overseeing business activities.

Some see discussing wealth with their children as taboo, or worry that discussing it will create entitlement and expectation. Too often however, failure to prepare or educate the next generation means they grow up enjoying the benefits of the senior family members’ success, without fully appreciating the sacrifice and determination that allowed their predecessors to succeed.^[25] Without that understanding, it is much more likely for a child to grow up with a sense of entitlement to the lifestyle to which they have become accustomed.

The traditional wealth transfer stereotype will be familiar to many: the founding generation builds wealth through their entrepreneurial spirit and hard work. The second generation reaps these benefits, leveraging the advantages to forge their own successful paths and enhance their own children’s lives. The third generation, having the advantage of the gains but too far removed from the hard work that started it all, and lacking the knowledge and experience to manage the fortune properly, consumes it.^[26]

Families desperate to avoid that three-generation loss of wealth can become obsessed with retaining financial wealth and maintaining control, limiting involvement by younger generations.^[27] However, this restricts the opportunity for the next generation to engage with the family business in a meaningful way. It can also overlook the value of the individual skills and passions that each family member can offer and that the family bank might employ in order to expand into new areas.^[28] 

The single greatest risk to family wealth is not the external disruptors, but in fact, the people around the dinner table.

Miscommunications and misunderstandings can arise in the most mundane scenarios. Add in the emotive combination of families, money and business, and you have a breeding ground for conflict. A lack of transparency, discussion and formalised processes can easily lead to a perception of unfairness and interpersonal conflict.

In such scenarios, advisors often witness protracted and costly legal battles within families where, for example, a child’s expectation does not match the reality of what they receive from the family. In the case of a deceased family member, sometimes there is little or no explanation left behind to the next generation to explain any disparity. A disgruntled family member will often go to extreme lengths to take what they believe they deserve, particularly if their loss has been another family member’s gain. As a dispute drags on, the family’s financial capital dwindles, as does goodwill, trust and the ability for the family to work together.

Lack of a shared mission

The lack of a shared mission is intrinsically linked to breakdowns in communication. Generations within a family can possess markedly different perspectives and life experiences, shaped by the economic, social, technological, and political environments of their times.^[29] These differences can spark conflicts when the expectations of one generation go unvoiced or are not embraced by others. Conflict is much more likely to arise when an individual or group of family members does not feel heard by the rest.^[30] Further, without a platform to facilitate cross-generational dialogue about the family’s big-picture goals, more specific policies and scenario-planning regarding family succession or financial support are much harder to develop and implement.^[31]

5. The benefits of using a family bank

Financially supporting family members more flexibly

Finding ways to financially support the next generation without instilling a sense of entitlement can be a challenge for families, especially those with significant wealth. One of the key advantages of the family bank is that it empowers the next generation to engage with the family business, build confidence and to become financially literate and self-sufficient. The family bank is not simply providing an endowment; rather, there are clearly communicated structures and policies around a loan or investment.

Family members are able to lean on the family bank for financial support, and in undertaking their venture with the help of family bank mentors and relevant education, they are able to gain real-world experience within a metaphorical ‘safety net’.^[32] This enhances their development of entrepreneurial skills, accountability and self-reliance.^[33] As noted, they also allow families to provide funding to family members that may not otherwise qualify for regular bank lending, and on terms that can be more flexible and tailored to the borrower’s circumstances.^[34]

Fostering open communication and creation of a shared purpose

A collective vision for the family is the foundation on which the family bank is built. This vision, as well as the documented policies and procedures that the family bank develops, is established with the voices of all the generations.^[35] By professionalising intra-family financing in this way, the family is encouraged to communicate openly and work together to share knowledge, ideas and experience.

Formulating this shared purpose also means that all family members understand the overarching goal of the family bank, what they can expect of the family bank, and what the family bank in turn expects of them.^[36] If all family members agree on the bank’s big-picture vision, there is a recognition that each of them has a role to play in growing the family’s collective wealth. No family member is more important than another, and not all family members require the same type or degree of support. This means that decisions or loan arrangements do not need to be equal among individuals to be seen as fair.^[37] Families are therefore better able to handle uncomfortable conversations that may arise, and maintain family harmony.

Preparing and engaging the next generation

The earlier that family members are involved in the family bank, the greater the opportunity they have to build the intellectual capital needed for them to manage their own futures, undertake greater roles within the family business, and grow the family wealth.^[38] With younger members, family banks can start by engaging in conversations about wealth in an age appropriate way, providing early theoretical financial education and building on those skills as the generation matures.

From there, the family bank can provide practical opportunities to instil the basic fundamentals of financial responsibility. A young family member could be asked to submit a basic lending proposal to the bank to allow them to start a part-time summer holiday business, for example.^[39] The proposal would include what the family bank would gain from the loan in the form of interest or monetary gains from the enterprise, as well as what the individual expects to gain in experience or education as a result of the endeavour.^[40] This allows the bank to assess the feasibility of the proposal in terms of the expected gains in financial, human and intellectual capital. It also demands accountability on the part of the borrower. These elements help to prevent the family bank being viewed as a ‘slush fund’ to be dipped into at their leisure.^[41]

Senior family bank members (or their trusted advisors) can guide younger generations and provide a sounding board for their particular project or venture. Additionally, due to the groundwork of communication and collaboration within the family bank, family members can learn, not just from the advisors and mentors, but also from each other’s successes (and their misadventures) as projects progress from proposal to completion.^[42] All failures carry lessons, and if a family member ends up in a position where they are unable to repay a loan, that in itself is a worthy learning experience.^[43] The family bank members will also be there to provide encouragement to the individual to learn from their mistakes.

Facilitates diversification and agility in business

Families cannot control all the external influences that can disrupt their dynamics or the trajectory of the family’s wealth success. Family banks offer families the framework to carefully consider, discuss and plan for the potential impacts of external influences before they occur, in order to best position themselves to navigate challenges.

The family bank approach also celebrates the individualities and desires of each member, and recognises that these add human and intellectual value to the wider family. Younger generations are generally more ‘attuned to the future’, open to new ideas and seeking new opportunities, and encouraging their participation allows the family to harness their unique skills and ideas.^[44] If generations can find ways of working with each other, younger generations are also more likely to stay invested with the family enterprise and not just go their own way.

Families should therefore not be afraid to allow promising talent to branch out into new areas or to chase their individual passions. By supporting endeavours and business ventures that may stray outside the confines of the family business’ original industry, the family can adapt to change, pivot with technology and diversify into new markets that align with family members’ individual skills or passions.^[45] Further, venturing outside the family business encourages family members to gain experience and learn new skills that they can then employ within the family business at a later stage.^[46]

6. How family banks operate

Each family, and each family bank is unique, as are the structures that each might require, and no real ‘standard’ exists. For some families, the family bank might dwell within the family office and be structured through a specially-formulated trust, limited partnership or company.^[47] The key to an effective family bank structure is less about the structure itself, and more about the fact that all members should agree to it. Whatever arrangement is used, the family bank should operate as a business, acting as the family’s ‘central mechanism for financial exchange’^[48] and at arms’ length from the family itself. It should also operate with transparency and consistency.

Governance and membership

The goal of the family bank’s governance structure is to assemble a cross-generational team that is able to collaborate to make ‘decisions that are aligned with the family’s shared values and vision’.^[49] For families that hold wealth within the first generation, a family bank could be made up of a few primary family members (i.e. the parents and adult children) who provide a documented loan to one of their own, including terms for repayment and the ability to charge interest, should the lenders think fit.

For families with high net-worth, and as wealth moves into the second or third generation, a family bank may evolve into a more formalised structure with carefully-considered governance.^[50] This could take the form of a family bank committee or board including some family members, and other experts outside the family, to maintain a layer of independence. Bringing in outsiders can significantly contribute to equitable treatment among family members and minimise potential conflicts.^[51] Potential advisors for the family bank, whether serving directly on its board or as external consultants, include wealth managers, accountants, investment advisors, and lawyers. It is beneficial for families to consider engaging professionals with whom they already have established trust, as these people will already have an understanding of the family’s wealth and the interpersonal dynamics at play.

Selecting external family bank advisors should ideally only happen after the family has established their agreed purpose or vision for the future. This is so that the family can ensure that those selected will be equipped to fulfil the family’s purpose in exercising their roles. When selecting external family bank members or advisors, families should consider whether the candidates have the appropriate experience dealing with inheritors and entrepreneurship, tax optimisation expertise, and be able to maintain impartiality and independence.^[52]

All family members should not automatically be members of the family bank; individuals should also be expected to earn their voice as a member. This could include requiring certain conditions to be met or qualifications achieved, before joining. For example, the family bank could require minimum education or work experience, or a minimum level of their own capital to co-invest, to ensure all family bank members have ‘skin in the game’.^[53] 

They should also consider other essential qualities to be an effective member. Can they disagree without emotion, and be respectful towards each other? Would they have the ability to objectively assess the viability of a project or to say no to another family member, if they did not believe the project was in the best interests of the family bank? And, would they be able to manage the fallout from that decision?^[54] Again, ensuring a degree of independence within the decision-making body of the family bank will alleviate the risk of negative fallout from such a determination.

Mechanisms to provide support beyond the financial

Family banks that are properly structured are uniquely placed to provide benefits beyond just monetary support. They can provide education sessions on topics like responsible borrowing, debt-to-asset ratios, budgeting and managing resources, and accountability to follow through on obligations. Perhaps a family bank member or advisor has connections within the industry that a young entrepreneur wants to enter. If so, they can provide access to those connections to help them grow their own network. Alternatively, one of the family bank members can act as a mentor and assist the entrepreneur in coming up with their business strategy or preparing for a pitch.^[55]

Formalised purpose, processes and policies

In addition to careful consideration of family bank governance, for a family bank to be successful it should determine and document the ‘Three Ps’ – the family bank’s Purpose, Process, and Policies,^[56] well before they are needed. This should be done democratically, including all age-appropriate generations in the decision-making. Having agreed, documented policies and procedures enables the family to maintain consistency across family members, and ensures that potential issues are worked through, prior to any personal emotion coming into play.^[57]

Purpose

The establishment of the family bank should begin with a discussion about the family’s wealth story and its philosophy regarding the purpose of its wealth.^[58] Some useful questions to pose and discuss are: Where has the family wealth come from? How do they define success? What does the family want their legacy to be? All family members should understand how they got to where they are, what the family’s goals are for the future, and how they intend to support each other in reaching their potential.

As the Rothschild family did, it is wise to jointly come up with a family motto or mission statement,^[59] which serves as a guidepost for future decision-making. Granting all generations a voice in the formulation of a shared purpose or vision allows the arrangements that follow to be tailored accordingly. It also enables the family’s vision to remain relevant through the generations.^[60] 

Policies

Once the foundations are laid in the form of the family’s shared purpose and vision, the rest of the family bank’s processes and policies can then be formalised. The practice of collective policy-creation further facilitates open discussion and builds communication skills. This can start with the construction of a family charter or ‘family constitution’, a document that serves as a record of the family’s history, as well as its ambitions and aspirations for its future.^[61] The family charter would incorporate the family mission statement, and contain specific guidelines for how the family wants to invest, educate family members, or how to resolve disputes within the family.

Processes

• Funding the family bank

One of the first considerations for families implementing the family bank is how they wish for it to be funded. Family banks are generally funded through the generations, with the most senior family members setting aside a pool of funds in order to provide other family members with financial assistance for specific means. Funds within the bank are often lifetime gifts from senior family members, earned through business activities, capital gain or income from other investments. In some instances, family businesses allocate a portion of proceeds to the bank.^[62]

Some families choose to fund them by way of contributions by various family members, whose equity share in the family bank is proportional to the amount they each provide. This has the added benefit of empowering all family members to participate in the bank, and contributes to a sense of ownership by every member, regardless of the contribution amount.^[63] 

Quantifying a sufficient sum for a family bank to hold is a difficult task, and will depend upon a range of factors. Families should consider:^[64]

1. Whether their bank should comprise one general fund, or multiple funds with separate amounts set aside for each potential borrower;
2. The amount of capital the initial borrowers may require, taking into account the likely or possible projects the borrowers might be looking to fund in the future, whether that be a business start-up, a home purchase, or further education;
3. The timeframe in which a borrower may wish to borrow funds;
4. The family bank’s risk appetite in terms of investments or lending; and
5. How willing and able the family members are to transfer assets into the family bank.

• Loan applications and agreements

The bank must establish transparent procedures for handling and evaluating loan requests to eliminate any claims of favouritism toward or against any family member. The application process itself should be open, allowing all family members to understand the purpose of the proposed loan, thereby promoting fairness. Such transparency also provides a level of accountability to the family on the part of the applicant.^[65] 

Applicants should be required to submit a business case for the proposed project that details what the expected financial return would be, as well as its potential to improve the applicant’s personal development, expertise, or independence, thereby contributing to the family’s intellectual or human capital.^[66] 

To evaluate the feasibility of a proposal, family banks might suggest that the applicant seek funding from external sources as well, exposing the project to external evaluation. This approach not only tests the project’s robustness but also offers the applicant valuable experience in presenting their ideas under independent scrutiny.^[67]

Family banks should consider and formulate clear guidelines about the types of loans they are comfortable making, for what purposes, and the terms of those loans. While most loans will be financial or investment loans, some might be what is referred to as an ‘Enhancement Loan’,^[68] one that nurtures human capital within the family and the development of certain skills or independence, without necessarily a financial rate of return. A common example is an interest-free loan for education, that the borrower repays after completion of their study. The funds can then be recirculated to fund the education of forthcoming generations.^[69]

Documentation of the loan arrangement is critical.^[70] Loans that are not documented properly can (and often do) create disputes within families if, for example, one party remembers the agreed terms differently. The lack of a documented arrangement can also give rise to situations where one party asserts that the funds were a gift, with no expectation of repayment. Where a borrower is married or in a relationship, the structure of the loan should be considered in concert with the applicable relationship property laws.

The terms of the loan arrangement should provide for a number of scenarios, including the ability to charge interest on the loan, an understanding of what milestones require the borrower to report to the family bank, and whether the loan could potentially be forgiven and in what circumstances. Any plan to forgive a loan should be made and reviewed in consultation with a tax advisor to ensure that no unintended tax consequences result. The loan agreement should also include a clear plan for what happens if the borrower defaults.^[71] Perhaps they were unable to make repayments when due, or perhaps the business proposal failed. Allowing an entrepreneur to fail and requiring them to pick apart the lessons from their mishap, means they are less likely to repeat their mistakes.^[72] 

In summary

The greatest wealth transfer in human history is currently in motion, and with it comes the question: what is required to make it successful? The old methods of tight control and lack of transparency are proving inadequate. Family banks offer a more wide-ranging, forward looking and exciting perspective. They can not only safeguard financial wealth, but also foster the family’s innate potential. By setting up a family bank, families can not only protect their financial legacy but also strengthen their ties, improve how they talk and plan together, get the next generation ready for the future, and shield themselves from any potential troubles that might come their way.

First published in The International Family Offices Journal. https://www.globelawandbusiness.com/journals/the-international-family-offices-journal @Globe Law and Business Ltd.