Families who built their wealth through a lifetime of hard work have a conundrum when it comes to passing that wealth to future generations: how to keep their kids and grandkids from becoming spoiled and entitled.
A good estate plan can help ensure that the family’s values are preserved from generation to generation, and a well-designed ‘family bank’ can be a key component to that plan. Those who want their family to enjoy the financial fruits of their labor, but who are also concerned about preserving the values of hard work and financial independence, should consider a family bank.
What is a family bank?
A family bank is not technically a bank. Rather, it is a formalized structure that allows loans or investments to be made within a family in a structured, thoughtful environment. The funds typically come from the elder generation, but can also be established by a group of family members to share their collective wealth and knowledge throughout the family.
Depending on the family’s goals, the family bank is typically a trust or a separate business entity. Assets are managed by a board comprised of family members and, ideally, at least one person from outside the family. The bank should have a clear statement of the values, which the board will use to manage potential loans and investments.
How does it work?
The key to having a successful family bank is a well-defined process. The more akin to a formal bank-lending process (or a private equity investment process), the better. A family member who seeks a loan or investment should be required to prepare a formal business plan and submit it to the board. These proposals typically range from loans to purchase a new home to paying for education, and ultimately to investments or loans in business ventures. The board should follow clear procedures to consider the proposal, using the family values as a guide.
If the family bank decides to proceed with the proposal, it should act just like a bank. That is, the loan/investment should be clearly documented, and the family bank should take security, especially for business loans. Loans should carry the appropriate rate of interest, and the loan and interest should be paid according to the documentation. For investments, family banks should structure the investments similarly to private equity or mezzanine financing, with higher interest rates and equity participation (warrants, stock, etc.) in the venture.
If the family member defaults, the family bank should follow clearly defined procedures for collecting the equity and/or assets securing the loan.
What are the potential benefits?
The most significant benefit is that family banks can change a family member’s use of funds from a distribution (a.k.a. gift) to an obligation. And, while formalities should be followed, the family bank can be significantly more risk-tolerant and lenient on the loan terms, allowing the family member to access capital on terms that would not be available from a traditional lender or investor.
This support from a family bank can be an incredible commercial advantage to the family member.
The process of obtaining the loan can also educate the family member on the family’s values and on the process of obtaining financing and making a strong business case. Also, the use of those funds can provide valuable education to the family at large about business and wise use of financial capital, so a requirement that the borrower share his or her experience with the entire family is critical. Further, the process of considering and making loans can provide the family a sense of common investment and community and ultimately lead to broader success for the entire family.
Another key benefit of a family bank is further asset protection for the family wealth. Pure distributions to beneficiaries can be subject to the claims of creditors, including former spouses, while loans and investments, with their added security and equity control, can provide another layer of protection against creditors’ claims.
Done correctly, a well-run family bank can actually make family members more financially independent, instead of reliant on and addicted to benevolent distributions of family wealth.
What are the potential pitfalls?
A family must work with its financial and legal advisers to ensure that it does not run afoul of any legal requirements or create unintended consequences, such as loans being treated by the Internal Revenue Service as gifts. The family should also consider using outside advisers or business associates to assist with the family bank decision-making, which can help alleviate tension among family members. Additionally, the family bank should not encompass too much of the family’s wealth; rather, it should complement an overall estate plan.
Failure to have a clearly defined family vision can create distrust and misunderstanding among family members. It is also important that the elder generation avoid too much control over the process and allow unorthodox proposals to proceed. Even failures by family members can provide excellent feedback and educate the family.
Finally, a family bank requires a level of complexity that some families may not desire. However, even without a formal family bank, a family can establish a clear vision and use loans to the kids and grandkids to obtain some of the benefits offered by family banks. Over time, that practice can grow into a full-fledged family bank.
Sverre Roang is a shareholder at Whyte Hirschboeck Dudek S.C.
