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Managing Capital and Liquidity in the Family Business
By François M. de Visscher, Craig E. Aronoff, John L. Ward
Palgrave Macmillan Copyright © 2011 Family Business Consulting Group
All rights reserved.
Balancing Liquidity, Growth, and Control
Throughout the world and across the centuries, family businesses share a common set of challenges: liquidity for shareholders, capital for business growth, and responsiveness to shareholders' control objectives. Let's consider the case of Carwood, a U.S. family business:
Judging from their beautiful new headquarters on the outskirts of Cleveland, the future seems secure for Carwood, a third-generation automotive parts company. Founded in the 19th century, the company has sales of $250 million. Reflecting its strong cash flows, the company has historically paid generous dividends to shareholders.
Behind this healthy image lies a company very much at risk. During the last five years, sales have begun to stagnate, mostly due to lack of industry growth and stronger competition from large and well-capitalized global companies. To keep its competitive position, Carwood has continued to invest in new equipment and production facilities, which will keep Carwood competitive in cost and productivity, but only if and when the industry begins to grow again.
Three family branches own Carwood. At the last board meeting, one of the branches expressed their desire to sell their shares in the company—even if it meant selling the whole business to raise the cash. Members of that family branch feel detached from the business and the rest of the family. They live far from Cleveland and seldom show up for annual meetings, even though they hold seats on the board of directors. Global competition, they argued, requires continuous and massive investment, which eventually would reduce the company's ability to pay dividends and could even hurt future shareholder value.
Said one member of this group, "Let's sell before it's too late."
Another group, in which the chairman is one of 12 shareholders, has no interest in selling its shares, let alone the business. The third and most populous branch with more than 20 shareholders in four families is split over the issue—some are interested in selling, some are not, others waffle back and forth.
Two family members from each shareholder group serve on the board, along with two outside directors who are unwilling to take sides. The board's lack of cohesiveness results in unsatisfactory board meetings and prevents it from making strategic decisions.
Because none of the three family factions has enough votes to prevail, the board and management are at an impasse. They called in an investment banker to evaluate their options:
* Sell, which may leave significant value on the table;
* Stay as is, which may be competitively risky;
* Find a partner to buy some shares, which may sacrifice significant control; or
* Recapitalize, which may require excessive debt to secure growth.
In what we like to call "the cousin collaboration," none of the shareholders—multiple descendants of the founder—owns sufficient shares to control the company and its strategic decisions. While all shareholders have equal rights, they have very different needs. Balancing the financial needs of a growing business with the divergent liquidity needs of a growing family is one of the most critical issues Carwood shareholders—and other multigenerational companies—will face.
Family shareholders' expectations of the business evolve from generation to generation. Sometimes the evolution is peaceful and smooth, but it is not unusual for gradual shifts in the family and the business eventually to erupt into a liquidity crisis, threatening to destroy the business. Avoiding such crises requires that family shareholders understand and address the financial forces at work.
Depending on the attitude of the shareholders vis-à-vis control and the timing of its liquidity needs, Carwood may yet be able to cobble together a combination of solutions.
THE FAMILY BUSINESS TRIANGLE
Successfully balancing the evolving liquidity needs of a family with the growing capital needs of the business and the implication both those issues have for control of the company influence the long-term survival of the family business across generations.
The triangle portrays the tension intrinsic to the financial life of a family business as it passes from generation to generation. If family control is to be sustained at the top of the triangle, equilibrium between shareholder liquidity and the capital needs of the business must be achieved at its base.
When liquidity and capital needs drift apart for any reason, equilibrium dissipates. Any tendency of family business shareholders to expand their "harvest" of the business's assets can pull the left base of the triangle out of position and undermine family control. In countless failed family businesses, the same pattern prevails: Dividends go up and capital investments in the business go down. Diverging liquidity and capital needs pull the triangle apart and family control collapses. (Please see Exhibit 2.)
This delicate balance is in many ways unique to the family business. In a publicly traded company, a shareholder's decision to buy or sell stock has no bearing on either capital available to the business or control of the business. Outside markets mediate both functions. But in a family business, cash flow has to meet both the liquidity needs of the shareholders and the growth capital requirements of the business. A shareholder who wants to sell stock potentially affects the business's ability to fund growth. Conflicts over liquidity or the introduction of outside capital can impact the family's ability to control the business. Channeling family business cash into operations or acquisitions, for example, can easily affect both family control and shareholder liquidity. Change in any of these three dimensions will alter the financial equilibrium of the entire system.
Capital needs of the family business are multifaceted and evolve over time. As in any business, a family business needs working capital to fund ongoing business activity, as well as growth capital to finance future growth, internally or by acquisitions. Entrepreneurial businesses tend to fund working capital needs with internal cash flow or short-term debt to match the cycle of the short-term or current assets. As a business becomes more established, and its balance sheet more solid, the business may avail itself of longer-term debt. More mature businesses may resort to the private or public equity market to fund more ambitious growth plans.
The business's need for and access to sources of growth capital are likely to increase as the forces of competition, globalization, and innovation challenge the company. Global competition, as in the case of Carwood, requires businesses to make increasingly large capital investments, further straining the business's ability to address shareholder liquidity needs.
Shareholder liquidity needs set family businesses apart from other forms of business. The family business cannot ignore the liquidity needs of its shareholders as could a public company. Addressing these needs, however, will significantly impact the capital resources available for growth.
Shareholders in a family company will exhibit three types of liquidity needs: immediate, current, and ongoing. Immediate liquidity needs may be caused by estate liabilities associated with the death of a shareholder. Family disputes, which cause one or more shareholders to sell all or most of their shares in the company, can also create immediate liquidity needs. Current liquidity needs often stem from the long-term family shareholders' desires for adequate current income on their capital, usually in the form of dividends to cover basic living expenses, children's education, or other needs. Ongoing liquidity needs may cause shareholders to press for access to the value of their capital, just as if they were invested in a publicly traded, liquid security. Without that flexibility, shareholders have a difficult time focusing on enhancing the value of the company because the value of their shares may never be realized. If they feel trapped in their inherited family business stock, they may focus on increasing the current income or immediate liquidity.
Family control needs. There are two types of control in a family company: management control and ownership control.
In the early stages of a family business, management and ownership tend to be concentrated in the same individuals. As the business grows, non-family non-owners are recruited into key management positions, and even larger numbers of shareholders won't work in the business. In general, the control objective of shareholders changes as the business transitions from one generation to another, and hence the impact that control has on shareholder liquidity and growth capital also evolves. The more control the family desires, the less liquidity will be available to shareholders and the less capital will be available to expand the business.
With conflicting demands of expanding families and a need for global business growth, family businesses of the 21st century find they are challenged to balance liquidity, growth capital, and control. Three concurrent transitions in today's family businesses—strategic transitions, generational transitions, and ownership transitions—make maintaining financial equilibrium particularly difficult.
* Strategic Transitions. Continually reinvesting in the business becomes a necessity in order to maintain competitiveness and build shareholder value. Today's family business may need to marshal the necessary capital to make well-timed acquisitions, expand into new markets, hire new people, develop new products, buy new equipment, and invest in technology. Its shareholders must be cohesive, motivated, and committed enough to take risks and build the business for the future—a kind of unity we call the "Family Effect" and describe in detail later in this book.
Without this kind of shareholder commitment and flexibility, many business-owning families will fail to revitalize strategy, stalling growth and potentially damaging shareholder value or even family control.
The globalization of today's business environment has further underlined the importance of family businesses growth. Family businesses may have to fend off competition from large, well-capitalized global enterprises, and at the same time they need to seek strategic opportunities to grow and maintain shareholder value. There are four ways family businesses can grow. (Please see Table 1.)
Each new generation must revitalize family business strategy and pursue its own dream. Accelerating business change, intensifying international competition, and shortened product life cycles are forcing successful businesses in many industries into a mode of almost constant strategic renewal. Strategic planning becomes a perpetual discipline. Innovation becomes a continual pattern. Highly professional management becomes the norm.
* Generational Transitions. Early in his career, the great centerfielder Willie Mays liked to play close to the infield, hoping to nail base runners from the outfield. The result: his most spectacular catches, glove outstretched over his shoulder, came as he raced at top speed toward the centerfield wall—a risky approach necessitated by his aggressive fielding. As Mays aged, he played deeper and deeper in the outfield. Asked about his retreat, he explained, "I'm getting too old to outrun my mistakes."
Like Willie Mays, many family business founders or senior-generation family members get more conservative as they grow older. The math is simple: they have fewer years left to correct missteps. They may try even harder to control the course of the business, clamping down on details and avoiding risk. As the years wear on, personal security in retirement looms larger as a financial concern, intensifying the tendency toward conservatism.
This natural evolution in senior family members' goals and attitudes can clash head-on with an opposite tendency: the desire of the successor generation to take risks and bring about change. Younger managers may feel the business isn't changing fast enough to keep up with the world around them. Anxious to pursue their own dreams, successors are often willing to take greater risks to grow the business. They want control of business strategy, often embracing the continuous improvement advocated by business schools, in direct opposition to their elders' plea, "If it ain't broke, don't fix it." Successors may be eager to invest in new strategies or markets, expanding their base of operation to match the energy and sense of promise they feel. They also may be eager to upgrade their living standard from that of the more frugal senior-generation members.
While the dilemma of growth vs. cash conservation is not foreign to most businesses' strategic planning process, it poses a particular difficulty in a family business environment where owners must reconcile conflicting demands for capital. The successor generation wants to risk business capital on grand long-term strategies. The older generation hopes to conserve cash for security and avoid strategies that seem risky. The two sides have difficulty pursuing common goals because their top priorities—growing the business vs. providing financial security—naturally conflict. In more mature multigenerational family businesses, a similar intergenerational conflict may arise between shareholders who seek long-term returns and those who desire current income. The family may need to raise additional capital to reduce the dependence of the younger generation on the older generation by buying out or even providing liquidity opportunities for some shareholders. That's how the transition from one generation of family owners to the next becomes a financing issue. Without additional capital, these normal intergenerational conflicts may become crises that cripple family control over the business.
* Ownership Transitions. Ownership transitions create the most familiar and most predictable kinds of liquidity crises in family business. Ownership transitions constitute the natural evolution of a family business. The business's founder may own all of the company's stock. In the next generation, the founder's children may develop what we call a "sibling partnership" where multiple people share control. The sibling partnership generation may introduce a new phenomenon in the family business: inactive shareholders. Liquidity and control goals are starting to diverge between those owners in management and those inactive owners who are not. When the sibling partnership generation transitions to the cousin collaborative, the family transitions from owner-operators to owner-investors.
As Table 2 illustrates, the nature of family ownership and the expectations family shareholders have of the business change substantially from generation to generation.
Let's take a closer look at these generation-by-generation changes:
* Owner-Manager State: Concentrated Ownership. The founder-generation family business provides a backdrop against which the advantages and disadvantages of later generations of family ownership can be seen. In this entrepreneurial stage, family control is at its firmest, most intense, and most forceful, placing relatively few demands on the business and instead feeding it with entrepreneurial energy and drive. Ownership is typically concentrated in the hands of one or a few shareholders who are committed to agreed-upon goals. Shareholder liquidity needs are met by the owner's salary, benefits, and perks. Tax planning and cash flow allocation drive financial decisions. Business capital needs are met by cash flow that is plowed back into the business. The primary source of conflict by shareholders, if any, is how cash flow from the business will be used. A shareholder might experience an unforeseen need for cash that could raise questions about draining capital from the business. But generally, this stage is one of relative cohesiveness in the face of the challenges of building a business.
* Sibling Partnership Stage: Birth of the Inactive Shareholder. The goals and expectations of family business shareholders often begin to diverge as early as the second generation, squelching the energizing effect of cohesive family ownership. As stock passes to heirs of the entrepreneur(s), some may not be active in the business, either by choice or not. If inactive shareholders are neglected or uninformed about the business or feel shut out, unappreciated, exploited, or needy, their inactive status creates the potential for two kinds of conflict over capital and liquidity. They may grow resentful of those who are working in the business and receiving salary, perks, recognition, and so on. They easily become suspicious that active shareholders are exploiting the business by draining too much cash for their own compensation or their own pet management projects. Second, if inactive shareholders feel dividends are their only reward for ownership, they may begin focusing on current income at the expense of long-term business growth. A pattern may be set of inactive holders pressing for dividend increases and greater shareholder liquidity, regardless of the impact on the business. This is the seed of a classic conflict that has destroyed many family businesses—a potential family business train wreck waiting to happen.
* Cousin Collaborative Stage: Resolving Diverse Family Interests. The conflicts between active and inactive shareholders may take center stage in later generations of family ownership as shareholder factions become more outspoken. Unless steps have been taken to fortify the family's commitment to the business and family ownership, shareholders' financial goals diverge even more at this stage. Shareholder factions are larger and more diverse and may be more conscious of their power. Branches of the family may disagree over an array of issues, not the least of which are how to accumulate cash and how to harness the business's economic power. These conflicts are made even more difficult by the fact that many businesses outgrow the owning family's financial means by this stage. Additional capital must be raised outside the business if it is to grow and thrive.
Excerpted from Financing Transitions by François M. de Visscher, Craig E. Aronoff, John L. Ward. Copyright © 2011 Family Business Consulting Group. Excerpted by permission of Palgrave Macmillan.
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