During the first quarter of this year I had the great privilege of witnessing a significant accomplishment by a long time client. I started working with this family in the late 1980’s as they were contemplating exiting their business due to some feedback from their lender and general frustrations with short cash flow. They asked me to take a look at their situation and share my assessment and recommendations.
Their lender had indicated that since they were not able to “zero out” their operating loan once a year from the operating cash flow of their business, this suggested they were not making money. The lender further argued that if they were not making money they should consider exiting their business. My client was alarmed and considering an exit. I dug into the numbers and had extensive discussions with the client. My analysis indicated that in fact they were very profitable but the combination of their growth rate and the structure of their balance sheet was creating their liquidity challenges. I shared with them that they were bankable and they could likely have their choice of lenders. They shopped their financing package and were presented with financing offers from 3 different lenders. The flood of emotional relief this family experienced upon refinancing was moving.
Fast forward to the first quarter of this year, 25+ years later, to the incredible experience for me. At our annual planning meeting where we were reviewing their financial statements, this client proudly shared that as of this past December they had completely paid off all of their debt. Their personal equity position is now over “8 figures”, they have plenty of liquid assets, and their business continues to churn out positive earnings and cash flow. We spent the meeting discussing the future for them personally, for their family and for the business. The pressures they now face are around stewardship of their sizable equity position, and making choices between options – enjoyable challenges to consider. It has been my privilege to serve this family along their remarkable journey of success.
When the family business has shareholders with diverse financial needs and interests, disagreements over distribution policies can be challenging to the business and the family. To better manage these discussions, it may be helpful to know or consider the following:
Estimate the financial needs of the business utilizing both strategic and operational business planning.
Determine the shareholders’ risk tolerance –are they willing to utilize leverage to finance future needs o the company? The current environment for obtaining outside capital should be taken into account.
Determine shareholder attitudes regarding desired ownership percentages into the future. Are they willing to take on outside investors?
In situations where shareholders are taxed personally for business profits, allow for tax related distributions at the highest tax level applicable.
Set a base annual living expense distribution that the business should be able to accommodate without endangering its ability to compete.
Based on best estimates from the business planning process, estimate the capital needs of the business over the next 3 to 5 years.
Establish a distribution formula based on the needs of the business and risk environment of the business. Some businesses have relative low risk levels as a result of stable markets, strong customer base or niche products or services not easily challenged or duplicated. Potentially higher business volatility will generally demand a higher level of reinvested earnings and a lower level of shareholder distributions in excess of tax and baseline distributions.
Remember these issues are not static, it is important to review shareholder concerns on liquidity and risk on at least an annual basis. Discuss with the board potential implications of the answer to these questions on the existing distribution policy and capital needs of the business. This also underscores why it is critical that management of the company establish and review strategic initiatives with the board on a regular basis, and that the board consider the impact of those initiatives on shareholder objectives. Finally, shareholders need to revisit their objectives and distribution expectations in light of the strategic opportunities identified for the business.
Recently at a seminar a well-respected advisor proclaimed that any succession plan that allows stock to pass to those not working in the business is a bad succession plan. For anyone who has experienced family dissension or destruction over conflict between those in and outside of the business, this certainly will sound like sage advice. But, while this may seem sound advice for a smaller business where there is little chance for significant reward beyond that which can support a single owner or that owner’s family, the issue is a bit more complex where larger assets are involved.
If the business is successful over time and grows large enough, there is an opportunity for building an enduring enterprise that creates both career paths for those working in the business, and returns (in the form of investment appreciation and dividends) for those who are not working in the business. Furthermore, an aligned ownership group can support growth models with the patient capital approach that is a competitive advantage for family firms. When combined with a liquidity policy that allows for the voluntary buyback of a small percentage of shares on an annual basis, the shareholder tree can be slowly pruned over time, increasing the likelihood of a unified shareholder group.
If we think of a family business in terms of a snapshot in time, it does seem logical to keep the family business in the hands of only those employed in the enterprise. But if we take a longer-term perspective, this decision may exclude the possibility of a family enterprise that ends up being governed by owners with independent directors serving along non family executives in building the business. Or, we may open ourselves up to the possibility that a next generation leader will come from one of the branches that might otherwise been prevented from ever owning the business.
One size does not fit all when it comes to family businesses. Each family must decide what path to pursue in terms of who can own the business, and all options should be considered in the decision-making process.