Steve Waichler is a director of Follett and president of the Follett Family Council. John Ward is Wild Group professor of Family Business at IMD in Switzerland and professor of family enterprises at Kellogg School of Management. www.johnlward.com
Family businesses start small and can take generations to get a foothold in a market. Caution is essential, especially when it comes to borrowing cash. But, say John Ward and Steve Waichler, families are in a good position to diversify and build niche brands
Many successful family businesses operate with an unusual degree of capital constraint, remaining privately held and avoiding access to public capital. Their ownership families retain high concentrations of equity over long periods of time and perceive that issuing public securities would dilute value and diminish control. Many family businesses are also debt adverse, and their capital structures remain minimally leveraged. Other companies see debt as the cheapest and most flexible form of capital, and tend to leverage their equity. Conventional wisdom would hold that the capital restraint of family companies limits their resources and their ability to compete.
Yet, even with the "disadvantage" of their capital constraints, family firms still outperform other businesses in the long-term. How is it that this happens? More aggressive public companies, with larger capital bases to invest, would seem to have greater potential for growth. Yet, over the long haul family businesses perform better. Could it be that capital constraint provides a competitive advantage?
Most family businesses start small and grow gradually. With few resources, a founding entrepreneur sets out to build a sustainable business on sweat equity. At the early stages, many family businesses are built on an investment of human capital, the family working long hours and extracting little capital from the business. Often at this stage, loans are hard to get or perceived as too risky or costly. Instead of going into debt, capital is generated internally, retained and reinvested. Interest is perceived as a "tax" on cash, extracting liquid capital and reducing the flexibility and agility of the business.
Many family business founders learn early on that all businesses have cycles, even small ones, and that growing too quickly can be dangerous. Nothing erodes equity faster than having debt when sales and profits slump. Family business founders quickly learn these lessons of the balance sheet and cash flow, and as a result, they tend to grow their businesses more organically. When times are good, they have more cash to reinvest and do so, and when down cycles arrive they are leaner and so potentially more agile and patient.
The concept of organic growth of capital comes naturally to family businesses. Preserving sweat equity is an early motivator. No one wants to hand over value that's been built through years of personal sacrifice to lenders. As a result, family businesses tend to focus more on value preservation and generating reinvestment for growth internally. In addition to their debt aversion, many young family businesses do not pay out any dividends. Liquidity is reserved for business needs, and this frugal culture of retaining and building value in the business is an important part of creating sustainable family companies. By being conservative, family businesses are more readily established and can achieve sustainability sooner. Family successors often learn these key financial lessons from the family founder, and remain focused on building capital through retaining profits even after their companies have grown to a significant size.
The capital constraints of family businesses are often viewed as an inappropriate holdover from their founding days. As companies mature, the reasoning goes, they change scale and require more capital for strategic investment. Debt is seen as the least expensive source of additional capital, and equity offerings are viewed as generating whole new sources of capital for investment.
Capital constraints cause family businesses to take a long-term approach to building value, producing the strategic advantage of patient capital. Rather than focusing on fulfilling short-term expectations, family businesses often sacrifice short-term gains in order to maximise long-term returns. In many instances, the "constraints" of family business are combined with a concentration of control, which enables greater flexibility to pursue the right course, even when there are short-term consequences.
Capital constraints also serve to focus and motivate management. Faced with limits on capital investment, managers must prioritise their selection of projects and focus on the successful execution of a few at a time. This creates a greater concentration of effort and command of detail. Managers know that speed and efficiency are key to the success of their current strategic initiatives, and that successful completion is a prerequisite to initiating other projects.
Because of these dynamics, family businesses often concentrate their investments in a particular market space and penetrate them more profoundly. They often develop leadership positions in market share by focusing on their particular niche and serving those customers better. Having limited resources also leads to the development of less capital-intensive strategies. Many family businesses become the proverbial "big fish in the small pond," which helps lower the risk of their smaller scale in the larger business world.
In addition, many family businesses successfully pursue diversification. Their defined ownership culture often makes them good buyers of unrelated businesses. As careful stewards of capital, they are capable of pursuing diversification, while maintaining close attention to performance. In all these instances, the ability of family businesses to concentrate control, focus on costs, and balance strategic trade-offs is critical to success.
All of these elements illustrate how limited capital can shape family business culture in productive ways. They reveal the lessons learned in the founding and development of family businesses. Yet, many family enterprises grow significantly over time, achieving a scale, which might induce them to pursue more capital intensive strategies. But many maintain the pattern of internal capital generation, creating, retaining and reinvesting a higher portion of profits in the business.
Many families recognise that capital extraction leads to taxation and the erosion of value. This is equally true for income paid out as dividends, and many family businesses pay lower dividends in order to reinvest more in building equity. As shareholder value grows, ownership transfers to succeeding generations can be eroded by taxes.
The untold story of these constraints is that they often reinforce family function at a time when it is changing scale and ownership. Limited liquidity can help refocus growing ownership groups on the long-term creation of value within the business. This is true as ownership comes to understand that business equity is often the most efficient asset for transferring wealth.
Stock in privately held companies can be discounted for its lack of liquidity and for being held in minority interests. These discounts can reduce the tax burden of wealth transfers within the family. This, in turn, can help maintain internal capital levels, and keep more cash invested in the company.
Inactive family owners are sometimes seen as captive investors of their family business, but in fact the two have a symbiotic relationship. Minimising the demands on capital caused by taxation enables a higher level of wealth transfer for the family and helps maintain a higher level of investment within the business. This is yet another way that capital constraints reinforce the continuity of family businesses. Family ownership groups share a common financial interest, and must find common ways to address the ownership issues created by capital constraint. This reality often brings larger families together, and fosters the development of collective ownership structures and agreements. Ownership families that grow beyond a "family scale" must develop new ways to relate to one another and their business.
Ownership adaptation becomes increasingly necessary, and this is another way that the constraints of family business push them to achieve a higher level of function. Family businesses must maintain their symbiotic ownership and business relationship in order to sustain competitive business advantage. As the family and business change scale, larger family ownership groups can still maintain effective, concentrated business control by adapting innovative governance structures and practices. Ultimately, capital constraints push family businesses to be better governed in addressing the challenges of continuity.