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Balancing capital, liquidity and control

Francois de Visscher is founder and president of the family business consultancy de Visscher & Co.

The globalisation of world economies means many family businesses must grow strategically to survive. More often than not, the growth capital requirements of the family firm clash with the liquidity and control needs of the family shareholders. What to do? Francois de Visscher explains

One of the most dangerous survival tests for family businesses is their succession. There­fore, it is no surprise that as large amounts of wealth and company leadership around the world are shifting to the baby boom generation, many successors and heirs feel relief and complacency once the transition period is completed. However, the handing down of power and money is not an end point, but a new beginning of an ongoing process – with a new set of ­challenges.

Succession to the next generation exacerbates conflicts between the liquidity required for an expanded shareholder base and the growth capital needs of the business in a global economy (see The family business triangle on page 46). New tensions that are bound to emerge can impair proper business and family governance.
Liquidity needs change as the family evolves. The founding generation usually owns most of the shares of the company, and while he or she can certainly cash in on the value of the company at any point, most founders would never dream of doing so. They are, after all, in the mode of building a company and its value, not milking it. But as a family company evolves from the founder to the partnership generation of siblings, it embraces more numerous and increasingly diverse shareholders, each with their own lifestyle, needs and liquidity demands. Some members of this 'partnership generation' will work in the company, but others who may not be active in the business may be more interested in current liquidity and dividends than watching the company reinvest profits.

If the company is fortunate enough to transition to a third generation, the shareholder base continues to expand to the point where no one person, but a coalition of shareholders, controls the business. While each member of this 'coalition generation' owns relatively small interests in the company, their need for liquidity flexibility has expanded. Similar to stockholders in a large public company, they are evaluating their ownership in investment terms, bringing in the notion of risk and return, return on equity and appreciation value.

Capital needs are bound to start competing with liquidity needs, especially as the competitive landscape of today's global economy requires the company to grow. Size and scale are increasingly critical components of shareholder value creation. Extending the company's market reach may require two sets of new capital sources. First are the outside non-family loans and private equity investors who come with their own liquidity and control expectations. Competing in a global economy will also require the company to attract top-quality outside management. This new set of stakeholders will also expect to enjoy ownership such as stock options.

Suddenly the family business must embrace three types of owners with different expectations and liquidity horizons. Family owners, who represent patient capital, have the longest time horizon, but still require some ongoing liquidity. Management equity, which increases based on performance, expects medium-term liquidity. Outside investor equity, which provides transitional capital, insists on relatively short-term liquidity.

Competition for quality management and outside capital diminished the role of the family in the management of the company. The family will inevitably transition from an owner-operator to a governor of wealth, with new and conflicting capital and liquidity demands such as diversification and return on investment.

Family control and governance structures, in this competing environment for capital and liquidity, become one of the most important yet complex cornerstones of stability. The family must create a strong family control structure that can be a powerful ally to the outside source of capital and that can reinforce the family heritage, an intangible but integral part of shareholder value.

In search of the proper balance between capital, liquidity and control, business families have three strategic options to choose from: maximise growth; maximise liquidity for shareholders or exit all or part of the company.

Growth mode
Even family businesses can't escape the global economy. Competitors, from Bangkok to Brazil, may try to lure your customers with related products and services or distribution reach.

You may have to match those offerings just to retain the customers you have. If you don't grow, the value of the your business will diminish over time. The good news is that size doesn't necessarily imply physical assets. You can expand your business through global networks, distribution and e-commerce, without building new physical assets around the world.

But if you elect to grow your family business in a global economy, you'll need outside capital for growth, equity incentives for management, effective shareholder liquidity programmes and family control structures to maintain and nourish the family's 'patient capital'.

Whatever combination of internal and outside capital the company harnesses, a growing business would be wise to create three types of liquidity programmes to keep all stakeholders happy.

Ongoing liquidity programmes. These allow family shareholders to access the company's value and appreciation over time. For example, if in 2002 your stock was worth $100 a share and it has appreciated to $120, shareholders should have some mechanism for realising some of that growth. Ongoing liquidity needs stem from the long-term or permanent shareholders' desire for flexibility and freedom of choice. Without that flexibility, shareholders have a tough time focusing on enhancing the value of the company because the value of their shares can never be realised.

One-time liquidity programmes. These help shareholders who want to exit altogether. The death of a shareholder or a family dispute may cause one or more shareholders to divest all or most of their shares in the company. A transition to the next generation may also precipitate a buyout – of the previous generation or one or more blocks of shareholders who may not agree with the direction the company is taking. The company can accommodate these shareholders if it has created a buyout policy specifying who can sell shares to whom (the company itself, other shareholders or outsiders). The company could also set aside a reserve (such as a percentage of retained profits or a percentage of equity) to allow for the repurchase of a certain amount of shares.

Transitional liquidity programmes. These programmes are designed to provide liquidity for outside sources of capital such as private equity or debt or even management equity. The time horizon of this outside capital will always be shorter than internal or family shareholders. Patient capital (happy family shareholders) has the longest term because shareholder value of the family business is as much tangible as intangible (the family's legacy and reputation in the community). Hence, planning for the exit of outside capital sources must be part of the strategic and financial plan of a growing family business.

Outside sources of capital can also create conflict among family shareholders who may balk at the investors' requirements to tighten up liquidity going to shareholders. They want the business to use their capital for growth of the business, not liquidity of shareholders.

Going public, to raise perhaps 20% of growth capital, may seem like an attractive alternative to private equity or debt because you don't have to repay the capital and it doesn't change much about your governance and control. But the public market currently does not favour family businesses because today's substantial size and scale requirements are beyond all but the largest family companies' means.

If outside investors are invited into the capital structure of the family company, it makes sense for the family to create a very tight control structure, such as a family holding company or family office to hold family shareholders' stock and balance the control requirements of outside investors to a unified family capital structure. To the extent that your family shareholders are fragmented into many branches, you will want to prevent a private equity investor that owns, say 40%, from convincing enough family members to sell him their shares so the investor would suddenly own more than 50%. You may also need a forum such as a family council to address family issues, and allow the outside board to totally focus on the business issues. Your family council can debate potential liquidity concerns and help allay concerns of impatient shareholders.

Many family companies will have to be very true to themselves as to whether they can meet these challenges or not. Would you sacrifice liquidity for growth capital?

Liquidity mode
Some business families will not be up for the challenge of aggressive growth. They are content to run a good business and instead of investing profits into future growth, will distribute much of the value the company creates to shareholders. They won't bring in outside capital. They won't need to if they decide to serve the markets they now serve, stay small and provide liquidity to the shareholders. This is almost like transforming the business into an annuity.

There is a trade-off, because over time the company's value will diminish. And that might be perfectly acceptable for shareholders who want to diversify their investments or invest in ventures of their own.

Many Latin American companies have taken this strategy. Shareholders have set up some very good holding companies and family structures that accumulate the cash coming out of the business. At the end of the day the business may not be worth much. But the family has good liquidity for diversifying outside the business.

A family office or investment company can help the family diversify its assets, educate family members about how to handle wealth, and perhaps develop a pool to negotiate good prices on insurance and other products and services. It's always good to have an outside board, but in the case of the milking strategy, directors will be more dominated by family members and any internal management or token outsiders probably won't play a key role. A family council could help the family focus on how to maintain the family unit in the investment company, and on philanthropy.

Sell mode
A family might sell its company for liquidity or strategic reasons. A liquidity motivation may emanate from a very simple present value calculation for the shareholders. What can they get for the business today on an opportunistic basis and how can they reinvest that capital? If that amount is much larger than what the business would be worth in the future and what the interim income the business could produce, it might make good sense to sell.

On the strategic side, selling might make sense if expanding the business globally would require resources (commercial, management, etc) that are not currently available in the company, but might be easily found through an outside owner. Finding a good home for the company would allow management to continue to flourish and help the company reach its potential.

Families who opt to sell their company need to design new governance structures. There may be a board, but it would likely be comprised entirely of family members, and perhaps some key trusted advisers (such as the company's attorney and accountant). The main challenge for these families, though, is the big liquidity event. The family will need to explore whether it's in their interest to maintain any family control or involvement after the company is sold.

Some families sell the business, take their share and do their own thing. Others find it is much smarter to keep everything bundled together and become a financial family by creating an internal (or hiring an outside) family office. This may entail charity work, some investments, hedge funds – a strategy for a whole new family business.

The conflicting needs for limited capital resources by the business and the shareholders have led to the downfall of many private businesses. By consciously exploring the options of growing, milking or selling, families can identify strategies that will meet their increasingly diverse challenges.

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