Financing family business growth
After the family business reaches a certain size, it is often necessary to use outside capital to continue growing the business. This can come from several different sources, but before families seek outside investment they must first identify which form will work for both the business and the family, writes Jurgen Geerlings
While addressing the topic of how to finance a family business, I first would like to present a fundamental lesson learned from practice: "Make sure that the way you finance your business will not affect the soul of your family". Before you realise it, the financial issues of the business are intervening with the emotional commitment of the family. That has to be managed properly.
When the business receives outside capital to fund ongoing development, it also often brings a stakeholder who wants to be involved with business decisions. They will expect a fair share of the profits depending on the risk they perceive.
Given that starting point, there are three key questions to ask:
- Will we be able to finance the further development or growth of our business from our retained profits or from our own family assets?
- If not, are we willing to accept the influence of outside capital providers on the business (strategy policy) and ownership (dividend policy) decisions we make?
- If yes, on what pre-conditions will we base the selection of the proper capital source and provider?
In other words, is the family prepared to share the control of their business? That is indeed one of the most common and major dilemmas related to the financing of a growing family business. This brings me to the following statement: "Fearing loss of control is the wrong reason to avoid funding your business by means of outside capital".
The challenge is to design a flexible ownership structure that provides for several possibilities to attract capital from different sources without losing control. Sharing control does not equate to losing it. There are various techniques that can be put into place to make sure that the family owners will maintain control over the business.
At the same time, sharing control with outside stakeholders may result into a stronger and more sustainable business for future generations. The key is to achieve a shared vision among the family owners on the future of the business and on the involvement of the family members with the business. Once this has been settled, it will be easier to find the answers to the three key questions.
There is a basic distinction between two financial resources: equity and loans. Equity generally means a co-owner will partner with the family for the long-term, whereas loans have a lower impact on control (as long as the business goes well) but will have a direct impact on the cash flow of the business, simply because these have to be paid back within a certain period. In many cases, especially when the business is growing fast, the amount of money that can be borrowed is limited and the alternative would be raising outside equity capital. Equity comes from different sources with different consequences for both business and family.
Characteristics of some common sources of outside capital are:
- Informal investors: limited resource for medium sized or larger companies; a strong personal match between the owning manager or family and the investor is a prerequisite.
- Private equity: a large variety of providers are active with different scopes; captives usually have a longer investment horizon.
- Public offering: considered as a very flexible way of funding; the family members however have to be prepared for public exposure as well.
Partnering with other family businesses: families that know and trust each other may benefit for generations from working together on their own pace and conditions; the appropriate structure might be a joint venture or a minority stake in a daughter company.
In order to decide the best way for the family to raise outside capital, the following best practices could serve as a guide:
- Design and put into practice an ownership strategy that can count on a strong commitment from the family. An ownership strategy will serve as a framework for selecting the right equity source and partner. Obviously, this is not only a technical matter. The starting points of a sound and consistent ownership strategy are the identity of the family and the family values. The clearer the family values are being depicted, the easier it will be to decide for the pre-conditions for attracting outside capital.
- Introduce outside non-executive directors who, as an advisor, are willing to get well acquainted with the values, characteristics and vision of the family. Doing so, they can help balance the interests of the family and the business.
