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Now or never? Venture capital and the family business

Tony Bogod is chief executive of the BDO Centre for Family Business.

Around 1% of family businesses use venture capital as a source of funding, compared with more than 25% of non-family businesses. So how can venture capital be made more palatable to family firms, asks Tony Bogod

Imagine you were an investor with access to a market representing almost 75% of enterprises and half the economic activity in the country. Imagine, furthermore, that this market was characterised by strong culture, loyal managers and workers, long-term strategic commitment, pride in tradition and corporate independence, spawning major global brands such as JCB, Weetabix or Glenfiddich. Would this not be an area worth serious consideration for its investment potential?

You may, in fact, be surprised to hear that the opposite appears to be the case. The market described above is pretty much characteristic of the family business sector in most developed economies. And yet it is one that has been traditionally shunned by venture capital providers and other sources of private equity.

In July 2002, the BDO Centre for Family Business, supported by Sagitta Asset Management, commissioned some research on this topic from Dr Panikkos Zata Poutziouris, fellow in the management of small- and medium-sized enterprises (SMEs) at the Executive Development Centre, Manchester Business School. In order to consider current trends in this area, it is worth us re-examining some of the key findings of that research.

'Venture capital and the family business', as the study was called, discovered there are highly significant differences in the sources of development finance used by family and non-family businesses. For example, the former rely less on bank overdrafts or loans, owners' equity and capital from directors.

By far the greatest discrepancy, however, relates to venture capital funding. More than a quarter of non-family businesses rely on private equity for development but in family businesses the figure plummets to just 0.9%. Even allowing for the fact that the study focused on SMEs, and larger family businesses might potentially be more predisposed towards private equity, the differential is significant. It seems clear from this that there is a substantial barrier to venture capital funding in the family business sector. Indeed, a quick scan of available records reveals few published examples of external equity investors as partners alongside existing family shareholders in family businesses. Why?

Keeping it in the family
Many venture capitalists (VCs) and family businesses miss opportunities because each side makes assumptions about the other. It is generally believed, for example, that family firms are not in business to actively pursue orthodox growth and financial performance objectives to the same extent as their non-family counterparts.

This is often not the case. And as noted in the report: "Even for those growth-oriented family businesses sampled, whose sound performance, secure financial structure and open culture would make... a relatively attractive proposition for providers of equity finance, funding is rarely forthcoming".

Families often think venture capital investment will lead to a loss of control (cited, alongside "dilution" as a barrier to equity finance by 71.6% of family firms questioned). VCs are prone to see family firms as unprofessional, nepotistic, secretive, rigid and feud-ridden. Neither of these perceptions is necessarily true. And, as with so much else in the world of family firms, many of the issues that do arise can be solved relatively easily at the outset through open and honest communication.

The venture capital perspective
There are those in the investment community that understand this problem. Charles Richardson, managing director of small and medium investments at the venture capital and private equity house 3i, works with many family businesses but says the mere mention of them often sends up a red flag in the minds of most of his industry colleagues. "There is often an inherent misalignment of interests between the goals of family shareholders and VCs – particularly VCs interested in a fund with a limited lifespan," he says. "Most family companies are not ambitious enough to appeal to the private equity community."

Furthermore, many VCs are aware that the relationships and tensions in a family business can lead to boardroom wars of Dynasty proportions or, at best, added layers of complexity in the relationships and decision-making processes needed to bring about successful deals. With many larger family businesses, members of the family with significant shareholding can be spread all over the world and in some cases may not even be willing to talk to each other.

David Williams of Sand Aire Private Equity, which has a history of investment in family businesses, says that for most VCs: "There have been lower-hanging fruit – larger public companies with subsidiaries whose management has no emotional attachment to the business, which makes it easier to work with them." 

All experts agree that the marriage of family business with private equity can be fraught unless approached with care. If expectations are openly communicated at the outset, however, there are also substantial opportunities. Richardson says: "You won't find a VC that wouldn't like to have backed Morrisons, a major public company that is still dominated by a family. These companies looking at returning shareholder value are of interest."

And there are signs that this is far from a unique case.

Family businesses sell out
In recent years, family businesses have dispensed with qualms about flogging the family silver and sold off billions of dollars worth of assets. In the UK, for example, Brake Bros, the food distributor, was sold to CDRP Acquisition in June 2002 while the sale of the Littlewoods mail order business to the Barclay twins raised £750 million for its founding family, the Moores, in October the same year.

This set the scene for more high-profile sales last year. In August the family owners of Linpac, a packaging company, were said to have made £400 million following a management buyout supported by Montagu Private Equity. In November the George family, owners of Weetabix, the top UK cereal brand, sold their business to Dallas-based VC firm Hicks Muse for £642 million.

So far this year the trend is showing no signs of stopping in the UK. In March, Dualwise, which makes a well-known industrial soap called Swarfega, was sold by its owners, the Williamson family, to Barclays Private Equity for £135 million. The same month, Donald Fisher, one of Scotland's richest men, added a further £30 million to his fortune after selling his 103-year-old family laundry and textile rental business to its management team, in a deal financed by Close Brothers Private Equity.

All the above represent exits or management buyouts, with families not being the major shareholders after the deal. Examples of minority investments by VCs alongside family members, whether succession driven or not, still seem to represent the exception.

However, in a recent straw poll that we took of VCs, all expressed a commitment to investing in family business, with most saying they would like to increase the level of work they do with families. It could be that the relations between private equity providers and family firms are beginning to thaw.

Strategies for success
It is evident that family firms are becoming increasingly open-minded about opening up to outsiders, as well as selling up rather than holding on for generations. The question for family businesses and VCs alike is now: when and where can external equity bring benefits to both parties?

Succession is one important area for consideration. This is a highly-fraught time for even the best-run family businesses; less than 30% make it through to the second generation and only 10–15% survive through to the third. Anything that can improve this survival rate and produce a decent return for investors has got to be worth looking at.

One obvious way of using private equity at this point is to fund the retirement of a founder. VC capital can be used to acquire, say, 30% of the founder's shareholding while the remaining shares are passed down to the next generation. Clearly any such deal has to be a mix of "cash in, cash out" acceptable to the VC, but in a well-run, growing family business this can have benefits all round. The company is free of financial obligations towards the founder, the company gets a sizeable lump sum for growth and the VC makes a good investment with potential for high returns.

Succession is not the only point at which venture capital can come in handy within a family business, however. A sibling who has opted for life on a beach or a son with growth aspirations for the business could also lead to situations that could be imaginatively resolved with a helping of VC cash.

And alongside these ideas we have the recent trend of major family-owned brands being sold; this clearly suggests that there is now a major opening for VCs to work with families on growing the business in the run-up to a sale. Evidently, now is the time for private equity firms and family businesses to take more interest in each other.

VCs in the family way
And, indeed, not all VCs are averse to family firms. Ryan Robson of Sovereign Capital says that almost a third of his company's investments are in family businesses. According to Charles Richardson, 3i has historically maintained a wide portfolio of family business investments which it looks to for long-term shareholder value.

Sand Aire Private Equity's affinity for family businesses goes even further, in that it hardly deals with anything else. The company itself is part of a family firm, created in 1994 by the Scott family, which has been running financial services businesses since 1903. David Williams calls family businesses "the hidden champions of the UK economy".

Sand Aire specialises in working with entrepreneurs who built up their businesses 20 years ago and are coming up to retirement, offering a key opportunity to equity investors. "These people are asking themselves 'Do I pass down the business, do I sell to the big companies I have fought against all my life, or is there a middle route?'" explains Williams. "The middle route is for an equity house to come in and allow the founder to diversify their wealth, while keeping a very good management team in place."

There is almost certainly a golden rule here that applies to so much in the family business world. It is about communication. If VCs are prepared to take time out to understand what the family wants and what is acceptable to them, and the family is able to be open about its own agenda, a happy marriage can indeed prevail to the benefit of all involved.

For family businesses, the rule of thumb should probably be to never assume anything, even things they have heard on good authority from other families. Although family businesses have much in common, each one is still unique – and some could benefit from equity much more than others. Here again, only open communication between the business and the VC will reveal how much there is for both sides to gain. Let's get talking.

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