If your exit strategy is to pass your business down to the next generation of family members, selling a piece of the company to an outside buyer may surprisingly make a lot of sense as part of your overall exit plan.
Normally, keeping the business in the family means just that—preserving family ownership, not selling to an outsider. But selling a minority interest (less than 50%) of the company to an outside investor can help overcome some of the more difficult challenges that family business owners face in their exit and succession planning. Here’s how.
Selling a non-controlling interest in the company to an outside investor, often a private equity group (PEG) or a family office, can solve four problems that commonly arise when trying to achieve a smooth exit for outgoing family owners and prepare the next generation of family owners to lead the company effectively. These four problems include:
1. Liquidity for the Outgoing Owners
One of the most challenging issues to resolve is how to provide financial income and economic freedom for the outgoing owners, whom we will call Dad and Mom. Commonly, Dad and Mom have invested heavily in the company over the years, and consequently, a significant portion of their net worth is tied up in the company and its supporting assets, leaving Dad and Mom unable to retire or step down from the company without somehow obtaining cash from the business. Yet the company typically does not have a large amount of surplus cash sitting around to fund Dad and Mom’s exit. As they lack the cash, the most common solution is keeping Mom and Dad on the payroll well after the next generation has taken over the company. This rarely works for very long. At some point, Dad and Mom may come to resent and/or worry about being continuously dependent on the company. Or, the next generation, whom we will call the Kids, may grow tired of the payroll burden if they do not see any light at the end of the tunnel. Keeping Dad and Mom permanently on the payroll is not a winning solution.
Selling a minority interest of the company to an outside investor presents a more viable solution on how to create financial independence for Dad and Mom. The outside investor’s cash infusion can fund some or all of the outgoing parents’ financial needs, freeing Dad and Mom from staying on the payroll indefinitely and giving them power over their own assets. Meanwhile, the Kids maintain a controlling interest in the company. At a future date, they may pursue buying out the minority investor if they desire to restore 100% family ownership of the company.
2. Eliminating Personal Guarantees
A second significant financial obstacle common within family-owned companies deals with personal guarantees on the company’s commercial or trade debt. Often, Dad and Mom have covered the guarantees up to that point, but the Kids lack the collateral and leadership track record to assume that responsibility when Dad and Mom exit. This scenario puts Dad and Mom in the uncomfortable situation of turning over operational control of the company to the Kids while having to stay on the hook for the financial risk. Few parents will be enthusiastic about that prospect. The Kids have reason to be unhappy too, as they will likely wish to avoid burdening their parents. Also, as long as Dad and Mom provide the personal guarantees, they will have the power to exert influence or control over the company, which is typically a sensitive subject for the Kids. If the issue of personal guarantees remains unaddressed, it can prevent the entire family from achieving a successful exit.
Selling a minority portion of the company to an outside investor, such as a PEG or family office, can eliminate the personal guarantee barrier to exit success. The entrance of an outside investor can give lenders sufficient confidence and collateral to remove their requirement for any personal guarantees. Furthermore, PEGs and family offices can often secure for the company more favorable debt terms and rates due to their experience and long-standing relationships with their preferred lenders.
3. Insufficient Professional Management
One other major challenge within many family businesses is how to inject professional management expertise into the company without surrendering the family’s leadership of the company. This need becomes acute as the company grows and transitions from one ownership generation to the next. You have likely witnessed family-led companies that struggled or perhaps even collapsed because the successor generation lacked sufficient leadership talent and experience to run the company.
Bringing in an outside investor can upgrade the company’s professional management without displacing the family’s controlling interest. First, outside investors will usually occupy several seats on the company’s board of directors. The right investor will fill these seats with quality leaders who enhance the company’s strategic leadership, experience, and industry contacts. Additionally, as part of its investment, the outside investor may provide funds to hire new managers and employees to work for the family owner. Commonly needed positions include an experienced chief financial officer (CFO) and professional sales manager/leader. A significant upgrade in talent and experience at the board and management team level is achieved without undermining the family’s operational control of the company.
4. Objective Advice and Counsel
Within family-owned companies, personal relationships and dynamics can encroach into business matters, blurring communications, responsibilities, and accountabilities. These relationships can harm company growth and prevent Dad, Mom, and the Kids from achieving a smooth exit and succession. Even within well-functioning family relationships, when facing serious business issues, it is difficult to maintain objectivity when there are only family members in the room.
Here, too, an outside investor can add value to the family business as it moves through a succession process. The investor, again through its minority representation on the board, adds the missing third-party objectivity, perspective, and controls. For example, the investor will likely require the company to prepare annual business plans and budgets and periodically review them at the board level. Also, executive compensation—always a touchy subject in a family-owned company—will be set according to market rates and evaluated objectively according to human resources best practices. These types of steps reduce the risk of nepotism and address the concern that family politics will detrimentally influence major business decisions.
For the benefits of succession to materialize, family-owned businesses must work with the “right” investor – one whose values, business model, and expectations align with those of the family. As such, finding the right investor will take time and careful preparation. Ironically, the best way to keep the business in the family may be to sell a piece of the business to somebody outside of the family.
This information was published originally by NAVIX Consultants and is for educational purposes only. Please consult your tax, legal, and other advisors to evaluate how this material may apply to you and your businesses. NAVIX does not provide tax or legal advice nor services.