Matters Column

Things to consider when funding a family business transfer

July 20, 2018
| By Mike Brown |
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All business ownership transfers are complicated and emotional, and when ownership is transferred within a family, these issues are magnified. According to Forbes, less than one-third of family-owned businesses survive the transfer from the founding generation to the second generation (G2) and 50 percent of those don’t survive a transfer to G3. So, what is causing these businesses to fail? In many cases, it is because the acquiring generation does not operate the business with the same sense of urgency and competency as the founding generation.

Business founders are entrepreneurial, hard-working and adept at navigating their business through difficult situations. Every new business struggles for traction, working capital and employees, and by living through this struggle, the founding generation understands how to deal with industry or economic downturns. The acquiring generation, on the other hand, was typically not alive or present during this period and only recognizes the business as a stable, cash flow-generating entity. More importantly, they see their parents’ lifestyle only after the business is successful and not during its formative years. This mindset colors G2’s management of the business, which is generally not well-suited for industry or economic change.

Because of this disconnect, the structuring of the business transfer is vital to ensure that (1) the founding generation gets a fair value for the business; (2) the business is positioned for success in the future and (3) the acquiring generation is motivated to continue working as hard as their parents. To accomplish these goals, it is vital an entrepreneur avoids gifting the business to the next generation but rather requires they purchase the business. And just like an outside sale, an internal sale should be structured with both debt and equity.

The debt component of the transaction is traditionally comprised of both conventional bank debt and seller debt retained by the founding generation. Taking on bank debt will allow the founders to dividend a portion of the enterprise value at the sale and diversify their risk, but it also introduces a new professional adviser. A good lender will require some oversight of the business and be the first line of defense if there are issues in the future. The underwriting process also will provide an analysis of the strengths and weaknesses of the business, which will allow the new owner to develop a strategic plan focused on improving the business, not simply maintaining the status quo. Financially, a prudent amount of leverage is optimal for tax planning and lowering the overall cost of capital of the business.

If additional leverage is needed, there are ample sources for second lien or mezzanine debt. This market has thrived in recent years, specifically if the total nonsenior bank debt is in excess of $10 million. This market is significantly more expensive but will usually bring added capabilities to the business. The provider will often supplement the board with outside advice, facilitate growth through acquisition and be a source for additional growth capital if needed in the future.

The equity component of a family sale is usually the sticking point for the acquiring generation. It is essential the acquiring generation commit a meaningful amount of their personal capital to the business. Personal investment is a powerful signal to the founding generation and to all the employees that the next generation is motivated, ready to take over ownership and believes in the long-term success of the business. The quantum of capital varies significantly by the individual’s resources and history with the business. If they have been a part of the management team of a large and successful business for years, they likely have ample resources to commit; however, in a small business where the acquirer is young or coming from outside the business, personal capital may be scarce. In this instance, the amount isn’t important, just that it is significant to the acquirer.

If the acquirer is unable or unwilling (the latter is a troubling sign) to invest meaningful equity, the seller should consider an outside investor to back the second generation. There are ample sources available to provide minority equity investment (own less than a controlling share of the business), which will (1) facilitate the sale to the second generation; (2) ensure the first generation has capital sufficient to retire, and (3) allow the family to maintain a majority ownership of the business.

Minority equity investors, like mezzanine debt investors, will provide outside insights and leadership in addition to their capital. Their capital is more expensive but can also be “repaid” or “rebought” at a future date, based on the value of the business at that time. These can be a great bridge to shepherd the new ownership through a learning curve while allowing the family control.

In short, a family business sale is complicated, but simply gifting the business typically does not best position the business going forward. There are myriad different funding options, and all of these funding options can play a part in different situations. The key is to ensure the sellers are paid sufficiently to live their post-ownership lives while maintaining control within the family and positioning the business to maximize enterprise value for generations to come.

Mike Brown is partner and managing director at Charter Capital Partners. He can be reached at mbrown@chartercapitalpartners.com

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