Originally published in the Family Business Magazine
Is it time for outside investors?
A guide to tradeoffs, opportunities and innovation
By Peter Begalla, Michael Drexler and Jonathan Quigley
Inviting outsiders to invest in your family business has its advantages — strong balance sheets, operational expertise and know-how in scaling businesses. But there can also be friction, and the stakes are high. One ill-fated transaction can put a business and its legacy – sometimes built over centuries – at risk.
A successful transaction requires a sturdy framework to help family business owners navigate the seemingly endless options and agendas that come with the decision to share control. Each family and business will have unique governance and stakeholders.
Should we share control – or should we cede it completely?
You and your family have built the business and understand it best. It is the family and board’s choice that matters, until the day you sign the sale document.
To get to the right answer, it is beneficial to split the question into two parts. First, what is your vision for the business – and is your current leadership strong enough to get it there? Second, what is the family’s vision regarding involvement in the business?
If you feel you have the right leadership, want to remain in the driver’s seat and just need extra capital, you should retain control. There are many investors, including specialized “non-control” private equity funds, who will cater to this situation. You could also partner with another family via their family office, which often will consider minority stakes and make direct investments.
If you think new leadership would enhance the business but the current owners want to have “a second bite at the apple,” you should retain a minority stake but cede control to another investor. There are plenty of options in that scenario, and you will realize a slightly higher valuation because the new investor would pay a “control premium.” You will likely want to protect certain priorities that matter to you, which we will cover later.
Finally, if the family owners would rather move on and focus on other priorities, a complete sale of the business is the right answer. In this instance, it almost always makes sense to “auction” the business – it will give you the highest price, and you will care far less about the goals of your investor than in the previous two situations.
In all these scenarios, there is no right and no wrong – the decisions are entirely personal for you and your family. However, the process can be challenging.. In most cases, you must get consensus on the fundamental question: “Are we the best owners for this business?” Gaining alignment across multiple shareholders can be hard to obtain. You might need to bring in trusted advisers to facilitate those conversations. While this may take time, it is the wise thing to do. Getting this part right is essential in order to answer the questions that follow.
What should we look for in an external partner – and what do we need to worry about?
Having articulated your vision well in the first step will lay the foundation for success here. The right partner will align with the family’s and board’s vision for the business, as well as your personal vision and values if you stay involved. In almost all cases, this will take time — it can be a multi-year process of conversations and referrals. Some advisers might push you for speed, but it is always worth remembering that it is your business, and you control both timing and all decisions.
There are few shortcuts in this step. The time frame is to your advantage, as you get to know potential partners. Experience will help you separate a slick sales pitch from real alignment. It is worth getting granular; assess which potential partners can come up with aligned solutions to business challenges. If they shy away from joint problem solving at this stage, there is the potential for something to go awry further down the road.Good investors will be happy to solve problems jointly. This simple checklist covers questions many investors will ask.
- How will you grow, and how will your competitors react? What will be the basis of your gains in market share — new channels, new relationships, acquisitions, product or service innovation, pricing?
- Could your business double its size without collapsing under its own weight?
- Are your processes well documented? Where do you see improvement potential?
- Do you have all the right policies (IT/cyber, compliance, risk, ESG, expenses)? Are they consistent across the firm and its locations?
- If you double the business, can you run it with substantially less than double the staff?
- Can your existing organizational structure absorb an acquisition half your current size?
- What is the exit plan/requirements/expectations for the investor? Is succession planning for key positions necessary?
It is helpful to have initial conversations with a broad group of potential investors. The odds are low that the first potential partner you meet is your ideal match, Dig deep into your networks and those of your advisers. Are there investors who have a great reputation with companies like yours? Be wary of investors who push you on time – good partners understand the magnitude of the decision you are trying to make.
Be very clear about your values and “red lines” at this step. This will sharpen the search for an aligned investor. Have your books in order, so your conversation is grounded in the best facts available. Good investors will understand that almost every company will have some imperfections in the historic record and will appreciate the transparency. How an investor reacts to those imperfections will tell you a lot about their values and whether you are aligned.
Hire a good tax adviser upfront, and be proactive about the tax implications of any transaction. Tax issues destroy a lot of trust in late stages of transactions. Sellers anchored on a pre-tax valuation are often shocked by the post-tax number. Being proactive and informed is the only way around those destructive dynamics.
If you already have a strong and experienced board, they can be very helpful in evaluating and navigating the conversations with potential partners at this stage. But they will be even more helpful in what comes next.
What about governance and protecting our family’s interests?
This question has the same answer whether you are a minority or a majority shareholder – reciprocity, or the Golden Rule, is a great recipe for building strong businesses. You and your partners should align on several key governance points:
- Established, well-functioning and aligned governance systems are attractive — a strong board with independent members and effective committees, a complimentary family governance program where shareholders know their lane, and a management team that works within the boundaries. All of these working together in their respective areas make it easier for a minority partner to take a seat at the table. Also, it is important to note that if your governance is solid, you are setting the table. The new capital may add a seat or two, but it is fundamentally your table.
- Who makes the strategic decisions, particularly hiring/firing of the CEO and key management team members, strategic acquisitions/divestitures and sale of the business? If the majority investor is the decision maker, can the minority investor have veto rights on certain decisions?
- How are the economic interests of the minority investor protected? In our view, the best models are those that align the majority and minority investor on a per-share basis (same share class, same valuation, same upside). Be wary of different economic terms for majority and minority investors, as those often bring acrimony further down the road.
- How can the minority investors influence strategic decisions, even when they do not have formal veto rights? Good models give minority investors the space to express their views – for example, via participation in key board committees (compensation, risk, audit, strategy).
How do we protect the intangibles that are essential to the success of the business?
Most family-owned businesses will have a “secret sauce” – intangibles that are key to their success like culture, reputation, certain ways of doing business and treating their customers. Very often, those are not well documented or articulated – and consequently, new investors miss them and at worst destroy what made the business great in the first place.
It is essential that those intangibles are presented strongly in conversations with potential investors –it not only will protect the business but also will increase the likelihood of finding a truly aligned partner. However, almost all potential investors (and private equity firms in particular) are financially driven. You must describe how your intangibles contribute to or drive financial returns – for example, because they create competitive advantage or efficiencies.
If framed this way, intangibles can be incorporated into the joint value creation plan and incentives. For example, a key “culture carrier” will be included in the equity plan, positioned correctly in the new organization and motivated for growth under new ownership. Certain processes that are unique to the business should form part of the playbooks and value creation plans that are agreed upon with the new investor.
Presenting intangibles clearly and even forcefully can be very helpful in identifying the right investor – particularly as there is subjective value judgment involved. The right investor will understand the intangible aspects of yesterday’s success that will still apply tomorrow – and will agree to protect them. A less suitable investor will categorically challenge the history of the business.
What if we don’t find the right partner?
Even if ultimately there is no match and the family decides not to bring in outside investors, there still is merit in going through the framework and considering the questions mentioned here. The internal discussion around the right vision for the business and the family can be a catalyst to re-energize the family and increase engagement with the business. The external conversations with potential partners can bring new ideas and valuable information back to the business. In the words of one family business owner we know well: “it’s like cleaning up your house for a showing. Even if you don’t sell the house, you still have a nicer home than before — and it is still yours to enjoy.”
There are many good reasons to bring in outside investors and share control of your business. For a well-run business, there will always be a choice of investors (and sometimes choosing none can be the right answer). While there will inevitably be trade-offs, knowing what those trade-offs are and having alignment amongst the family on where the red lines are will put you in a strong position to select the right partner.
Peter Begalla is the founder of JPB Consulting Group and conference director for Family Business magazine. Michael Drexler is the chief strategy officer and Jonathan Quigley is the chief network officer at Brightstar Capital Partners