Private-equity groups: Liquidity for family businesses

By Alan J. Smith, Bay Pacific Group

Reprinted courtesy of EntreWorld.org

The new moguls of capitalism are here — private-equity groups — and that's good news for privately held companies, particularly closely held family operations. Over the past 20 years, private-equity groups, commonly called PEGs, have moved from the outer fringes to the hierarchy of the capitalist system. Their flexibility as a liquidity source offers a lot of ways for entrepreneurs to take some cash off the table, recapitalize the company, or simply sell out.

For the family-owned privately held company, PEGs are ideal, and that has a lot to do with the peculiarities of family businesses. In my three years consulting and brokering liquidity events for private companies — I founded Bay Pacific Group in 2002 to get into that business — about 60% of my clients have been family-owned. In the larger universe of all so-called mid-market private companies — those with annual revenue between $10 million and $200 million — about 40% would likely fit the family category.

Family companies, revealed

In my experience, family businesses, while legally no different from closely held companies in general, tend to be worlds apart in the way they function. Whereas owners of most private companies usually make decisions on the basis of what is appropriate for shareholders, those tied to families often let emotions, nepotism, and politics muddy the water.

Throw out the one-share, one-vote rule when it comes to a family business! The differing emotions within the family circle will often allow members with lesser stakes to override any specific share ownership stipulations in the interest of keeping the peace. It's not unusual for a family business to have extended members of the family working in the business that are less than capable in their role but, nonetheless, secure in their positions. Ah, nepotism is alive and well! A recent sale I was brokering eventually fell through, for example, when the owner's wife insisted that her two sons whose competence was questionable continue in their jobs at the same six-figure salary after the company was sold.

Finally, generational changes affect family businesses more than other private businesses. When the founder of a family-owned business that has operated for 35 years decides to retire, the dynamics are generally much more challenging than in other privately held companies. That is because he or she must weigh emotions as well as skill sets when evaluating which, if any, of the children should take over and in what roles.

Fit for a family business

All of these converging factors have a significant impact on how founders and their heirs need to find the right balance to successfully accomplish individual goals. The solutions will depend as much upon politics as economics. The smart family founders will search for achieving a balance that keeps everybody smiling as much as possible. In that quest, turning to the private-equity community can be an excellent fit.

It is interesting to point out that while America's venture capitalists, which provide seed and start-up funding to fledglings, have become the envy of the world for developing such firms as Google and Intel into hugely successful companies, investments being made today by private-equity firms on various deals to acquire, recapitalize, or invest in established companies are substantially higher — as much as four times the amount of money.

It is estimated that there are now more than 2,700 private-equity groups in the United States, up from just a few hundred two decades ago, and the number continues to grow. The trick for a privately owned company is to have access to those particular groups that invest in their industries and that are within their acquisition criteria. Virtually all private-equity groups have established acquisition and investment guidelines that they are more than happy to share.

In fact, most private-equity firms in today's market are constantly scouting for deal opportunities. There is a tremendous amount of money on the sidelines waiting to find a home. Part of that buildup of available money is a result of a lack of suitable alternative investments. With low interest rates, fixed-income securities, such as corporate bonds and bank instruments, are not attractive investments. Add then public corporate mismanagement and criminality issues (World Com, Enron, HealthSouth, etc.) that have been going on, and the result is more money going out of stocks into private-equity groups where the perception is that the investment is safer. Indeed, if you examine all the major corporate scandals of the past 25 years, none occurred where a private-equity firm was involved.

Tailoring the right family fit

Where does all of this leave the family company? With options. Lots of them. Teaming with an experienced M&A advisor that has relationships with the private-equity community and understands their parameters can unlock that opportunity. Working with a PEG that compliments your goals is key. Perhaps a "late-stage" investment in the future of the company by a PEG solves some issues. It can allow a company to take some money off the table while building a base for a stronger company moving ahead. It's quite possible for the company to still maintain majority control, a particularly sensitive issue for many family businesses. An agreement can be made for the PEG to invest in the company in increments over a time span, slowly increasing ownership while family members cash out along the way.

PEGs can offer much in the way of resources besides cash. They can provide advice based on their core competencies; they can bring in additional management from their contacts; and they can give a lot of guidance to help move the company forward. Remember, it's entirely in their best interests for a company to succeed — it's a true win-win. In short, a lot of the idiosyncrasies of family-owned businesses can be addressed at the bargaining table where unique deals can be carved out.

Conversely, when an acquiring stand-alone firm is buying a family company, really the only other exit option for a closely held business, the flexibility is much less. It's not to say that these can't be great deals, but most private companies usually only attract a limited amount of stand-alone companies and generally with a much tighter range of opportunity — often a complete acquisition or nothing. You can find a private-equity group solution, on the other hand, where a complete acquisition, a recapitalization, an employee-led buyout, a growth company needing an investment, a turnaround situation, an add-on or a buy-and-build scenario, can all be accommodated.

Making the best of a good thing

With all these great liquidity tools available, a privately held family concern should carefully evaluate its individual and collective needs. I'm often asked by a private-equity group what range of options a particular company might want to explore to see what the possibilities might be for a deal to be struck. I'm continually impressed by the sophistication and flexibility most reputable private-equity firms bring to the table.

Part of the reason is that this is what they do for a living. Whereas for the family-company owner, this is usually a one-time shot, the typical private-equity firm has worked with dozens of companies, in one form or another, and knows how to successfully complete transactions that provide value for all the parties. This is a tremendous post-closing asset that a private-equity group brings to the table. You get all their experience as part of the deal. They can be great partners, both short-term and long-term. Speaking of time horizons, this is generally a topic where there will be some understood agreement on what the short, intermediate, and long-term plans are for an eventual exit for all the parties.

For family-business owners approaching PEGs, the following suggestions might help them make the best of a good thing:

• Target the PEG to fit your needs — look for those that work within your industry and offer what you want, such as acquisition or late-stage investment.

• Gather appropriate historical financial information — at least three years prior — and set financing projections for three years going forward.

• Know your family's hot buttons, and work with family members to resolve or at least mitigate them before approaching the PEG.

• Confide in PEG investors about likely family bottlenecks — don't worry about having to save face, they've heard it all before. Besides, if they thought your business was perfect, what need would there be for them to step in? There's a fine line between presenting your business as worthy of investment and acknowledging that such could make it better.

• Educate yourself and family members about the emotional stumbling blocks involved in letting go of some control and also that it can be a wise step.

There is that old saying that you can't have your cake and eat it, too. Well, with the versatility of the private-equity community to tailor a plan to your needs, family companies just might be able to have the best of both worlds. When your time comes to cash out in one form or another, make sure you explore the possibilities of a private-equity deal. You just might solve a lot of problems for a lot of people, particularly your loved ones, where some understanding, flexibility, and unique tweaking can be accomplished.