The shareholding structure is distinctive in family businesses. There are usually concentrated shareholdings held by a select number of shareholders who are related. They usually have a long term view of their shareholdings. Family shareholders are not wholly economically rational; they are likely to have a socioeconomic relationship with the business tinging their rationality. As shareholders and as managers they will have access to privileged information in a way that shareholders in a business with larger shareholder bases would not. As the businesses are owned by relatively few shareholders who retain their shares for long periods of time, liquidity in the shares of the business is usually very limited. Even where such businesses are listed on a stock exchange, the shares remain relatively illiquid due to large proportions of shares being retained by the family.
These characteristics of family business equity suggest that this type of equity is a distinct asset class. It has a long term outlook, it concentrates funds on a few operations, it is risk averse and is cautious regarding gearing levels. It creates value through positioning the service or product offering in the market by knowing the clientele and by incremental innovation. It looks for sustainable improvement of business performance. Financialization is an anathema to this way of thinking. Studies show differing conclusions on the performance of family businesses compared with other types of business based on business size, listing and the criteria for better business performance. However, it is possible to see how good family businesses manage to perform well.
High concentration of ownership (and thus wealth of the owner) in the business means the owner is very exposed to the risks the business takes and ought to be very aware of them. Incurring debt brings the risk of insolvency caused by non-payment of interest or capital. Debt brings a rigidity to the business as activity has to be aligned to the terms of the loan, notably the financial covenants. Gearing may be low in general in family businesses, but debt is non-diluting of business ownership. There are tax benefits in debt servicing. Debt is usually cheaper to service than new equity issued to external parties. Debt servicing does impose discipline on the business as the business has to plan to provide regular payments to pay the interest on the debt. That said, debt is usually incurred for specific reasons, perhaps related to a particular project. Consequently, investment is cautiously decided and implemented as it often involves some debt.
Where equity is used, the source is carefully considered, and family equity alone is preferred where possible. Dividends on equity can be reduced or suspended. The use of equity aligns the financing party interests. Expanding the equity capital of the business creates greater capacity to use debt in future through having a low debt: equity capital ratio. Furthermore, if the new equity is from the family then control of the business remains in family hands. Yet shareholders expect dividends where possible and preferably at decent yields. There is no tax advantage in using equity compared to interest repayment of debt. Furthermore, external equity cedes control in proportion to the size of the external equity stake.
As noted, family members may be less exacting as shareholders as they balance up the socioeconomic wealth they derive from the business with the financial wealth, deviating from rational analysis of strict financial theory. The family rationale in these circumstances is that there will be higher financial returns in the long term, so investing in apparently lower yielding projects is innovation and some of them will return handsome profit longer term. This keeps the business and its value chain going. The cost of reducing its operations are greater than the cost of the apparently low yielding investment. If enough such projects do succeed, then this rationale works, but if it turns out to be a less efficient use of finance than alternative uses, then the family business and its value chain stagnates and declines with time.
Gearing may help raise equity returns on projects by reducing the overall weighted average cost of capital for projects, but seeking the right equity/ debt balance is a subjective matter and constantly changes with the changing business environment. Changing the gearing also changes the risk profile of the business and thus business behaviour. More debt may mean more externally imposed financial rigour, but it may overshadow strategic business thinking in order to achieve shorter term goals just to pay the interest on the debt to external lenders. Therefore, family business financial management is a juggling game. It tries to keep in motion the growth of the business, income needs of the family and the sustainability of the business. This boils down to shareholder and management discussion of dividends (business profits funding family income), leverage (debt to generate profitable operations versus the risk debt brings) and portfolio management (family income needs versus diversification of business activity for the sustainability of the business).
Regular dividend payments may be a family need, but it can also show financial discipline, for example to potential lenders. However, that dividend level needs to be aligned to the business’ target growth rate to ensure it does not derail business strategy. That alignment also needs to ensure the dividend level is regular from year to year so the family can have some reliance on the figure.
Industries and markets rise and fall with technology, and social and political change. Therefore, it helps family businesses to assess if their sector is in its inception, growth, maturity or decline. This helps assess the future sustainability of the business and consider that against the dividend rate for the family. A family business in a coal merchant business might now extract as much profit as possible in dividends into private wealth or use the business’ funds to diversify into an aspect of renewable energy or another sector where the knowledge, skills and assets of the business may be applicable. That diversification may also be the start of a portfolio approach of the family to its business holdings and in which it occasionally buys and sells such holdings. Many family businesses fail to assess the cyclical nature of their sector. Consequently, the wealth generation of the business is not used to innovate, diversify or build portfolios. To do this requires a strategic, portfolio management approach to business management.
My colleagues and I can assist family businesses with their mergers and acquisitions, corporate restructuring, corporate governance, commercial legal issues, regulation, employment and company law issues as part of the strategic and financial management of family businesses. Furthermore, through our nexaflex, nexaGC and nexasupport services we are able to provide close, regular and aligned support to ambitious family businesses.
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