Travis W. Harms

Family business directors are best served by assessing financial performance on both an absolute and a relative basis. Absolute financial performance can simply be read off the face of the financial statements, but making appropriate relative comparisons requires reliable data on similarly situated firms.Benchmarking data typically focuses on financial performance but provides little perspective on the strategic financial decisions that can have a major influence on the sustainability of the family business.Family business directors generally have little perspective on how other companies handle certain items like capital allocation, capital structure, and dividend policy. With the release of our Family Business Benchmarking Study, we aim to fill that gap.Each section includes both data analysis and insights to help family business directors interpret the findings and apply them to strategic decisions.

Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story. As a family business director, you need the whole story. We’re not aware if Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital (ROIC), because it tells you the Rest of the Story.?Don’t forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses.  There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies.The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.

After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure buyers back onto the field in 2024.And when deal activity heats back up, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep. In this week’s post, we review five reasons family business directors need a QofE report before approving an acquisition.1. Avoid overpaying for earnings that aren’t sustainable.Audited financial statements provide assurance that the past performance of the target company is faithfully represented. However, successful acquirers are focused on the future, not the past. A thorough QofE report helps buyers extract what truly sustainable performance is from the welter of the target’s historical earnings. Paying for historical earnings that don’t materialize in the future is a recipe for sinking returns on invested capital. QofE reports analyze historical earnings for adjustments that convert historical earnings to the pro forma run rate earnings that make an acquisition worthwhile.2. Identify opportunities for cost savings in the target’s expense base.The detailed analysis of cost of sales and operating expenses in a QofE report can uncover opportunities for acquirers to boost margins at the target through cost-saving initiatives. By observing trends in headcount by function, occupancy, and other components of operating expense, buyers can identify redundancies and develop strategies for enhancing post-acquisition cash flow from the target.3. Find revenue synergies with your existing business.A thorough QofE report is not just about expenses. Observing revenue trends by product and business segment, coupled with analysis of customer churn data, can help buyers better understand how the target “fits” with the existing business of the buyer, which can open up strategies for fueling revenue growth in excess of what either company could accomplish on a standalone basis. Armed with a better understanding of opportunities for revenue synergies, buyers can move to the closing table more confident of the upside to be unlocked through the transaction.4. Clarify working capital needs of the target.Incremental working capital investment is the silent killer of transaction return on investment. A thorough QofE report will move beyond the income statement to evaluate seasonal trends in the core components of net working capital. Doing so helps buyers plan adequately for the ongoing working capital requirements they will need to fund out of post-acquisition earnings. Working capital analysis in the QofE report also helps buyers negotiate appropriate working capital targets in the final purchase agreement.5. Assess capital expenditure needs at the target.Not every dollar of EBITDA is equal. EBITDA multiples are a function of risk, growth, and capital intensity. Buyers cannot afford to overlook capital intensity when evaluating targets. A thorough QofE report examines historical trends in capital expenditures and fixed asset turnover to help buyers better discern the prospective capital expenditure needs of the target and how those needs influence the transaction price and prospective returns. For family businesses contemplating an acquisition, the stakes are high. You can’t eliminate risk from an M&A transaction but obtaining a thorough QofE report on the target can help directors avoid mistakes and increase the odds of a successful deal. If you are considering an acquisition in 2024, give one of our senior professionals a call to discuss how our QofE team can generate Insights That Matter for your diligence team.WHITEPAPERQuality of Earnings AnalysisDownload WhitepaperFor buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

What Buyers and Sellers Need to Know About Quality of Earnings ReportsFor buyers and sellers, the stakes in a transaction are high. You only get one chance to do it right.Commissioning a quality of earnings report is an essential step in getting the transaction right.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.Leverage the experience of our QofE team to generate Insights That Matter in support of your next transaction.

Happy Halloween!  This week, we have four frightening guests who share their most terror-inducing family business challenges.  It’s definitely not for the faint of heart, but if you are brave enough to face your fears, check it out!Get your preferred copy of the book, The 12 Questions That Keep Family Business Directors Awake at Night,here.The Scariest Thing That Faces Family Business Directors - Halloween 2023 from Mercer Capital on Vimeo.

Suppose that your exposure to the French language consists of two years of high school classes twenty-five years ago. Imagine how frustrating it would be if suddenly the only news outlet available to you was Le Monde. With no small effort on your part, there’s a good chance you would be able to discern the broad outlines of the day’s events, but the odds of misunderstanding a key part of the story would be high, and any subtleties or nuance in the writing would be totally lost on you.That is likely how many of your family shareholders feel when it comes to comprehending the financial results of your family business. Perhaps they took an accounting course at some point in their lives. Or simply by virtue of having grown up around the family business, they have developed a vague sense of the differences between revenue and equity, or assets and expenses. As a result, when they read a financial report, they are generally able to discern the broad outlines of performance for the year or quarter, but the odds of misunderstanding a key part of the story are high, and any subtleties or nuance beyond the most rudimentary data are likely to pass them by.Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this whitepaper, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful.

Family shareholders are entitled to know what long-term strategic decisions are being made on their behalf by the managers and directors of the family business and why those decisions are being made. In this video, Travis Harms discusses three fundamental corporate finance questions that will help family business shareholders understand the basics of corporate finance and will ultimately result in more engaged and valuable shareholders.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) If you want to dive even deeper into the world of corporate finance, read our whitepaper "Corporate Finance in 30 Minutes." In the whitepaper, we provide more insight into the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make. Our goal with this whitepaper is to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion.

As market and financial data for 2022 continue to roll in, we are beginning to prepare for our annual benchmarking study. One early finding is that investors clearly distinguished between companies that pay dividends and those that don’t. Across the size spectrum, investors favored dividend-paying stocks in 2022, as illustrated in Table 1.Table 1 :: Average Returns by Dividend Status While it was a down year across the board, the average return for companies that paid dividends was less negative than those that did not. In this post, we explore two potential reasons for this outcome and the lessons for family business directors.Lesson #1 – Dividends are a powerful signal to shareholdersActions speak louder than words, and dividends speak louder than slide decks. Dividends tell shareholders what time it is and what the future looks like.Paying a dividend—or not—tells shareholders whether it is planting time or harvesting time. The implicit signal from non-dividend payers is that the company has more attractive investment alternatives than available capital (i.e., it’s planting time). However, dividend payers are communicating to shareholders that they are generating more cash flow than can be responsibly reinvested (i.e., it’s harvesting time).We can confirm this in general terms by looking at the prevalence of dividend payers among the small-cap (S&P 600), mid-cap (S&P 400), and large-cap (S&P 500) indices. As shown in Table 2, nearly 80% of the large-cap companies in the S&P 500 paid dividends in 2022, compared to just over half of the small-cap companies in the S&P 600.Table 2 :: Prevalence of Dividend Payers by IndexAs companies grow and mature, they often use dividend payments to signal to shareholders what time it is.Second, companies can use dividends to signal to shareholders what they believe the future holds. Stock prices are all about expectations for the future, not what has happened in the past. Companies tend to only change dividends when they believe the new level will be sustainable, so investors interpret dividend changes as powerful signals regarding management’s confidence in the company’s performance going forward.Table 3 :: 2022 Return by Dividend ChangeAs shown in Table 3, those dividend payers that increased dividends during the year outperformed those that maintained or reduced their dividends during 2022.So what is your family business’s dividend policy telling your family shareholders about what time it is and what the future holds for your family business? As we have often remarked, shareholder letters may or may not get read, but dividend checks always get cashed. Are your dividend actions aligning with your words about the family business’s circumstances and future prospects? If not, there is a good chance you are eroding credibility and trust with your family shareholders, and credibility and trust are the lifeblood of successful and sustainable family businesses.Lesson #2 – Dividends reduce shareholder riskMarkets are complicated, and returns are influenced by many factors. However, at the risk of oversimplifying, stock prices fell in 2022 because higher interest rates increased the cost of capital for businesses. As the Wall Street adage says: “Don’t fight the Fed.”Rising interest rates do not affect all investments equally, however. The longer investors have to wait to receive cash, the more sensitive an investment is to interest rates. A steady dividend stream shortens the “duration” of investments in dividend-paying shares relative to non-dividend-paying shares. So, in a rising rate environment like 2022, basic present value math suggests that dividend-paying stocks will outperform.But one shouldn’t expect that what worked in 2022 will not always work going forward. Table 4 summarizes average annualized returns for the same group of companies for four years ending December 31, 2021. Over this period, during which the federal fund’s effective rate fell from 1.42% to 0.08%, returns for dividend payers lagged those of their non-dividend paying peers.Table 4 :: Annualized 2017-2021 Returns by Dividend Status Dividends reduce risk (and upside potential) for public company investors. What about your family shareholders? What role do dividends play in managing the investment risk of your family shareholders? We’ve written previously about how your family business has more than one value. Of the three “values” of your family business at any given time, the lowest is the value of a minority (non-controlling) position in shares that is not readily liquid, as depicted in Table 5.Table 5 :: The Levels of Value The “marketability discount” in Table 5 measures the economic burden of illiquidity commonly borne by family shareholders. The magnitude of that discount is not the same for all family businesses. Rather, it is a function of several factors, prominent among which is the amount of expected future dividends. As markets demonstrated in 2022, dividend payments mean that investors don’t have to wait as long to receive a return on their investment. For family shareholders facing an uncertain but potentially lengthy holding period, regular dividend payments ease the burden of illiquidity.ConclusionYour family business’s dividend policy is sending a signal to and is affecting your family shareholders' risk (and potential return). Are you and your fellow directors being intentional about the signals sent by your dividend? Are you incorporating the risk-return tradeoff for your family shareholders in your dividend policy deliberations? Intentionally crafted or not, all family businesses have a dividend policy: is yours sending the right signals?Mercer Capital has worked with family businesses in crafting their dividend policy. Let us know if you have questions about your dividend policy and the message it is sending your family shareholders.

Many enterprising families have January 1, 2026, circled on their calendars. Why? Because the individual estate tax exemption reverts to $6 million (give or take, depending on inflation) in 2026 from its current level of $12 million. As a result, many estates that are not currently large enough to be taxable will become so, and the effective tax rate for all estates will increase.A recent Wall Street Journal article highlighted the benefits, and potential downsides, of family limited partnerships, or FLPs (and their close cousin, the family limited liability company).The “magic” of the FLP is the ability to transfer assets to heirs, and out of taxable estates, at discounted values. The WSJ article points out that the IRS is skeptical of many FLP planning strategies, noting that audit challenges may become more frequent as the IRS puts its new $80 billion enforcement budget to work.While the valuation discounts applicable to FLPs may seem like estate planning magic, there really is no sleight-of-hand involved. Instead, valuation discounts reflect economic reality.Fair Market Value Is an Arm’s-Length StandardEstate planning transfers must be accounted for using the “fair market value” of the subject interest. Revenue Ruling 59-60 offers the following definition for fair market value: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”Fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant factsThere’s a lot there, but for this post, we will simply highlight that fair market value is not determined with respect to a specific buyer or seller and therefore does not consider any familial relationship between the transferor and transferee in an exchange. Rather, fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts.Under this standard of value, business appraisers typically value interests in FLPs using a three-step approach.The Market Value Balance SheetThe first step is to compile a listing of all assets owned by the FLP, reduced by any liabilities. FLPs hold all kinds of assets, some of which have more readily ascertainable values than others. So, for some FLPs, the market value balance sheet can be constructed simply by referring to a brokerage statement, while other assets, like shares in a family business, will require a separate valuation process. Once the market values of the assets and liabilities have been determined, the difference between the two, referred to as “net asset value” or “NAV,” provides the starting point of the valuation analysis.It's Nice to Be in ChargeIf the subject interest possessed sole discretion over the operations of the FLP, net asset value would be an appropriate proxy for fair market value. After all, rather than sell the interest at a discount, the holder of such an interest would instead liquidate the underlying assets and settle the liabilities of the FLP, thereby realizing the net asset value.However, the FLP interests used in estate planning transfers rarely have such authority (as would be possessed by a sole general partner). Small, limited partner interests lack the ability to direct the operations of the FLP or force the liquidation or distribution of the underlying assets. Willing buyers operating under the fair market value standard are wary of such investments. All else equal, they prefer to be the ones making the key investment and operational decisions. When submitting to someone else’s decisions, they demand a higher return on their investment by applying a discount to the pro rata share of net asset value.This reflects a simple economic reality: minority interests in asset portfolios are worth less than the corresponding share of net asset value. There is ample real-world evidence supporting this conclusion in the market for shares in closed-end funds, which regularly trade at discounts to NAV.It’s Even Better to Be LiquidThat is where the similarities between FLP interests and shares in closed-end funds end, however. Unlike investors in closed-end funds who can quickly convert their shares to cash, there is little to no liquidity for most interests in FLPs. All else equal, investors tend to prefer liquid assets to illiquid ones. As a result, our “willing buyer” from the fair market value definition requires an additional discount to be convinced to buy a minority interest in an FLP.The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristicsOnce more, this discount is no mere valuation parlor trick but instead reflects economic reality. The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristics:Duration of the expected holding period. Since investors prefer liquidity, the longer a willing buyer would expect to be stuck holding the FLP interest, the larger the discount.Magnitude of expected distributions. Even when not readily marketable, some FLP interests receive regular distributions (beyond those needed to pay pass-through tax liabilities), while others receive none. The greater the magnitude of the expected interim distributions, the lower the discount.Expected capital appreciation of underlying assets. For the willing buyer, returns can only come from two sources: distributions (accounted for above) and capital appreciation. All else equal, the faster the underlying FLP assets are expected to grow in value, the smaller the discount.Holding period risks. Return follows risk, and owning the subject FLP interest is riskier than owning the underlying assets outright. The more incremental risk associated with the subject FLP interest, the greater the return required by the willing buyer, resulting in a larger discount.Be Sure the FLP Structure Is Right for Your FamilyValuation discounts for FLPs are not convoluted mirror tricks on the part of appraisers but rather reflect the straightforward economic reality of FLP interests. However, for these discounts to withstand IRS scrutiny, the economic reality we’ve described in this post must match, well, reality. As noted in the WSJ article, families forming FLPs should be prepared to live with the economic reality of having an FLP, including identifying and adhering to a clear business purpose, formal meetings, and pass-through taxes.We have valued minority interests in well over 1,000 FLPs over the past forty years. We don’t know if an FLP is right for your family, but if you and your tax and legal advisors conclude that it is, give one of our valuation professionals a call to see how we can help you.

We have traditionally advised you about what not to talk about at the Thanksgiving dinner table, but this year, we thought we would highlight a more positive family business conversation that you might want to have with your family shareholders—if not this weekend, then sometime soon.The question is: What is the economic meaning of the family business for our family?  Is it an economic growth engine for the benefit of future generations or a source of lifestyle for shareholders today?  Is it a “safe haven” store of value or a source of wealth accumulation allowing shareholders to diversify away from their economic dependence on the business?  Gaining consensus on this question can help make the many other questions family businesses ask about dividend policy, capital structure, and capital budgeting easier to answer.Check out this brief five-minute video about the meaning of your family business from our recently launched Family Business On Demand Resource Center.The Four Meanings of Family Business from Mercer Capital on Vimeo.

For many family business leaders we talk with, “private equity” is a four-letter word. However, a September Wall Street Journal article highlights a recent thaw in the historically icy relationship between family businesses and private equity investors. In 2021, we predicted that non-family equity capital would grow increasingly common in family businesses. This WSJ piece confirms that our prediction is on point.Of course, family business suspicions of private equity were never completely ill-founded. There are some elements of the standard private equity playbook that don’t sit well with the ethos of many enterprising families. But the WSJ article shows that it’s more complicated than the longstanding caricatures would suggest. In this post, we identify a couple of potential “pros” for private equity that family business directors should be aware of and also confirm a couple of the well-known “cons” to accepting private equity investment.Pro: Access to Growth CapitalThere’s a large body of research literature documenting how family ownership correlates with superior business performance. While this is obviously great, it highlights a more subtle threat: family ownership can actually inhibit the growth of high-performing family businesses. We’ve written before about how family businesses are either “planting” or “harvesting.” For family businesses in “planting” season, the market opportunity may outstrip the family’s capital resources and/or willingness to use debt financing. In such cases, the family business may be prevented from reaching its potential (to the detriment of its employees, customers, suppliers, and other stakeholders) because of the capital constraints of the family. Bringing in a private equity partner can provide access to the growth capital needed to unlock the true potential of your family business.Pro: Ability to Retain Ownership & InfluenceMany private equity investors are willing to purchase less than 100% of the family business and may even want family members to remain in key management roles. Retaining ownership alongside a private equity investor allows the family to take some economic chips off the table but still benefit from the foundation for future growth laid by the family. When private equity investors grow the family business successfully, the value of the interest retained by the family can eventually exceed the value of the entire business at the time of the private equity investment. The WSJ article we linked above highlights an outlier case in which a founding family benefited from four successive private equity transactions; the family’s proceeds from the most recent transaction (for less than 5% of the company) exceeded that from the initial sale of a controlling interest in 2006.Con: MBAs Really Don’t Know It AllMoney buys influence. Private equity investors providing capital to your family business will, of course, want to make important decisions regarding your family business. The professionals tapped by private equity firms to manage portfolio companies often have great business acumen. However, being an expert about business, in general, does not necessarily translate into being an expert about your business. Greater capital resources – coupled with the hubris that often accompanies large pools of capital – create the opportunity for bigger mistakes.The WSJ article includes the cautionary tale of Sun & Skin Care Research, Inc., whose new PE-installed CEO promptly made a few key decisions that led swiftly to the demise of the once-stable family business. We suspect that one of the reasons all those academic studies find outperformance on the part of family businesses is that the company and industry-specific knowledge that accumulates and is retained in the business over the course of decades and generations is hard to match, no matter how fancy a newcomer’s degree (or pedigree) may be.Con: It’s All About the (Portfolio) ReturnWhile private equity firms have become more enlightened in recent years compared to the slash-and-burn attitudes of the early corporate raiders of the 80s and 90s, generating outsized returns is still the goal of PE investors. Doubtless, successful enterprising families are also profit-conscious. But private equity returns are not just about being profitable. Many private equity investors like to tout operational savvy as the key ingredient to their returns, but the real secret sauce continues to be the use of OPM: Other People’s Money.PE firms use financial leverage to generate a multiplicative return on their equity. So long as the operating reality matches the excel model, it all works out. Throw in an unexpected recession or another hiccup, and that debt load can quickly raise existential questions for the business. A family manages a business like its fortune depends on its continued existence (because it generally does); a private equity firm manages a business like it is one part of a diversified portfolio of winners and losers (which it is).Conclusion: What to Do When Private Equity Knocks On Your DoorPrivate equity is inherently neither good nor bad. When a private equity buyer expresses interest in your business, you and your fellow directors have an obligation to take them seriously and determine whether it is an opportunity that merits your attention.Perhaps the most important thing to keep in mind is the natural imbalance in the family-private equity relationship: they buy and sell businesses all the time, and you probably don’t. That is why it's essential that you have a trusted team of professional advisors to help you engage with potential investors. If you have received – or expect to receive – an investment proposal from a private equity firm, give one of our professionals a call for an independent, outside perspective.

Stock buybacks were in the news last week as the newly-passed Inflation Reduction Act includes a provision levying a 1% excise tax on share repurchases by public companies. As we’ve noted in previous posts, we question Congress’s grasp of the basic economics of what a stock buyback is, but Congress is not our focus today.Privately held family businesses are exempt from the tax, but it is important for directors to understand the real economics of stock buybacks (or, in the case of family businesses, shareholder redemptions).Family business directors are stewards of family capital. Family shareholders entrust their capital to the family business and the directors and managers of the business use that capital to generate a return. Unlike money from a bank, the family business doesn’t owe interest to its family shareholders. However, that doesn’t mean that family capital is free. There is an opportunity cost associated with family capital. This means that if their capital was not invested in the family business, family shareholders would have the opportunity to invest it elsewhere to earn a return. We refer to that opportunity cost (i.e., what an investor could earn by making a different investment of comparable risk) as the cost of capital. The cost of capital is a critical concept for family business directors as they evaluate how to invest family capital within the family business. The cost of capital is the breakeven point for whether an investment is financially prudent: if the expected return from an investment is less than the cost of capital, the shareholders would be better off investing that capital elsewhere. In other words, outside the family business. The supply of capital projects dwindles as the level of expected return increases. In other words, there are a lot more capital projects that are expected to earn a 5% return than a 15% return. So one of the primary tasks of family business directors is monitoring the supply of attractive capital projects, those for which the expected return exceeds the cost of capital.For some companies, the supply of such projects far outstrips the amount of family capital available to invest. Directors of these companies are faced with a rationing decision: of all the financially acceptable investments that we could make, which ones will we make with our limited family resources? These are generally companies operating in new or growing industries.For others, the supply of capital projects with expected returns in excess of the cost of capital is small. Directors of these companies are faced with different decisions. Do we (1) return capital to family shareholders so they can invest to earn the cost of capital, or (2) do we hold on to the capital and try to find new avenues to invest to earn the cost of capital? Too often, however, directors make a third, ill-advised choice – they hold onto the capital without a compelling plan for how they can use it to earn the cost of capital. When directors elect to return capital, they can do so in two ways, by paying a dividend to all shareholders (pro rata to their ownership interests) or repurchasing the shares of select shareholders. From the perspective of the company, these paths are equivalent economically in that, under both strategies, family capital leaves the family business to be put to use elsewhere. While paying pro rata dividends might seem most “fair,” some family shareholders may prefer to keep their capital invested in the family business, while others might be more eager to put their capital to other uses. Still, other shareholders might be seeking a way to be out of business with their family members. In any of these cases, a share repurchase can be the right tool to both prevent “lazy” capital from accumulating on the family business’ balance sheet and realign ownership interests to better conform to shareholder preferences and risk tolerances. Your congressman may not understand what a share repurchase is, but you and your fellow directors should. If you suspect a share redemption might be in order for your family business, give one of our professionals a call to discuss your situation in confidence.

Last week, Tod’s – the Italian maker of luxury shoes – announced plans by the founding Della Valle family to take the company private. Under the proposed transaction, the Della Valle family would invest €338 million to increase its ownership interest from just under 65% to 90%. Following the transaction, the remaining 10% equity position will be held by luxury conglomerate LVMH.The proposed purchase price of €40 per share represents a 21% premium relative to the pre-announcement trading price for the shares of about €33 per share. From a pandemic low of approximately €18, Tod’s share price peaked at approximately €64 per share in June 2021, from which level shares have fallen steadily to the €30 to €35 range preceding the going private announcement.Motivation For TransactionHaving been a public company for more than twenty years, what is the family’s motivation for taking the company private now? According to the Wall Street Journal, the Della Valle family is taking the company private to “accelerate its development” and “free the company of ‘limitations’” resulting from its public status. The plan to “accelerate” development is interesting, given that it seems like the most common reason companies cite for going public is to improve access to capital to “accelerate” company growth.Most family businesses will never have to think about whether to list their shares on a public exchange, much less – having done so – to reverse course and take the family business private again. Nonetheless, we believe Tod’s transaction highlights two obligations of all family businesses, whether publicly listed or not. The first is the imperative to perform, and the second is the responsibility to report.The Imperative to PerformThe stock price chart presented above is uninspiring. Over the past five years (prior to announcing the going private transaction), Tod’s shares had shed approximately 50% of their value. In contrast, the shares of luxury conglomerate LVMH tripled in value over the same period, from €233 to €691 per share, while shares of Gucci parent Kering nearly doubled (from €313 to €553).A quick look at the income statement for Tod’s confirms that the underperformance of the shares mirrored underperformance operationally. Since acquiring the Roger Vivier brand in 2016, annual revenue at Tod’s has fallen at a 2.5% annual clip. Earnings have suffered as well, with the company reporting net losses in 2020 and 2021. The losses in 2020 and 2021 forced the company to discontinue dividend payments, which had already fallen with earnings from €2 per share in 2016 to €1 per share in 2019. In short, the company failed to deliver value to its shareholders, and the financial performance suggests that it may have been strategically adrift. Following the €400 million acquisition of the Roger Vivier brand (from a related party, no less), Tod’s invested approximately €220 million in capital expenditures and one small acquisition during the five years ended 2021 (less than 5% of revenue). Against a backdrop of weakening organic performance, the company had dwindling resources for significant capital investment to spur growth. Not being accountable to public investors frees family business leaders to consider a broader range of performance objectives other than profit alone. However, being privately-held does not free family business directors from the imperative to perform. Any non-financial goal to which a family may aspire, no matter how noble or laudable, is ultimately supported and underwritten by growing, profitable core business operations. One task of a director is to consider how best to allocate the family’s capital resources to earn a competitive return on capital.Being privately-held does not free family business directors from the imperative to performFamily shareholders may not have the flexibility of public investors in the short term, but in the long-term family capital will flow toward its highest and best use. Chronic underperformance will cause the highest and best use to be found outside the family business, which will likely undermine many of the non-financial goals and objectives of the family, often to the detriment of employees, suppliers, customers, and other stakeholders.We can’t quite envision how taking Tod’s private will “accelerate” its growth. That said, the family has recognized that the current trajectory is not sustainable and is attempting to address the company’s underperformance. Are you and your fellow directors holding yourselves accountable for generating sustainable competitive returns on capital for your family shareholders?The Responsibility to ReportThe second obligation is the responsibility to report. While the “limitations” of being a public company prompting the transaction were not enumerated, the burden of reporting results to public shareholders is time-consuming and sometimes requires companies to disclose what they believe is competitively sensitive information. While public companies in Europe are not on the quarterly reporting cycle faced by SEC registrants in the U.S., the annual (and semi-annual) reports of European companies are far more detailed than those of their U.S. counterparts, as you can see here.Having read through the most recent annual report, it is not hard to see why Tod’s management would be eager to get out from underneath that reporting burden. Privately-held family businesses save a lot of time and money by not being subject to onerous financial reporting obligations. However, that does not mean that shareholder reporting is not important for family businesses. In reality, shareholder reporting is more important for family businesses than public companies. After all, public companies are reporting their results and strategy to anonymous strangers and institutional investors, while family businesses report their results to grandparents, parents, siblings, aunts, uncles, and cousins.In our experience, many family businesses ignore the benefits of being intentional and strategic about how they report financial results to family shareholders. They do so at their own peril. Uninformed family shareholders eventually become suspicious family shareholders. And suspicious family shareholders often become disgruntled – or, even worse – litigious family shareholders.Uninformed family shareholders eventually become suspicious family shareholdersFamily business directors are stewards of the family’s wealth, and reporting is a fundamental obligation of stewards. No, it is not necessary to prepare SEC-worthy quarterly reports for your family shareholders. But that does not give directors license to ignore shareholders. Rather, it gives family business leaders the flexibility to report what family shareholders need to know, with the appropriate frequency and in the most relevant format. Any time and resources saved by shirking this responsibility will pale in comparison to the costs and distraction of dealing with suspicious and unengaged family shareholders.We will return to the topic of shareholder reporting for family businesses in a future post. In the meantime, check out our whitepaper on communicating financial results to family shareholders, which you can download here.

This week, McDonald’s was in the news with a new plan raising expectations for franchise operators. The more stringent renewal reviews will include an assessment of performance history and customer complaints. The company told its franchisees that “…receiving a new franchise term is earned, not given.”Franchisees pay handsomely for the right to use the McDonald’s name, expecting that the goodwill associated with the golden arches will generate attractive returns for them as owner-operators. For its part, McDonald’s is dependent on the operations of its franchisees to maintain and enhance brand goodwill. After all, consumer perceptions of the brand are driven by their experiences in franchise-operated locations far more than activities at the corporate office. In other words, franchise operators are stewards of the McDonald’s brand. The company intends a more intensive review process to ensure that poor-performing or non-conforming operators do not reduce the value of the brand.While it is rare for family businesses to license the family name for use, family business managers and directors are stewards of the family name and the family’s capital. Directors and managers use the family’s capital (both social and financial) to operate the family business with the goal of providing an attractive risk-adjusted return for family shareholders.If your family business had to go through a renewal process to continue using the family’s name and capital, what factors would determine whether the business was worthy of renewal?Stewardship ReportingPeriodic reporting to owners is a fundamental obligation of stewards. The content of that reporting will be unique to each family. However, there are some broad elements that should be considered for any stewardship reporting model.Capital allocation. How is the family’s capital being allocated? Is the family’s capital being invested in real estate, working capital, production equipment, rolling stock, or intangible assets like a tradename? How much of the family’s capital is allocated to assets that don’t directly support the operations of the family business? What is the rationale for the allocation decisions that have been made? How do those decisions further the company’s strategy?Risk. To what risks is family capital exposed? To what degree is family equity capital being blended with third-party debt capital to extend the reach and scale of the family’s resources? What are the economic, regulatory, and industry risk factors that could influence company performance in the future? What customer/supplier concentrations or key person dependencies could adversely affect the company? What steps are available to mitigate these risks, and are those steps financially feasible?Operating performance (over time). Is the family business growing or shrinking? Is it gaining or losing market share? Are there new products or markets that offer an attractive growth platform for the company? If the family business has momentum, what is it doing to keep it? If the family business doesn’t have momentum, what is it doing to gain it?Operating performance (relative to peers). How does the operating performance of the family business compare to available benchmark measures? What is the cause of significant variances – underperformance, overperformance, or a fundamental difference in the business model or strategy?Efficiency. How do operating results compare to the resources allocated to producing those results? While not perfect, return on invested capital (ROIC) is a useful performance measurement framework for many family businesses. How much revenue is the family business generating per dollar of invested capital? How much operating profit does the family business generate per dollar of revenue? What is the trend in these measures over time, and how do they compare with available benchmarks?Investment returns & valuation. Family capital could be invested elsewhere, so what investment returns are being generated by the family business over time? Calculating investment returns requires developing periodic estimates of the value of the family business – what are the controllable (company performance) and uncontrollable (market performance) factors influencing the value of the family business and investment returns?What returns are being generated by alternative investments? How does the risk of the family business compare to the risk of those alternatives? Does the resulting tradeoff between risk and return “fit” your family shareholders?ConclusionFamily business directors and managers don’t have to submit to a renewal process to secure the right to continue using the family’s social and financial capital. But pretending that you did have to is not a bad exercise for directors and managers. What factors could you cite to support your continued stewardship of the family’s capital? Do you have a periodic reporting process in place that addresses those factors?Designing a reporting process that is tailored to your family and business can help ensure that family capital continues to be put to good use. Give one of our family business professionals a call to discuss your reporting needs.

The uncertain macroeconomic environment is causing corporate managers to consider how a recession would influence their businesses. Last week, the Wall Street Journalpublished comments from eleven public company CFOs discussing their expectations for how their businesses would fare if the expected economic downturn occurs.Perhaps not unexpectedly, the CFOs interviewed by the Journal were generally optimistic regarding the outlook for their companies in the event of a recession.Some focused on how recession-resilient their industries are, including Big Lots (discount retail), Match Group (online dating), Anheuser-Busch InBev (beer), and Olaplex Holdings (beauty products). The CFO of Tripadvisor anticipated that 2+ years of pandemic-induced cabin fever will put travel at the top of consumers’ wish lists even amid a recession.Others highlighted actions that they have already taken, or can take, to mitigate the effects of a downturn: ClubLending has tightened credit standards for hourly workers, the CFO of Williams-Sonoma cited the ability to cut expenses and reduce inventory and capital spending, PerkinsElmer indicated that a larger base of recurring revenue will put the company in good stead, and Krispy Kreme discussed the company’s strategy of expanding distribution points.Finally, the CFO of Applied Materials replied that – in terms of order flow – no slowdown in demand is evident yet, while the CFO of Whirlpool believes that pandemic-related demand will continue to outpace constrained supply. How realistic are these expectations? Only time will tell; however, since all eleven companies are publicly traded, we can see how investors are grading those expectations. Exhibit 1 summarizes year-to-date share price performance for each company.Consistent with general stock market trends, share prices are down for each company, with Anheuser-Busch InBev faring the best (-12%) and discount retailer Big Lots feeling the most pain (-51%). Investors seem to be on board with the thesis that beer consumption is recession-proof but less convinced about the prospects for Big Lots. Your family business doesn’t receive a daily grade from the market, but you do have expectations for the future. How will your family business fare if a recession sets in, and how are expectations affecting the value of your family business today? When discussing value, we find it helpful to group expectations into three primary categories: cash flow, risk & return, and growth.Cash FlowValue is not a “what have you done for me lately?” game – it is a “what will you do for me tomorrow?” game. How will stubbornly high inflation, tight labor markets, and persisting supply chain disruptions affect the cash flows for your family business over the next year?What effect will rising prices have on demand for your product or service? Are your customers net beneficiaries of rising price levels, or will rising prices put a dent in their propensity to spend on your product?How are labor availability and wage pressures influencing the cost of doing business for you? Are you able to pass higher operating costs along in the form of higher prices, or are your profit margins getting squeezed?Is maintaining an appropriate level of working capital tying up more of your cash flow? Have supply chain disruptions caused you to hold larger quantities of more expensive goods? Are any of your customers facing financial distress that could stretch out collections?Is the increasing cost of capital goods reducing cash flow that would otherwise be available for debt service or owner distributions?Risk & ReturnSince the end of 2021, yields on long-term treasury securities have increased from 1.94% to around 3.30%. Our colleague Brooks Hamner, CFA, ASA wrote about the inverse relationship between interest rates and valuation multiples several weeks ago. While Brooks was writing specifically about the value of investment management firms, his observations apply broadly to all companies. In short, all else equal, rising interest rates put downward pressure on the value of all financial assets.But thinking about your family business specifically, how have expectations regarding risk evolved as the economic picture has become murkier? Like A-B InBev, do you have a compelling case that your family business really is recession-proof? Or would investors be skeptical of the strategies at your disposal to counteract the negative effects of a broader economic slowdown?GrowthFinally, how would a prolonged recession change the ground rules for your industry and the effectiveness of your family business’s growth strategy? Would a downturn cause you to defer capital investment in support of the next growth engine for your family business? Or, would a slowdown allow you to capture market share at the expense of financially-weaker competitors? How could the structural changes that accompany economic disruptions alter the demand trajectory for your product or service?ConclusionCash flows, risk & return, and growth provide a helpful framework for evaluating expectations for your family business. If the Wall Street Journal had called you last week, what would you have told them about your plans?

For one weekend a year, the spotlight of the financial world shifts from New York to Nebraska.  The annual meeting of the Berkshire Hathaway company has developed a cult following among shareholders and financial journalists alike.  A compound annual return of 20% over 55 years (!) will do that for you.Actuarially speaking, the number of opportunities to see Warren Buffett, 91, and his longtime partner Charlie Munger, 98, on stage together at the annual meetings is dwindling.  One area of particular interest for the Oracle of Omaha’s followers in recent months has been Berkshire’s overflowing war chest.  At the end of 2021, Berkshire’s balance of cash, equivalents, and short-term treasuries stood at nearly $144 billion, compared to $71 billion at the end of 2016, and “just” $34 billion ten years prior.The consummate value investor, Mr. Buffett attributed the growing cash stockpile to an absence of compelling investment opportunities.  Better to hold cash than make bad investments, after all.  Market volatility in the early months of 2022 did loosen the purse strings a bit as Berkshire made a large acquisition (Alleghany Corp) and built large positions in three publicly traded companies (HP, Occidental Petroleum, and Chevron).  All told, the first quarter investing activity drew cash down to approximately $105 billion, which is still enough to cover payroll for a while.Mr. Buffett certainly doesn’t need us to remind him of the perils of “lazy capital” on the corporate balance sheet – the yearend cash stash represented approximately 20% of Berkshire’s overall market capitalization.  Giving Mr. Buffett the benefit of the doubt (which he has probably earned at this point in his career), are there any good reasons for family businesses to hold some cash in reserve?  In our view, there are three potential benefits to keeping some cash on the balance sheet.Reduce RiskAs the adage goes, no one goes bankrupt holding cash.  While modern finance theory suggests that public company managers should not be willing to sacrifice much return to reduce bankruptcy risk, family business directors cannot be so sanguine.  Since the family business often represents a significant portion of overall family wealth, corporate bankruptcies are catastrophic for the family.  Some families can leave a bit of marginal return on the table if it helps push the likelihood to financial distress to a negligible level.  There is no single right answer that will fit every family; however, directors need to acknowledge the tradeoff, calculate the decrement to return from holding cash, and be deliberate about the decision they make.Fund Opportunistic InvestmentsCash is the contrarian’s friend.  You can keep wealth by staying in the middle of the investment pack, but you only get wealthy by venturing away from the pack, buying when prices are depressed and other investors are afraid to invest.  Or, don’t have the liquidity to invest.  While describing the stock market as a “gambling parlor” at Saturday’s meeting, Mr. Buffett acknowledged that the attendant market volatility allowed Berkshire to identify attractive investments saying, “We depend on mispriced businesses.”  Unfortunately, credit availability is inversely related to the volume of attractive investment opportunities.  To take full advantage of market dislocations, sometimes it helps to be your own banker.  Ample cash on the balance sheet can afford your family business that luxury.Be Strategic About OwnershipIn addition to making opportunistic investments, Berkshire has also used its cash hoard to repurchase over $50 billion of shares during 2020 and 2021.  So long as markets are efficient, share repurchases are, by definition, a zero net present value project.  While Mr. Buffett would prefer to make investments in other businesses, when he believes that attractive opportunities are not available, he has not been averse to buying Berkshire shares.Berkshire doesn’t really care about the identity of its owners.  Shareholders come and shareholders go.  When Berkshire repurchases shares, it does so in open market transactions, not knowing – or caring – who the selling shareholders are.  Family shareholders can be described in many ways, but anonymous is not one of them.DNA is not a reliable indicator of whether an individual will be an effective family shareholder.  As a result, there is – for many families – a significant difference between what the shareholder list is and what the shareholder list should be.  The capacity of many families to “muddle through” with suboptimal ownership for years and even decades is remarkable.  But other families elect to make ownership a strategic priority.  It is much easier for families to be intentional about who owns shares in the family business when there is enough liquidity on the corporate balance sheet to repurchase shares from departing shareholders.ConclusionWe have previously sounded the warning about allowing excess cash and other non-operating assets to accumulate on family business balance sheets.  We stand by that warning, but the example of Berkshire Hathaway does highlight that – in addition to its (opportunity) costs – cash has its uses.  Is there a purpose behind the cash on your balance sheet?  Have you accumulated cash with intention or through inattention?  What is your cash doing for you?

As recently noted in the Wall Street Journal, large public companies are announcing share repurchase programs at a record pace. And, yes, the article includes the usual hand wringing about whether buybacks are “good.” We tend to think that – for public companies – share repurchases are neither good nor bad in themselves. Individual share repurchases may, of course, be ill-advised if, for example, the repurchase price proves to be too high, the resulting leverage imperils the company’s future, or the repurchase crowds out other uses of capital that would generate a superior return. But there is nothing inherently good or bad about share repurchases as such. Repurchasing shares is one of two options companies have for returning capital to shareholders and doesn't need to carry any philosophical or emotional weight beyond that. For some reason, we don’t recall ever seeing articles bemoaning the level of dividends being paid by public companies.For both public and private companies, share repurchases occupy the same place in the cash flow waterfall, as depicted in Exhibit 1 below. The operating cash flow of any business (after being either supplemented or depleted by net borrowings or repayments of debt) will be used to do one of three things: (1) add to the company’s cash reserves, (2) be reinvested in productive capital assets, or (3) provide a return of capital to shareholders. The relative proportions of these three uses depend on many company-specific factors including the risk tolerance of the shareholders, the available capital investment opportunities, and the return preferences of shareholders. Whether paid as a dividend to all shareholders, or used to repurchase the shares of some, both strategies are essentially a return of capital. As the news stories consistently point out, share redemptions compete for cash flow with capital investment and cash accumulation. So do dividends. Like many issues, what is straightforward for public companies becomes a bit more complicated for family businesses. Two factors in particular increase the degree of difficulty for family businesses. First, the motivation for redemptions can be complicated by personal relationships. Second, price is not a given as it is for public companies.Motivation for RedemptionsWho is the villain here? Too often, families assume that a redemption transaction is a sign of failure and that if there is a redemption there must be a “bad guy.” This does not need to be the case. Shareholder redemptions are not a sign of failure, they are a sign that different family shareholders have different economic profiles, risk tolerances, and return preferences. While those differences are occasionally rooted in some lingering irrational emotional baggage, our experience is that such cases are less common than one might assume. Those circumstances grab the headlines, but most redemption transactions are far more mundane.Shareholder redemptions are not a sign of failure, they are a sign that different family shareholders have different economic profiles, risk tolerances, and return preferences.As family businesses mature and shareholders multiply, it is only natural that being a member of the family doesn’t necessarily mean it makes sense for someone to be a shareholder. Taking the emotion out of redemption transactions is the first step to arriving at a healthy outcome: a share redemption is a targeted return of capital that allows family businesses to provide a better “fit” to the economic characteristics of family shareholders. No shame in that.Price, Value, and the Art of the PossibleThe terms of any shareholder redemption transaction include, at a minimum, the number of shares to be redeemed and the price per share to be paid. For public companies, the price is uncontroversial, because the market provides the price every day. The company is no different than any other buyer. In fact, sellers don’t even know if they are selling their shares to another investor or back to the company. And they don’t care.Without the daily market mechanism, family businesses face a bigger challenge in setting prices. Not only is there no market transparency regarding the value of the company, but the absence of a liquid market for the shares means that the value of the shares to the shareholder is different than the value of the shares to the company.All else equal, investors prefer ready liquidity. From the perspective of individual minority shareholders in the family business, such liquidity is lacking, which means that the value of those shares to them is impaired relative to the value if the company were publicly-traded. We refer to this decrement to value as the marketability discount, and these discounts are often on the order of 20% to 40% of the “as-if-freely-traded” value of the shares. But the family business is not just any other buyer for the shares – unlike individual family shareholders, the corporate treasury doesn’t really bear the economic burden of illiquidity. So, the shares are effectively worth more to the company than they are to the selling shareholders. Viewed positively, this opens up a range for fruitful negotiations; viewed negatively, this opens up a range for family dysfunction.A qualified business valuation can establish the range, but it cannot identify the right price for the transaction.A qualified business valuation can establish the range, but it cannot identify the right price for the transaction. It is up to the family business and the selling shareholders to identify the optimal price within the negotiating range at which to execute a share redemption that accomplishes the goals of the redemption transaction. This moves the discussion from the “science” of valuation approaches, methods, and inputs to the “art” of the possible.In a future post, we will offer some thoughts on the “art” of the possible, but for now, it will have to suffice to say that successful share redemptions in family businesses are not as rare as you might think, but do require a heavy dose of good faith, a short memory for personal slights (real or perceived), and the ability to keep the end goal in mind throughout the process.

The list of forecasting cliches is long (thanks, Yogi Berra!), but we were recently reminded of a good one: there are only two kinds of forecasts – lucky and wrong. That reminder came from an article by Joachim Klement 10 Rules for Forecasting published on the CFA Institute website.Klement’s list is focused on macro level economic forecasting, but several of his rules apply equally well to the micro level of individual family businesses. In this post, we consider four of Klement’s rules in the context of family businesses.Rule #1 – Data MattersIf it is hard for professional managers at public companies to remain dispassionate when predicting the future, it is doubly hard for managers and directors at family businesses. Humans are story-seeking animals, but the desire to craft a simplistic narrative that both neatly explains the company’s historical performance and extrapolates that performance into the future may prove counterproductive. It’s not that narratives are bad, but the temptation to make the data “fit” a preferred story can be overwhelming. Far better to adjust one’s narrative to “fit” the actual data, even if elements of that story are uncomfortable. Allowing the data to tell the real story opens up the space needed for a meaningful conversation about where the real and preferred stories diverge, the sources of those divergences, and whether those divergences are permanent or capable of being closed.Rule #3 – Reversion to the Mean is a Powerful ForceOdds are that your family business is indeed special, but not that special. Twenty percent growth rates have a habit of eventually giving way to 10% growth rates, which in turn, eventually deteriorate to 5% growth rates. Likewise, lucrative profit margins tend to attract the sort of competition that corrodes lucrative profit margins. Outside of regulated utilities, business is competitive, and forecasts that assume existing – or new – competitors will stand idly by while you execute your strategic plan are not realistic. While past success may reveal what your family business has done well, one should be wary of simply assuming the formula that worked so well in the past will continue to work equally well in the future. As Amazon founder Jeff Bezos is reputed to have said about his competitors: “Your margin is my opportunity.”Rule #9 – Remember Occam’s RazorOccam’s Razor is the principle that in explaining a thing no more assumptions should be made than are necessary. Accuracy is a more desirable attribute in a forecast than precision. Identifying the appropriate level of complexity in a financial projection is one of the biggest forecasting challenges facing family business directors and managers. For what it’s worth, we tend to value parsimony a bit more when projecting operating expenses than revenue.A zero-base “build-up” approach for forecasting revenue can be a helpful corrective to overly optimistic trend extrapolation. Total revenue, whether for a segment, division, or the consolidated family business, can often be modeled as the product of unit volume and effective pricing. In other contexts, market share and aggregate market size can be useful benchmarks for forecasting revenue.Predicting growth rate trends for operating expenses is often a sufficiently reliable approach. Operating expenses are often somewhat fixed, and while individual expense categories may exhibit more volatile behavior, keeping an eye on implied operating margins can help in assessing the overall reasonableness of operating expense forecasts.Rule #10 – Don’t Follow Rules BlindlyKlement’s final rule is a good reminder for writers of blog posts about making forecasts. There is a genuine difference between helpful discipline and blind rigid adherence to any set of abstract forecasting rules. Hopefully, your family business is making forecasts for a business purpose, not simply for the sake of mastering the art of making forecasts. Keep that business purpose front and center, and feel free to discard the prescriptions and proscriptions of arm-chair quarterbacks when they undermine that purpose.ConclusionFollowing Rule #10, it may be important to distinguish between a goal and a forecast. Goals express what we want the future to look like, whereas a forecast presents an unbiased picture of what the future will look like. The rules that make sense when crafting a forecast may not be appropriate when setting goals for future performance. Goals serve a valuable purpose for family business managers and employees, but when making capital budgeting, dividend policy, and capital structure decisions that can affect the family for generations, directors need unbiased forecasts.Does your family business have a disciplined process for separating fact from fiction and developing actionable forecasts that your directors can rely on? Sometimes an outside perspective can be helpful when you need to prioritize data over hopeful narratives, instill respect for reversion to the mean, keep things simple, and distinguish discipline from blind devotion to a set of forecasting rules. Give one of our family business advisory professionals a call today to discuss your challenges in confidence.

Here at Family Business Director, we are focused on the numbers of family business: measuring and assessing financial performance, establishing dividend policy, setting capital structure, making capital budgeting decisions, and structuring shareholder redemptions.  We believe these topics are crucial, and that many of the conflicts that enterprising families experience are avoidable when these tasks are done well and communicated effectively to family shareholders.  In our experience, well-informed shareholders are engaged shareholders.All that said, we also recognize that family business leaders face many other critical challenges.  In this week’s post, we provide a quick roundup of some of the best pieces we’ve come across recently dealing with management succession, governance, attitudes toward wealth, family relationships, board dynamics, and more.Winning at management succession must be a priority for family businesses focused on long-term sustainability. In this article, John Ward and Stephen McClure of The Family Business Consulting Group offer a comprehensive list of 15 guidelines for family business succession.Family businesses aren’t always great at drawing boundaries. Family and business tasks can become intertwined, and the burdens of family governance can fall on too few shoulders.  Marion McCollom Hampton and Nick DiLoreto of Banyan Global examine the effect of “Overloaded Structures” here.The pandemic may be easing, but the use of virtual platforms for at least some family meetings is probably here to stay. Katelyn Husereau of CFAR offers some timely tips, tricks, and best practices for on-line family meetings here.Inheriting wealth is very different from creating wealth. Coaching the next generation of the family on how to view, and become responsible stewards of, inherited wealth is a common concern of family business leaders.  In this article, Sarah Schlesinger of Continuity Family Business Consulting identifies six ways members of the rising generation can productively integrate wealth into their lives.Genuine, healthy family relationships are based on solid connections among family members. Steve Legler writes about the need for enterprising families to look beyond the org chart to discern whether the right kind of human relationships are in place.  Check out Steve’s insights here.Is your family business board having genuinely productive conversations featuring different perspectives, or does everyone just go along to get along? Allen Bettis explores the hidden costs of prioritizing artificial harmony in the board room in this article.Speaking of boards, recruiting and retaining quality independent directors that can help guide your family business to the next level is an investment. Are your expectations regarding compensation for directors reasonable for today’s market?  Bertha Masuda, Bonnie Schindler, and Susan Schroeder of Compensation Advisory Partners summarize some key findings from their most recent survey on the topic here. Happy reading!

From time to time in this blog, we take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.What are the most important qualitative factors to consider when evaluating a proposed capital project?Net present value analysis, internal rate of return, and other quantitative analyses are important tools for evaluating capital projects. While family business directors should be acquainted with these tools and generally understand how they work, it is just as important that directors understand the limitations of these tools.Quantitative capital budgeting tools cannot answer this question: should we undertake the proposed capital project?Specifically, these capital budgeting tools are ideal for answering this question: Is the proposed capital project financially feasible? Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project? The first question opens the door to the second, but the tools of capital budgeting – no matter how sophisticated or quantitatively precise – cannot answer the second. To answer the second question, you and your fellow directors need to consider three qualitative factors, each of which can be framed in the form of a corresponding question.1. Market OpportunityThe market opportunity question is simply this: Why does the proposed capital project make sense? Management must be able to provide a simple, straightforward, and compelling answer to this question. The components of an acceptable answer to this question should focus on the customer need being addressed by the project and how the project is an improvement over how the market is currently meeting the identified customer need. Under no circumstances should the answer to this question reference a net present value or internal rate of return. If the minimum conditions of financial feasibility have not been met, the proposed project should not be in front of the board.2. Strategic FitOnce the market opportunity has been demonstrated and vetted by the board, the next question is this: Why does the proposed capital project make sense for us? In other words, how does the proposed capital project relate to the family business’s existing strategy? Does the proposed project represent an extension of the existing strategy, or does it deviate from the strategy?One temptation that family businesses can succumb to is modifying an existing strategy for the express purpose of justifying a proposed capital project that a key constituency really wants to do, which is inadvisable. Instead, the board should understand why a change in the company’s existing strategy is warranted and why the proposed change to the strategy is an improvement given current market and regulatory conditions, competitive dynamics, and opportunities. If the board determines that the proposed change in strategy is appropriate, then the discussion can move to whether the proposed capital project should be approved. If strategy is the driving factor, the proposed capital project may not necessarily be the best way to execute on the new strategy.Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.This discussion presupposes, of course, that the family business has a strategy that has been clearly communicated to management, employees, and shareholders. Absent a guiding strategy, capital budgeting can devolve into what one of our clients sagely referred to as “a race to the table.” If there’s no guiding strategy, the first manager to arrive at the board meeting with a financially feasible project is likely to receive approval, even if the project does not promote the long-term health and sustainability of the family business. Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.3. ConstraintsThe final question is this: Can the proposed capital project be done by us? Management's time and attention, infrastructure and systems, and human resources are limited. Will undertaking the proposed capital project divert scarce resources away from other areas of the business? In our experience, managers proposing capital projects tend to underestimate the impact a project will have on the rest of the business. While it is certainly true that some expenses are fixed in the short term, all expenses are variable in the long-run. Resource constraints can be overcome, but directors should be certain that the full cost of doing so has been contemplated and reflected in the capital budgeting analysis.ConclusionDoes your family business have a robust capital budgeting process that determines whether a proposed capital project is financially feasible? If it does, that’s great. But the approval process cannot end with a green light on the financial side. Family business directors need to be diligent to answer the qualitative questions identified in this post.Originally posted on Mercer Capital's Family Business Director Blog April 29, 2019

Kicking off with the inspired lyrics, “Down dooby doo down down,” Neil Sedaka assured legions of teenage girls in 1962 that “Breaking Up Is Hard to Do.” Sixty years later, the actions of the Follett family are telling family business directors that maybe breaking up is not so hard after all.Tracing its roots to a Chicago area used bookstore opened by Charles Barnes (who later partnered with Clifford Noble) in 1873, the Follett Corporation has been owned by the Follett family since 1923. Soon thereafter the company began to focus on the educational market, with publishing, wholesaling, and retail operations on college campuses. Continued expansion over the decades culminated in the operation of three business segments:Follett School Solutions, a K-12 software and content companyBaker & Taylor, a distributor of physical and digital books and services to public and academic librariesFollett Higher Education, an operator of collegiate retail storesStarting in 3Q21, the Follett family began to “break up” the family business, selling each of its three operating divisions to a different buyer.In September 2021, Follett announced the sale of Follett School Solutions to Francisco Partners.Two months later, Follett announced the divestiture of Baker & Taylor through a management buyout.Earlier this month, Follett announced the sale of Follett Higher Education to an investor consortium led by a family office, Jefferson River Capital.We don’t know what motivated the decision of the Follett family to exit its legacy businesses. Whatever the cause, the series of transactions over the past six months provides a timely reminder that to thrive, businesses need the right owners. Even though the broad theme of books and education would seem to have provided better "glue" for the three business units than many conglomerates we see, the businesses were sold to three different buyers. Although no financial terms were disclosed for any of the transactions, we can only assume that selling the divisions to different owners generated greater net proceeds to the Follett family than a selling to a single buyer would have. What are some possible explanations for that? Why do different businesses sometimes need different owners?Risk ProfilesSome businesses are inherently riskier than others. All else equal, selling large-ticket discretionary items that consumers can easily defer or substitute is riskier than selling staple items that consumers need regardless of economic conditions. That is why the beta (a general measure of risk for public companies) of General Motors is 1.20x while that of General Mills is 0.50x. Return follows risk, and some shareholders are better equipped than others to stomach greater risks in hopes of earning greater returns. That is why some investors own General Motors while others own General Mills. Owning a General Motors-type business while having General Mills-type family shareholders is not a sustainable situation. Both the business and the family are likely to suffer.Return PreferencesShareholder returns come in two forms: current income and capital appreciation. Some investors seek current income, while others desire capital appreciation. Some businesses are better positioned to provide current income, while others more naturally provide capital appreciation. As with risk profile, if the return attributes of your family business don’t “fit” with the return preferences of your family shareholders, there is likely trouble ahead.Capital NeedsBusinesses are either in “planting” or “harvesting” mode. Businesses with a strategy for tackling a large market opportunity often require more investment capital than the operations of the business can provide. As a result, they need to seek out external sources of capital, whether debt or equity. For many families, owning these businesses can be challenging if there is a reluctance to undertake significant borrowings or to admit non-family investors into the shareholder group.On the other hand, some families are flush with capital that needs to be put to work and can grow restless with mature businesses that are perpetually in “harvest” mode. Pushing incremental capital into a business that cannot use it effectively can also breed serious problems for enterprising families.Portfolio CompositionFinally, some businesses may be worth more to a particular investor because of the composition of the rest of that investor’s portfolio. The traditional “strategic” acquirer scenario is the most obvious case, but not the only one. Even what are typically classified as “financial” acquirers often seek out certain types of companies, as illustrated by Francisco Partners, the acquirer of Follett School Solutions. The press release for that transaction notes that “FSS will join Francisco Partners’ growing portfolio of K-12 education-focused businesses and technologies, including Renaissance Learning, Discovery Education, Freckle, myON and Mystery Science.”A legacy operating business often demands – and receives – the lion’s share of the family’s attention, but it is important for family business leaders to occasionally step back and take a broader portfolio view of the family’s wealth. Taking an inventory of the overall wealth of the family can help leaders to assess what businesses make sense for the family to own and which businesses might make more sense for someone else to own.Conclusion: Getting Back to WhyWhy is your family in business together? From an economic perspective, what does your family business mean to your family? Breaking up may be hard to do, but for some family businesses it may be the right thing to do. Selling a family business – or a piece of the family business – does not mean that the broader family enterprise is failing. There are plenty of other businesses to be acquired and/or philanthropic objectives to be pursued. The Follett family illustrates this point well, as described in the press release for the Follett Higher Education sale: “The Follett family and its Board of Directors have enjoyed being part of improving the world by inspiring learning and shaping education for the past 150 years and the Follett family will continue to drive education through advocacy with future projects. The next steps for the Follett Family legacy will be to enhance its effects with future family business education and the Follett Educational Foundation.”Do your family businesses have the right owners? Does a careful analysis of risk profile, return preferences, capital needs, and portfolio composition reveal a good “fit” between your family shareholders and the various businesses your family owns? If not, do you have a strategy for moving toward a better fit? Your enterprising family’s long-term sustainability may depend on it.

Browsing through the archives of the Harvard Business Review, we recently discovered an article from 2013 that we had previously missed.  In “Deciding How to Decide,” authors Hugh Courtney, Dan Lovallo, and Carmina Clarke advocate using a broader set of tools to make difficult capital budgeting decisions.  While the entire article is well worth reading, we were especially struck by how the authors categorized the different types of capital budgeting decisions facing corporate managers.The authors identify five different types of capital budgeting decisions, distinguishable based on how familiar the decision is and how predictable the outcomes are.The easiest decisions are those that are familiar and have predictable outcomes. Because the company has a long track record of making similar decisions, there is a good understanding of what ingredients contribute to a successful outcome.  In other words, the company has developed a reliable model for making the decision.  Furthermore, the inputs to the model can be specified with confidence, resulting in a high degree of certainty as to the outcome.  According to the authors, a domestic site selection decision by McDonald’s illustrates this type of problem.At the other end of the spectrum are novel decisions for which the company has little or no basis for predicting future outcomes. The company has no history from which to construct a good model, which is perhaps beside the point, since there are no reliable model inputs to be found anyway.  The example cited by the authors for this type of decision is deciding how McDonald’s should respond to potential backlash over the fast-food industry’s role in obesity.  There is no precedent action that managers can readily draw on to formulate a model, and it is nearly impossible to predict how consumers and society will respond to various actions. The authors then proceed to identify which capital budgeting tools are most appropriate for which situations.  Their comments and suggestions are insightful and worthy of consideration by family business directors.  For additional perspective on capital budgeting techniques, you can download our whitepaper “Capital Budgeting in 30 Minutes” here.... the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide.Yet, we walked away from reading the article with a nagging sense that perhaps the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide.  In other words, what types of capital projects should be going into your capital budgeting funnel?  For example, before deciding whether to lease or build a new distribution facility, family business directors must first – whether explicitly or implicitly – decide that enhancing distribution is a more appropriate use of family capital than acquiring a competitor, or investing in research & development, or securing supply, or any of a host of other potential decisions having varying degrees of difficulty.It is at this level of “meta” capital budgeting that we suspect family business directors could benefit from the decision classification scheme outlined by the authors of the HBR article.  The “easy” capital budgeting decisions entail less risk, but also promise less return.  Multi-generational business transformation arises from making “hard” capital budgeting decisions.  What is the appropriate mix of “easy” and “hard” capital budgeting decisions for your family business?  Net present value, internal rate of return, and the other traditional capital budgeting tools are not really equipped to answer this question.We suspect that deciding “what” to decide is yet another manifestation of what your family business “means” to your family.In our experience, there are four basic “meanings” a family business can have for a family.  Knowing what your family business “means” maybe the best path toward deciding “what” to decide.For some families, the business exists to drive economic growth for future generations. With this forward-looking perspective usually comes a desire for higher absolute returns and a willingness to accept more risk.  For these families, the ideal mix of capital budgeting decisions is likely tilted more toward the types of transformational capital budgeting decisions having low degrees of familiarity and predictability.Other family businesses serve as a mechanism by which to preserve the family’s capital. A prominent concern for these families is that all their economic eggs are in a single basket, so they want to build a stout fence around that basket.  As a result, they will be best served by focusing on capital budgeting decisions having a high degree of familiarity and predictability.In contrast, other families respond to the “single basket” problem by seeking to find more baskets. The focus for these families is maximizing the harvest from the family business to enable family shareholders to store some eggs in different, uncorrelated, baskets.  These families may be more willing to accept risk once an acceptable number of other baskets have been filled.  Making a large volume of “easy” capital budgeting decisions that serve only to increase the size of the existing basket is not a suitable meta-capital budgeting strategy for these families.Finally, some families view the business principally as a source of lifestyle. The primary concern for these families is maintaining the current level of real, per capita distributions.  Depending on the biological growth of the family, doing so is likely to require making some capital budgeting decisions that are either less familiar or have less predictable outcomes. How are you and your fellow directors deciding what to decide? Is there consensus around the economic meaning of your family business to your family? Gaining consensus around the meaning of your family business can be a crucial first step to making all the strategic finance decisions you make line up with one another.

Our family business clients naturally want to know what their business is worth today. But an even better question asked by many of them is what they can do today to make their family business more valuable tomorrow. While the specifics of value creation are unique to each business, we like to use a common framework to help our clients identify pathways for creating value.The framework was developed many years ago by the founder of our firm, Chris Mercer. Chris has an inordinate affection for acronyms rivaled only by his enthusiasm for pickleball. So, with a big hat tip to Chris, we’ll use this first post of the year to ask whether your family business is READY for 2022.Risk. Investors don’t like risk. Given the choice between two investments that offer the same reward, investors will always choose the one with less risk. The best way for investors to manage risk is through diversification, but family shareholders are often not very well diversified. As a result, family business directors need to be especially vigilant about managing risk within the family business. The most common risks facing family businesses relate to concentrations, which can take many forms: management, customer, supplier, geographic, product, etc. What strategies are available to reduce the risk of your family business in 2022?Earnings & cash flow. Investors like cash flow. In fact, investments are valuable because of the expectation that they will generate cash flow, whether in the next week or the next decade. Cash flow is rooted in earnings. Earnings depend on revenue and margin. Revenue measures how much business your company is doing, and margin measures how efficiently your company conducts its business. While earnings are the wellspring of cash flow, they are not cash flow. Among the most important decisions family business directors make is how to allocate earnings between cash flow to shareholders today and reinvestment to fuel greater cash flow to shareholders tomorrow. Is your family business profitable enough to provide current cash flow to shareholders and make appropriate investments for the benefit of future generations?Attitudes, aptitudes & activities. Investors like discipline. Founder-led businesses can be highly profitable, but not necessarily very valuable if the “secret sauce” is tied up in the personality and unique gifts of the founder. Family businesses that have successfully converted the unique attributes of the founder into repeatable and transferable business processes are worth more than those that cannot, or do not, make that leap. Do you have the right people in the right places doing the right things over time? To borrow an overused cliché from the popular business press, how “scalable” is your family business?Driving growth. Investors like growth. Yesterday’s earnings and cash flow are, strictly speaking, irrelevant to investors, who care only about the future. The value of your family business is determined by the view through the windshield, not the rearview mirror. What are you and your fellow directors doing to prepare for the future? Does your family business have a disciplined process for identifying, evaluating, and paying for investment opportunities that will generate growth in future cash flows?Year-to-year comparisons. Investors like a clear story. Hollywood is obsessed with making prequels to satisfy the curiosity of moviegoers for the “backstory” of their favorite characters. Historical financial results comprise the “backstory” for your family business. Is there a coherent narrative arc from what your family business has been in the past to what you are planning for it to be in the future? This is where strategy becomes critical. What aspects of past strategies will you carry over into the new year? What pieces of your current strategy should be cast aside? What new strategies will be necessary for your family business to thrive in 2022? The new year is upon us whether we are READY or not. Give one of our family business professionals a call today to kickstart a conversation about how to increase the value of your family business in 2022.

"He thinks he's even more able than he is and that's helped him. Never underestimate the man who overestimates himself. Some of the extreme successes are going to come from people who try very extreme things because they're overconfident. And when they succeed, well, there you get Elon Musk." - Charlie Munger"If the objective was to achieve the best risk-adjusted return, starting a rocket company is insane. But that was not my objective." - Elon Musk"You got to know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run." - Kenny Rogers Long-time Warren Buffett confidant and business partner Charlie Munger was in the news this week for giving frank interview responses on a wide range of topics. Among his comments was the quote about Elon Musk's productive overconfidence cited at the top of this post. Return follows risk, and the only way to earn outsized returns is to take outsized risks. As Musk himself acknowledges, hewing to textbook notions of prudent risk management would have derailed SpaceX before it ever got off the ground (literally or figuratively). Attitudes toward risk are hard to quantify and are unlikely to be uniform across a family. It is reasonable to assume that investors in public companies have similar views of risk. After all, they all chose to be there. Family shareholders, on the other hand, likely have not designed their investment portfolios from scratch, and the family business often represents a far larger portion of the overall portfolio than modern investment management theory would deem prudent. Most mature family businesses that we know do not have an appetite for taking on the sort of outsized risks for which Mr. Musk is famous. Instead, they adopt a more cautious posture of calculated risk-taking like that espoused by the late, great Kenny Rogers in his immortal song, "The Gambler." Confidence and Capital BudgetingAs 2021 draws to a close, family business directors are busy evaluating capital spending plans for the coming year. Capital budgets are influenced by the availability of capital to invest in the future, the availability of projects in which to invest, and the willingness of shareholders to forego current returns in the hopes of greater future rewards.So, just how confident should family business directors feel when forecasting business results in 2022? The Organization for Economic Cooperation and Development, or OECD, publishes a Business Confidence Index ("BCI"), which is based upon survey responses related to developments in production, orders and stocks of finished goods in the industrial sector. Readings above 100 indicate increased confidence, while measurements below 100 correspond to a pessimistic outlook. After dipping into bearish territory in 2H19 and bottoming out in the early months of the pandemic, the measure has given an expansionary reading since July 2020.Chart 1: OECD Business Confidence Index (2019 - 3Q21) Responding to survey questions is one thing, cracking open the corporate checkbook is another. We examined capital investment data for small- and mid-cap public companies over the same period to get another perspective on corporate confidence. Chart 2: Capital Investments for Small- and Mid-Cap Public Companies (2019 - 3Q21) Corporate investment spending corroborates the OECD confidence index. M&A activity is more volatile, but corporate managers also slowed capital expenditures materially during the middle quarters of 2020. Circling back to the confidence of Elon Musk, we can track capital expenditures for Tesla over the same period. Chart 3: Tesla Capital Expenditures (2019 - 3Q21) In contrast to most of the companies examined above, Mr. Musk was hitting the accelerator on capital spending during the pandemic, spending 134% more on capital expenditures during the middle quarters of 2020 than in the same period of 2019. Clearly, Musk is a "unicorn" and most family businesses are not blessed (or cursed, depending on your perspective) with a personality like his. So what lessons can family business directors take from his confidence and disregard for normal risk management (as embodied by Mr. Rogers' Gambler)? No Blind "Confidence Premium"For public markets, share price performance is the ultimate scoreboard. As summarized in Table 4, confident investors (defined here as those companies that did not reduce capital expenditures during the middle quarters of 2020), on balance, did not fare as well as their more cautious counterparts. Knowing when to fold 'em appears to have paid off for most companies.Table 4: Post-COVID Stock Appreciation of "Confident Investors" Reality is messy, so easy answers don't work. The data in Table 4 suggests that closing one's eyes and being aggressive for the sake of being aggressive is not a great strategy. Our analysis of the data indicates that there is no automatic "confidence premium" available to more aggressive companies. For family business directors, this means that there is no substitute for careful analysis of the available investment opportunities. We have previously proposed that – in addition to the financial metrics that serve as a gating function for potential investments – directors carefully evaluate the market opportunity, strategic fit, and constraints associated with a potential capital investment. Rewarding ConvictionsThere may not be a "confidence premium," but there is a clear reward for maintaining one's investment convictions in the face of discouraging market returns. We wanted to see what impact, if any, prior stock price changes had on companies' willingness to invest during the pandemic. For the most part, the companies that invested the most during the pandemic had experienced favorable stock price movements during 2019. In other words, the "confident investors" were to some degree chasing momentum, as shown in Table 5.Table 5: Post-COVID Stock Appreciation of "Confident Investors"There are two notable exceptions to this momentum story. Shares of the most confident investors in the Consumer Staples and Information Technology sectors had underperformed those of their industry peers during the pre-COVID period. These "conviction" investors bucked the broader trends in post-COVID returns in Table 4, generating premium returns of 12% (Consumer Staples) and 43% (Information Technology), respectively.Contrarian investing requires thick skin and a steady stomach. In our experience, successful family businesses are often the best-suited players in their respective industries to invest at opportune times. Not being subject to the public stock market's reaction to next quarter's earnings release frees many family businesses to invest when others are holding back. Over generations, such enterprising families reap the rewards of investing with strategic conviction.So, where does your family business find itself during the current planning cycle? Are there investing convictions that your family business should double down on like Elon Musk, or is it time to follow the Gambler's advice and take some chips off the table? Sometimes an outside perspective can help bring clarity; call one of our family business professionals to discuss your investing outlook in confidence.

Previously on the Family Business Director Blog, we shared our prediction that the number of family businesses raising non-family equity capital will grow dramatically in coming years.In this week’s post, we share excerpts from a discussion with Dennis Hinton, Managing Director at North River Group, a private investment firm focused on non-controlling equity investments in family businesses. Mr. Hinton shares some common reasons family businesses seek non-family equity and how family business owners can achieve liquidity and diversification.Your firm, North River Group, makes non-controlling equity investments in family businesses. What are the most common triggers for the family businesses that are looking for non-family equity capital?Dennis Hinton: The most common trigger for a family business to get connected to us concerning non-controlling (minority) capital is around growth capital, or where the capital goes onto the company’s balance sheet to fund a specific initiative. However, this is not the ideal situation for North River Group. We seek to invest non-controlling equity capital into family businesses where they do not need capital. Stated differently, our capital is used for “liquidity,” or cash goes into the shareholder’s pocket. Most business owners, especially family businesses, do not know this is an option. They think their options are to either sell 100% of the company or do nothing. Selling less than 50% of a business provides a sort of “hybrid” liquidity event for a family-owned business.Do you find that family business owners are becoming more receptive to the idea of having non-family shareholders? If so, why do you think that is the case?Dennis Hinton: Yes and No. As traditional private equity becomes more mainstream, I think many family-owned businesses are uncomfortable with how they operate. Specifically, many family-owned businesses that have been around for a long time usually have done so through the avoidance of debt. Adding a lot of debt to a company’s balance sheet changes the dynamics of how a family-owned business operates. For example, many family-owned businesses pay their bills to their vendors as soon as they receive an invoice. However, a private equity owned, debt burdened business might view this as an opportunity to “squeeze” a bit more cash flow by delaying paying invoices for 30, 60, or even 90 days. Short term these gimmicks work but long term they lead to an erosion of trust with key stakeholders. Second, most entrepreneurs simply don’t like taking orders from others. While a strategic or private equity buyer talks about “partnering” with such a family-owned business, in reality, many times, this partnership turns into a dictatorship. Many times after an acquisition, a buyer will come in and micro-manage the prior owner operator(s). In a non-controlling equity investment transaction, these dynamics do not exist.What sort of governance rights do non-family investors typically require when they invest?Dennis Hinton: There are really only 3 governance provisions we require when doing these types of transactions:Agreement on annual CPA audit firm.Agreement on any family compensation increases above 2 or 3% annually.A Put Right or Redemption Right. Of the 3 provisions, the Put Right or Redemption Right is the only one that has any detail to it. While we never make a non-controlling investment intending to exercise such a Right, a preset and prenegotiated separation agreement is beneficial for both parties should a difference of opinion ever arise.Many families are leery of private equity funds because of their relatively short (4-7 year) investment horizons. Are there investors out there that are not tied to the fund cycle treadmill?Dennis Hinton: Yes, there are more and more investment firms with longer investment horizons. However, most are focused on the change of control investments or minority growth equity investments. We believe we are quite unique in that we don’t have any preset time horizons for investments. Additionally, we focus on providing family business owners liquidity by purchasing less than 50% of their business.What advice do you have for an enterprising family that is considering whether outside capital might be appropriate for them?Dennis Hinton: Chemistry matters. Specifically, when a family is deciding whether or not to partner with an investment firm in a minority capacity, there has to be a high degree of trust between both parties as it is a true partnership. While legal documents can provide high level parameters for how a partnership will operate post-closing, they can never include all situations that arise when running a business. When such a situation arises, both parties need to have confidence that the other party will work towards a fair and just outcome (which can sometimes conflict with one’s own financial interests). Finally, aside from business matters, we have always enjoyed working with business owners that we like personally – it makes the partnership much more fun. Mercer has experience working with family businesses to evaluate outside investment opportunities. Give us a call if you have an offer you want us to analyze alongside you.

This summer, we partnered with Family Business Magazine to conduct our inaugural survey of dividend practices at family-owned businesses.  This week, we feature an article that we wrote for the magazine summarizing the survey results.  We hope you enjoy and gain some insights that can help you and your family evaluate your current policy and make plans for the future.Determining what portion of earnings should be distributed to family shareholders each year can be perilous.Few decisions faced by family business leaders are as perilous as determining what portion of earnings should be distributed to family shareholders each year. Pay too little, and shareholders having no other source of liquidity from their shares may grow restive. Pay too much, and attractive opportunities for growth may wither on the vine, imposing a hard to define, but very real, cost on future generations. As a result, maintaining the appropriate balance between current income for existing shareholders and reinvestment for future generations can feel like a tightrope walk for family business leaders.When embarking on such a high-stakes endeavor, prudent leaders want to learn as much as they can from others in similar situations. To help family business leaders learn from one another, Mercer Capital partnered with Family Business Magazine to administer a survey on dividend practices at family businesses. Nearly 300 enterprising families responded, and we provide a summary of what we learned in this article.Are There Any Families Like Mine?The respondents to the survey represent a diverse group of family businesses, in terms of age, industry, size and geography. The median age of the family businesses in our sample was about 70 years, with nearly half being founded prior to 1950. The largest industry concentrations were in manufacturing (30% of respondents) and real estate (12% of respondents). About half of respondents reported revenue of less than $100 million, and approximately 10% reported more than $1 billion of annual revenue.What’s the Plan?Unlike shareholders in public companies, family shareholders can’t easily access the value of their shares by selling on the open market. Dividends are the most tangible expression of what can often feel like merely “paper” wealth. It’s nice to be rich; it’s even better to have money. Given this dynamic, it is not surprising that family businesses are more likely than public companies to pay dividends. Whereas about half of public companies pay dividends to shareholders, over 80% of the family businesses responding to our survey indicated that they do. However, nearly half of respondents reported not having a formal dividend policy. In other words, a significant group of family businesses are paying dividends, but they’re not sure why.Those who do have a formal dividend policy reported a few different policy objectives. As shown in Exhibit 1, the most common dividend policy identifies a target payout ratio of earnings (net earnings for C corporations, or earnings after tax distributions for pass-through entities). While family businesses prioritize paying dividends, overall payout ratios tend to be modest, with the target payout ratio for 60% of respondents at less than 25% of earnings. This suggests to us that most family businesses are wary of killing the golden goose.Exhibit 1 Dividend Policy Objectives Nearly 30% of dividend policies prioritize the investment needs of the business and treat dividends as a residual amount after attractive investment opportunities have been funded. Finally, a smaller minority of respondents prioritize shareholder returns in the form of establishing a target dividend yield (generally on the order of 2% to 4% of value). What Signal Are You Sending?Dividends are powerful signals about management’s outlook for the family business. Annual reports and shareholder letters may or may not get read, but dividend checks always get cashed. Because of this “signaling effect,” public company managers are loath to cut dividends in the face of a short-term earnings crunch and are hesitant to raise dividends beyond a level that they are confident they can maintain. In contrast, nearly half of the family business survey respondents indicated that dividends fluctuate from year to year, and only 20% reported having a mechanism in place to smooth out dividends amid volatile earnings. Without strong, well-cultivated shareholder consensus and engagement around the dividend policy, dividend volatility can reduce the “value” of the dividend stream to shareholders. Uncertainty regarding the dividend stream makes it harder for shareholders to make reliable personal financial plans. Dividend uncertainty also presents challenges for family business managers who need to plan significant capital investments years in advance.Public companies can emphasize dividend stability amid volatile earnings using share repurchases. Buying back shares and paying dividends are both tools to return capital to shareholders. Public companies tend to allocate more capital to share repurchases than to dividend payments. There are likely several reasons for this, one of which is that when earnings are down and capital is scarce, slowing the pace of share repurchases is less of a negative signal to investors than cutting the dividend. In other words, share repurchases serve as a release valve for volatile earnings at public companies. However, only 21% of our survey respondents reported having a formal share repurchase program available to provide liquidity to family shareholders. Without this release valve in place, it should not be too surprising that families report a higher degree of dividend volatility. We suspect that more family businesses will institute share repurchase programs in the future.Pandemic BluesThe COVID pandemic presented a (hopefully) once-in-a-generation challenge for family businesses.  Much like the broader economy, the pandemic did not affect all family businesses in the same way.  We asked survey participants to describe what effect the pandemic had on the performance of their family businesses and their dividend decisions.  Exhibit 2 summarizes the responses.Exhibit 2 Effect of Pandemic on Family Business DividendsJust over half of respondents indicated that the pandemic had no adverse effect on the financial performance of their family business. As a result, a significant majority of these respondents did not modify their dividend practices in response to the pandemic. Nonetheless, nearly 15% of those family businesses reporting no ill effects from the pandemic on financial performance reduced dividends, presumably to preserve family business capital in the face of grave economic uncertainty.Among family businesses that did see their financial performance suffer during the pandemic, there was a mix of dividend responses. Approximately 27% of such family businesses elected to maintain their dividend, signaling to family shareholders that they were confident in the long-term prospects of the family business. The remaining companies either cut dividends or suspended them entirely.Nearly 20% of all survey respondents reported suspending dividends altogether because of the pandemic. Given the significance of dividend payments to family shareholders, the decision to suspend dividends reveals the gravity of the threat the pandemic posed to some family businesses. Deciding when and how to reintroduce dividend payments will be a significant challenge for these families.What’s It Mean to You?Crack open a standard finance textbook, and dividend policy will look easy.  Simply invest in all available positive investments with a positive net present value, maintaining an optimal mix of debt and equity financing, and distribute what is left over.  Unfortunately, that theory assumes that shareholders are economic robots.  However, most family shareholders are people.  Unlike robots, people invest things (including family businesses) with meaning.  We asked survey participants to describe what their family business means to them, and the responses are summarized on Exhibit 3.Exhibit 3 Family Business Meaning In our experience, the most successful (and peaceful) enterprising families are those in which there is consensus regarding what the family business means to the family.  When there is alignment on meaning, it is easier to find alignment on dividend practices.  This is borne out when we examine the median target payout ratios for businesses sorted by the different family business meanings noted in Exhibit 3.  As shown in Exhibit 4, there is a clear correlation between what the family business means to the family and dividend practice. Exhibit 4 Family Business Meaning and Target Payout Ratio If the family business serves as a source of wealth accumulation and diversification for family members, it makes sense that payout ratios would be relatively high. In contrast, if the family business is perceived as an economic growth engine for future generations, large dividend payments will detract from that goal. Misalignment on meaning can trigger shareholder discontent: Individual shareholders who want the company to be a source of wealth accumulation will likely be frustrated if the rest of the family views the company as an economic growth engine and makes dividend decisions accordingly. The Last WordMany survey respondents provided additional comments that were illuminating. We will close with one that we think expresses the sentiments of many family shareholders: “I feel that maybe some businesses don’t discuss dividends openly. I feel that we are one of these. It is ‘undiscussable.’”Don’t let dividends be an “undiscussable” in your family. We hope the results of this survey can provide a starting point for healthy dividend discussions at your family business. SUMMARY RESULTS 2021 Family Business Dividend Practices SurveyDownload Summary

For most of us, Thanksgiving is a time to disregard normal dietary restraint in the company of extended family members that one rarely sees. For some enterprising families, however, Thanksgiving quickly devolves from a Rockwellian family gathering to a Costanza-style airing of grievances. So, in the holiday spirit, we offer this list of the top ten questions not to ask at Thanksgiving dinner. If you have trouble distinguishing between the board room and the dining room, this list is for you.1. Why can’t I work in the family business?Nearly all family businesses welcome the contributions of qualified family members; however, having the right last name is not a sufficient condition of employment for successful family businesses. As families grow into the third and subsequent generations, family employment policies can become especially contentious. Crafting a workable family employment policy that specifies required qualifications and external work experience is often one of the first and most important tasks undertaken by a family council.2. Why does cousin Joe get such a big salary?This can be a great question, and it is quite possible that Joe is either under – or over – paid relative to his contribution as an employee. As family businesses grow, the board should carefully evaluate how compensation practices for family members compare to those for non-family members. Working in the family business should be neither indentured servanthood nor a sinecure. It is a job, and successful families treat it as such. Having one or more independent (non-family) board members can be a great way to ensure that compensation practices in the family business are fair.3. Why does cousin Sam get anything from the business?This question gets to the heart of many family business disputes we have witnessed: the belief that family members who don’t spend their lives working in the family business aren’t entitled to any distributions. Successful families are able to separate the return on labor (wages and benefits) from the return on capital (distributions). Just as the family members providing labor are entitled to market-based compensation, family shareholders are entitled to distributions if and when paid, even if they don’t work in the business. That’s simply what ownership is. It works that way for public company shareholders, and there’s really no reason to treat your family shareholders any differently.4. Why isn’t the shareholder redemption price higher?A shareholder liquidity program can be a great way to promote peace in the family. Even when a shareholder liquidity program exists, however, shareholders often don’t understand that the family business has more than one value. Which value is appropriate for a redemption program depends on the family dynamics and goals for the program.5. Why doesn’t the business pay a bigger dividend?Being wealthy is not the same thing as feeling wealthy. Many family shareholders are wealthy but don’t necessarily feel that way because dividends either aren’t paid or are only a token amount. Having a well-reasoned and easily-articulated dividend policy is an essential step in promoting family harmony and sustainability. Occasionally, founders and second-generation leaders withhold distributions simply on principle, even if the business has limited reinvestment opportunities. This rarely ends well.6. Why doesn’t the business invest more for the future?This is the flipside to the previous question. Funds that are distributed are not available to reinvest in the family business. A single dollar of earnings cannot be both distributed and reinvested – a choice is required. Making that choice wisely requires knowing what time it is for your family business. As the family grows biologically, it is natural to wonder if the family business will, or can, keep up. You have to sow before you can harvest.7. Why doesn’t the business borrow more money?Growth requires capital, and since family businesses rarely have an appetite for admitting non-family shareholders, that means debt may be the only way to fund important growth investments. Prudent amounts of leverage to help finance growth investments can actually help secure, rather than imperil, the family business’s future. But before borrowing money, directors should ask a few key questions.8. Why does the business have so much debt?Some shareholders fret about using too little leverage, while others worry about the risk of having too much debt. Over the long-run, the capital structure of your family business should reflect the risk tolerances and preferences of your family shareholders. The idea that you can financially engineer your way to a lower cost of capital (and therefore, higher value) for your family business through fine-tuning capital structure is over-rated. Capital structure determines how much risk and reward shareholders can anticipate, but does relatively little to influence the actual value of your family business.9. Why don’t we register for an IPO?There are examples of families that have taken their businesses public while retaining control over the board of directors. It’s not always a lot of fun. Despite retaining control, being public means inviting the SEC and other regulators to take a keen interest in your business. Even if your family keeps its eye on the long-run, Wall Street can take you on a wild ride based on the short run. Having publicly-traded shares may be what’s best for your family business, but it’s a big step and a really hard one to take back.10. Why don’t we sell the business?When is the right time to convert the illiquid wealth that is the family business into ready cash? A buyer might approach your family business with an offer that you weren’t expecting, or your family might decide to put the business on the market and seek offers. In either case, you only get to sell the business once, so you need to make sure you have experienced, trustworthy advisors in your corner. Selling the family business will not remove all the stresses in your family; in fact, it may add some.Of course, all of these are really great questions to be asking – the Thanksgiving dinner table is just not the right venue. This Thanksgiving, try setting business to the side for at least one day. Our advice: instead of talking about the family business, stick to a safer topic like politics. Above all, be thankful for the opportunity to be a family that works together.Happy Thanksgiving!

Despite our best efforts, having four kids in the house means that we are a net candy importer over the Halloween weekend. Staring at the piles of candy in our house this morning brought to mind several recent conversations we’ve had with clients and prospects. The topic of those conversations was “lazy” capital.What Do We Mean by Lazy Capital?We were introduced to this term a few years ago, and it rather aptly describes a common situation in family businesses: capital on the balance sheet that is not generating a fair return for family shareholders.Where Does Lazy Capital Come From?Unlike leftover Halloween candy, lazy capital tends to accumulate slowly. I’ve not seen too many family businesses that have intentionally built bloated balance sheets. Perhaps ironically, the threat of lazy capital accumulating on the balance sheet is greatest for successful companies. How do successful companies wind up with excess capital?The following five broad headings capture most of the reasons.1. Reluctance to Invest in New Business LinesLike all companies, a family business has a natural lifecycle. At some point, the original business of the family will mature, with slow (or no) sales growth and more limited reinvestment needs. At this point, the family business directors should be deliberate about either (a) adopting a “harvest” mindset or (b) identifying new fields to “plant.” Families that are unwilling to take on the risk of “planting” a new crop of investments are much more likely to see lazy capital accumulate.2. Reluctance to Pay DistributionsSome family businesses appear to avoid paying significant distributions out of earnings on principle: owning shares in the family business should not provide one with disposable income. This “principle” is generally animated by a belief that the family shareholders cannot be trusted with financial resources. Granted, there is no shortage of individual family shareholders whose stories amply validate this fear. However well-intentioned, we suspect that a reluctance to pay distributions often has serious unintended negative consequences for the family, one of which is the accumulation of lazy capital on the family business balance sheet.3. Reluctance to Divest Unproductive AssetsFamily businesses occasionally have sentimental attachment to lines of business, facilities, and other assets that have outlived their usefulness to the family business. If Division X is consistently generating a 2% return on invested capital with no real prospects for improvement, it should not be considered untouchable, even if it was the apple of Grandpa’s eye thirty years ago. Family business managers and directors are asset allocators, and a refusal to evaluate business assets and segments with a cold eye will lead to a bloated balance sheet stuffed with operating assets that either do not earn an adequate return or no longer fit the strategy of the family business.4. Reluctance to Do Things DifferentlyWithout intentional attention and monitoring, the business practices that worked well a decade ago may not be driving optimal use of capital today. Working capital can be an overlooked hiding place for lazy capital. Active management of accounts receivable, inventory, and payables is critical to ensuring that the family is earning an appropriate return on its capital.5. Reluctance to Acknowledge Available Borrowing CapacityMany family businesses are debt averse. Capital structure is a function of, among other things, family risk tolerance. Yet, there is a difference between a family business preferring to operate without debt and one maintaining a cash balance sufficient to meet every potential contingency facing the business. The prudent move for debt-averse families is to maintain and update credit facilities that will allow the business to handle sudden cash needs that may arise without carrying unwieldy cash balances which weigh down investor returns. Even families that prefer not to use debt should acknowledge their ability to issue debt in the future if needed. That borrowing capacity should not be ignored in risk management discussions. Ignoring the available borrowing capacity of the family business leads to an exaggerated sense of how much liquidity the company needs to maintain on the balance sheet.What Are Some Consequences of Lazy Capital?Unlike leftover Halloween candy, an accumulation of lazy capital is unlikely to lead to tooth decay or increased risk of diabetes. However, there are some negative consequences of which family business directors should be aware.Diminished ReturnsThis one is just math – if a significant portion of your family business capital is allocated to low-returning assets, the overall return earned by the family will be pulled down. In today’s low-rate environment, the return on cash is functionally zero. As a result, allocating 10% of invested capital to cash means taking a 10% haircut to what would otherwise be ROIC. We’ve written about ROIC in a prior post because for most family businesses it is the best comprehensive measure of performance. Whatever form it takes, lazy capital puts pressure on ROIC.Lazy ManagementWe are all more aware of how viruses spread these days, and laziness is infectious. The presence of lazy capital on the family business balance sheet can take away a healthy “edge” in how the business is managed. It is not in anyone’s best interest to fabricate some artificial sense of crisis. However, we suspect most businesses operate best with what one of our high school coaches was fond of referring to as a “sense of urgency.” An accumulation of lazy capital can blunt the productive sense of urgency and breed unintended negative consequences throughout the business.Disgruntled ShareholdersLazy capital flourishes in an environment of limited, or poor, shareholder communication. And poor communication inevitably leads to mistrust and conflict. Positive shareholder engagement is much easier to maintain when family shareholders are confident that their capital is being put to good use.How to Get Rid of Lazy Capital?It’s easy enough to foist leftover Halloween candy on unsuspecting co-workers. Disposing of lazy capital is less straightforward, but the two primary strategies are to (1) return the lazy capital to shareholders so they can put it to work themselves, or (2) find more productive uses for the lazy capital within the family business.Finding the right strategy for dealing with lazy capital in your family business is a complex process that needs to consider the attributes of the business, your industry, and your family. Give one of our professionals a call today to review your situation in confidence and see how we can help.

The most common valuation-related family business disputes we see in our practice relate to measuring value for buy-sell agreements. Far too often, buy-sell agreements include valuation provisions that appear designed to promote strife, incur needless expense, and increase the likelihood of intra-family litigation.The ubiquity of valuation provisions in buy-sell agreements that do not work is striking. While there are many variations on the theme, the exhibit below illustrates the broad outline of the valuation processes common to many buy-sell agreements.The buy-sell agreement presumably exists to avoid litigation, but the valuation processes in most agreements seem to increase, rather than decrease, the likelihood of litigation. It is almost as if failure is a built-in design feature of many plans.Top Five Causes of Valuation Process FailureAmbiguous (or absent) level of value. As we discussed at length in section 3 of the What Family Business Advisors Need to Know About Valuation whitepaper, family businesses have more than one value. There is no “right” level of value for a buy-sell agreement, so the agreement must specify very clearly which level of value is desired. Failing to specify the level of value, and just assuming that the eventual appraiser will know what the parties intended is a recipe for disaster. The difference between the pro rata value of the family business to a strategic control buyer and the value of a single illiquid minority share in the family business can be large. Yet too many buy-sell agreements simply say that the appraisers will determine the “value” or “fair market value” of the shares. That is not good enough.Information asymmetries. Most buy-sell agreements have no mechanisms for ensuring that the appraiser for the selling shareholder has access to the same information regarding historical financial performance, operating metrics, plans, and forecasted financial performance as the appraiser retained by the family business. The resulting asymmetries give both sides a ready-made excuse to cry foul when the valuation results do not meet their expectations. We recommend a thoroughly documented process of simultaneous information sharing, joint management interviews, and cross-review of valuation drafts to eliminate the likelihood of information asymmetries derailing the transaction.Lack of valuation standards / appraiser qualifications. It is not hard to find an investment banker, business broker, or other industry insider who probably has a well-informed idea of what the family business might be worth (particularly in the context of a sale to a strategic buyer). However, when executing the valuation provisions of a buy-sell agreement, it is crucial to specify the qualifications for the appraisers. While an opinion of value from a business broker might be suitable for some purposes, the scrutiny that is attached to a buy-sell transaction can best be withstood by an appraiser who is accountable to a recognized set of professional standards that set forth analytical procedures to be followed and reporting guidelines for communicating the results of their analysis. There are multiple reputable credentialing bodies for business appraisers that promulgate quality standards for their members. The buy-sell agreement should specify which professional credentials are required to serve as an appraiser for either the selling shareholder or the company.Unrealistic timetable / budget. Families often share a well-founded fear that the valuation process will prove interminable without specified deadlines. Deadlines are important but must be realistic. If there is ever a time for a “measure twice, cut once” mentality, it is in buy-sell transactions. Due diligence and analysis takes time, and the schedule set forth in the buy-sell agreement needs to take into account the inevitable “dead time” during which appraisers are being interviewed and retained, information is being collected, and diligence meetings are being scheduled. The same goes for budget: if you think a quality appraisal is expensive, see how costly it is to get a cheap one. Provisions that identify which parties will bear the cost of the appraisal can help incentivize the parties to reach a reasonable resolution, but can also be so punitive that they discourage shareholders from pursuing what is rightfully theirs. Each family should carefully evaluate what system will work best for their circumstances.Advocative valuation conclusions. Sadly, even when the level of value is clearly defined, information asymmetries are eliminated, valuation standards are specified, and the timetable and budget is reasonable, the two appraisers may still reach strikingly different valuation conclusions. Whether this is a result of genuine difference of (informed) opinion or bald advocacy is hard to say, but it is rare for the appraiser for the selling shareholder to conclude a lower value than that of the appraiser for the company. Valuation is a range concept, so it should ultimately not be too surprising when appraisers don’t agree. Yet that inevitable disagreement adds time and cost to many buy-sell valuation processes.Is There a Better Way?Given the challenges and pitfalls described above, is there any hope that a valuation process for a buy-sell agreement can reliably lead to reasonable resolutions? We think so. We have identified three steps that we recommend for clients to help make their buy-sell agreements work better.Make sure that the buy-sell agreement provides unambiguous guidance to all parties as to the level of value and qualifications of the appraiser.Retain an appraiser to value the company now, before a triggering event occurs. This is essential for two reasons. First, it transforms the “words on the page” into an actual document that shareholders can review and question. No matter how carefully one defines what an appraisal is supposed to do, the shareholders are likely to have different ideas about what the output will actually look like. This appraisal report should be widely circulated among the shareholders, so they have an opportunity to familiarize themselves with how the company is appraised. Second, performing the valuation before a triggering event occurs increases the likelihood that the family shareholders can build consensus around what a reasonable valuation looks like. People tend to take a more sane view of things when they don’t know if they will be the buyer or the seller.Update the valuation periodically. Simply put, static valuation formulas don’t work in a changing world. Periodic updates to the valuation help the valuation process become more efficient, and help all shareholders keep reasonable expectations about the outcome in the event of an actual triggering event. Discontent and strife are more likely to be the product of unmet expectations rather than the absolute valuation outcome. Periodic valuations help to set expectations and reduce the likelihood of friction. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. This week's post is an excerpt from the whitepaper, What Family Business Advisors Need to Know About Valuation. If you would like to read the full version click here.

For family businesses that have never had an external valuation, there is likely to be some confusion as to what the process involves. In this post, we give a brief walk-through of the valuation process, from engagement through to issuance of the final report.EngagementThe first step in the valuation process is preparing and executing an engagement letter. The engagement letter should clearly define several key components of the valuation, including:The subject interest to be valued (i.e., XX shares of XYZ Corporation, Inc.) - There needs to be absolute clarity on what will be valued. It is not uncommon for enterprising families to develop a rather elaborate structure of holding companies and operating businesses, and the engagement letter should clearly state what is being valued.The "as of" date for the appraisal - Any valuation conclusion pertains to a specific subject interest as of a specific date. Markets change, and the value of a family business is not static across time. For most engagements, the valuation report is issued after the "as of" date. In other words, there is nearly always some lag between the effective date for the conclusion and when that conclusion is rendered.The level of value for the conclusion - As we discuss at greater length in the following section of this whitepaper, family businesses have more than one value at any particular date, so the engagement letter should specify which level(s) of value are relevant for the valuation.The standard of value and purpose of the engagement -  The engagement letter should indicate how the valuation is expected to be used and what the corresponding standard of value is.Fees - Most valuation engagements can be performed for a fixed fee. Occasionally, the scope of an engagement is sufficiently open-ended that the parties agree to calculate fees on an hourly basis. In either case, the engagement letter should spell out how fees will be calculated and when billings will occur. Prospective clients naturally want to know how much a valuation will cost. Unfortunately, the answer to that question is that it depends on the complexity of the assignment. Most valuation professionals will ask to review a family business’s financial statements to help in preparing a fee quote. This allows the valuation professional to gauge the complexity of the analysis that will be required. Valuation fees are ultimately a product of the estimated time required to complete the engagement and a targeted effective billing rate. Effective billing rate is a function of project complexity and the ability of the firm to leverage staff resources effectively to complete the valuation engagement efficiently. When comparing fee quotes, family businesses should keep this in mind. When presented with widely diverging fee quotes, one should ask if there are underlying differences in scope expectations or perceived complexity that need to be clarified.Data CollectionValuation is a data-intensive process. Concurrent with the engagement letter, most valuation firms will provide a preliminary information request. While potentially voluminous, the requested items are often ready to hand for family businesses, and include historical financial statements, financial projections, data on the assembled workforce, customer relationships, market segments, and product lines. In addition, clients often have access to industry-wide performance measures that are not readily available to those outside the industry. In short, the valuation professional will seek to collect the same sorts of data on the subject company that a potential investor would.DiligenceUpon receipt of the requested information, the valuation firm will perform diligence procedures, including relevant economic and industry research and analysis of the subject company’s historical and projected financial performance. The diligence phase of the engagement culminates in an interview with senior management of the family business. The purpose of the management interview is to help the valuation professionals identify and articulate the underlying narrative of the company: what makes this family business tick, and why is it valuable?AnalysisThe heart of the process is the application of valuation methods under the asset-based, income, and market approaches. Each approach seeks to answer the valuation question from a unique perspective.What are the current market values of the business’s assets and liabilities? This is the key question underlying the asset-based approach. It may involve assessing whether there are assets or liabilities that do not appear on the company’s balance sheet and evaluating whether there are assets having current market value different from that recorded on the balance sheet (such as real estate that has been owned for decades).What are the expected future cash flows of the family business, and how risky are those cash flows? This is the income approach to valuation, and it involves a careful analysis of the historical earnings of the family business, as adjusted for unusual or nonrecurring items, and the outlook for the economy, relevant industry, and the family business itself.What can be inferred about the value of the family business from transactions in reasonably similar businesses? This is the essence of the market approach, and it involves searching for and analyzing comparable public companies and/or transactions involving comparable private companies. In applying these methods, the valuation professional seeks to develop reasonable inputs and consider prevailing market conditions at the “as of” date for the valuation.Draft Report ReviewConcurrent with performing the analysis, the valuation firm will prepare a draft valuation report which describes the company, relevant industry and economic trends, valuation methods applied, and inputs used. The client should have an opportunity to read this document in draft form. This draft review is a critical step in the valuation process, helping to ensure there have not been any misunderstandings or miscommunications that would undermine the credibility of the conclusions in the valuation report.Clients should read the draft report carefully to assess whether the valuation firm developed a balanced and informed view of the industry and the company. Clients should be able to recognize their company in the valuation report. If they don’t, the draft review process should allow them to discuss those concerns with the valuation analyst.Issuance of Final ReportOnce the draft review process is concluded, the valuation firm will issue a final report. The final report should include the attributes of the engagement from the engagement letter and a clear description of who is entitled to use the report and for what purpose.BillingBilling practices vary and should be detailed in the engagement letter. Many valuation firms request a retainer at the beginning of the engagement and invoice for the remainder of the professional fee at the end of the engagement, either upon completion of the draft report or issuance of the final report.TimelineIn the normal course, family business leaders should anticipate that the valuation process described in this section should take six to eight weeks to complete. Most valuation firms are able to adjust as needed to accommodate reasonable deadline requests so long as they are communicated to the valuation firm during the engagement process. Prompt responses to information requests and follow-up questions help to keep the valuation process on track. Regular communication between the client and the valuation firm is the most important factor in meeting deadlines for project completion.ConclusionMercer Capital has worked with hundreds of family businesses over the last 40 years. If you think your family business needs a valuation but don’t know where to start, give one of our professionals a call, we’d be happy to help discuss your needs today.This week's post is an excerpt from section 2 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.

Why should family business leaders care about the value of their business? If the family is not contemplating a sale of the business, why does valuation matter?Clearly, valuation matters a lot when it is time to sell. But valuation matters at other times as well. In this post, we describe four common valuation applications in family business.Ownership Succession and Tax ComplianceEnterprising families prioritizing sustainability of the family business over decades need a strategy for ownership succession from generation to generation. Ownership transfers within a family unit can occur either during the present owner’s lifetime or upon death. In either case, compliance with tax laws require that the shareholders determine the fair market value of the shares being transferred.Family shareholders occasionally confuse fair market value with what they believe the shares to be worth to them. Fair market value is the statutory standard of value that emphasizes the actions of "hypothetical willing" buyers and sellers of shares in the family business. Revenue Ruling 59-60, which provides guidance for valuation of closely held companies, presents a working definition of fair market value:2.2 Section 20.2031-1(b) of the Estate Tax Regulations … define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.In other words, fair market value is not defined by what a particular family shareholder feels like the shares are worth to them or “what they would be willing to pay,” but is rather defined by a more rigorous process that considers the behavior of rational, willing, and well-informed parties to a hypothetical transaction involving the subject block of shares.Shareholder RedemptionsNot all family shareholders need the same things from the family business. A share redemption program can help provide interim liquidity for shareholders and provide a release valve in the event relationships among the shareholders deteriorate to the point that it becomes advantageous for some shareholders to be bought out completely.In contrast to tax compliance valuations that must conform to fair market value, there is more flexibility in pricing shareholder redemptions. In other words, enterprising families can seek to execute shareholder redemptions at a price considered to be “fair” or that otherwise advances the goals of the share redemption program.Regardless of the underlying goals or valuation philosophy selected, it is important for the transaction price to be the product of a disciplined valuation process. Doing so helps to ensure that the share redemptions do not detract from broader family goals or undermine other estate planning objectives of family shareholders.Performance Measurement, Evaluation, and CompensationWhether family members or outside “professionals,” the managers of the family business are stewards of family resources. Family shareholders should be entitled to periodic reporting on the effectiveness of that stewardship. While there are a variety of “internal” measures of corporate performance that are helpful in this regard (return on invested capital, etc.), periodic “external” measures that reflect the change in the value of the family business over time are also essential.Most observers acknowledge the benefit of aligning the economic interests of managers and family shareholders. The most common strategy for doing so involves using some form of equity-based compensation, and the most common equity-based compensation programs require periodic valuations for administration. Many family businesses have installed employee stock ownership plans, or ESOPs, to provide a broad-based ownership platform for employees, and ESOP administration requires an annual independent valuation of the ESOP shares.Corporate Finance DecisionsFinally, valuation is an essential component of the most important long-term corporate finance decisions made by family business directors and managers.The graph below depicts the inter-relationships between the capital structure, dividend policy, and capital budgeting decisions facing family businesses.The capital structure and capital budgeting decisions are linked by the cost of capital. There is a mutually reinforcing relationship between the value of the family business and the cost of capital, as each one influences, and is in turn influenced by, the other. The cost of capital depends on both the financing mix of the company and the riskiness of capital projects undertaken. The cost of capital also serves as the hurdle rate when evaluating potential capital projects.The availability of attractive capital projects is also reflected in the value of the family business and is the point of intersection between capital budgeting and dividend policy. If attractive capital projects are abundant, family business leaders will be more inclined to retain than distribute earnings.Finally, the cost and availability of marginal financing is also affected by the value of the family business. The resulting cost of capital influences both the value of the family business and the decision to distribute or retain earnings or to borrow or repay debt.In short, the value of the family business is inextricably bound up with these critical corporate finance decisions and is an important consideration in making those decisions.This week's post is an excerpt from section 1 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.

Family business advisors help companies and leaders navigate a wide range of business and family challenges, ranging from corporate governance to succession planning to family relationship dynamics and all points in between. Over the past several years, many of the family business advisors we have met have expressed a desire to better understand the intersection between business valuation and the family business advisory services they provide. We have written this whitepaper to help fill in that gap. The whitepaper is organized in four sections, each of which seek to answer a specific question about valuation.

Cargill is one of the largest family businesses in the world. Earlier this year, we analyzed the Family Capital list of the world’s 750 largest family businesses; Cargill checked in at number 15 on that list, with annual revenue reported to be in excess of $110 billion. Cargill made headlines earlier last week for its acquisition (together with another family business, Continental Grain) of Sanderson Farms, a publicly traded poultry business (ticker: SAFM).It is not every day that family businesses acquire publicly traded companies, so the transaction is worth exploring a bit further. For family business directors contemplating M&A activity of their own, or thinking about whether now is the right time for the family to sell, the Sanderson Farms acquisition rather perfectly illustrates why family businesses have more than one value.The Value of Sanderson Farms on a Standalone BasisSince its shares are traded in the public markets, we know what Sanderson Farms was worth on a standalone basis. Prior to rumors of a potential transaction influencing trading, SAFM shares closed at $155.74 per share on June 18, 2021 (corresponding to 7.9x trailing EBITDA).Business values always reflects consensus expectations regarding future cash flows, risk profile, and growth prospects. We will spare you the math, but the public market expectations for each of these factors is summarized in Table 1. As is the case with many agribusiness companies, earnings for Sanderson Farms are cyclical, depending in large measure on various commodity markets. Table 2 relates the estimate of "ongoing" EBITDA noted above, to recent earnings (the green dotted line). So, what does the public market price of $155.74 "mean"? If investors paid that price, and the company continued to operate on a standalone basis while growing at 2.9%, those investors would earn an annualized return of 6.5% on their investment, which is consistent – on a risk-adjusted basis – with alternative investments available to them. The Value of Sanderson Farms to Cargill/ContinentalIn contrast to public market investors, the Cargill/Continental consortium agreed to pay $203 per share for Sanderson Farms, or 10.4x trailing EBITDA. This represents a 30% premium to the public market price. Why where these buyers willing to pay more to for the company? As described in last week’s post, Cargill and Continental are strategic buyers. In other words, they anticipate integrating Sanderson Farms into their existing poultry operations. By doing so, their expectations for the three factors determining value are different, in some respect, than the expectations of public market investors for the company on a standalone basis.Table 3 summarizes several different scenarios that correspond to the $203 per share transaction price. Why might Cargill and Continental have different expectations than public market investors? Cash Flow. As strategic acquirers, the Cargill/Continental consortium might reasonably expect to be able to extract higher earnings from Sanderson Farms by combining with existing operations. Common cost savings in mergers come from consolidating facilities and eliminating redundant overhead costs. As shown in Table 3, the purchase price implies approximately $50 million of annual cost savings. In recent years, total selling, general and administrative expenses for Sanderson Farms have been on the order of $200 million annually. Could the buyers anticipate eliminating 25% of the existing corporate overhead? Perhaps, but one shouldn’t rule out other expense saving opportunities within cost of goods sold as the combined entity will likely enjoy greater negotiating leverage with suppliers than Sanderson Farms did on a standalone basis.Growth Prospects. Moving one column to the right in Table 3, we see that the higher acquisition price could also be explained by more aggressive growth expectations. It is likely that the newly combined entity will also enjoy enhanced negotiating leverage with customers as well as suppliers. Perhaps the greater market share of the combined entity will unlock opportunities for faster growth than would be available to Sanderson Farms on a standalone basis.Risk. Return follows risk. If the acquiring consortium enjoys a lower cost of capital than SAFM does, it may be willing to accept a lower prospective return on the acquisition. By way of perspective, published data on the returns for shares of companies stratified by size suggests that the returns for mid-cap firms like Sanderson Farms is on the order of 125bps higher than the return for large cap companies the size of Cargill. The acquiring consortium is more likely to anticipate incremental value from each of the three potential sources, as illustrated in the rightmost column of Table 3. It is important to note that transaction prices do not necessarily represent the maximum price that a strategic buyer could pay for the acquired company. In other words, it is possible that Sanderson Farms is really worth $220 per share to Cargill/Continental, but the seller was only able to extract $203 per share due to the relative negotiating leverage of the two parties. The value of the seller on a standalone basis (in this case, $156 per share) sets the floor for the transaction, while the (unobservable) value of SAFM to the acquiring consortium represents the ceiling. The ultimate transaction price of $203 is the point within that range at which the negotiating leverage of the two parties was balanced.Takeaways for Family Business DirectorsMost of our family business clients are not likely to acquire a public company. Even so, family business directors should bring the same discipline to bear when evaluating a potential transaction.When considering an acquisition opportunity, it is important to carefully analyze not just what the target company could be worth to you, but also what it is worth to the existing owners. Developing a bid for the target within that range should consider both the actions of other potential bidders for the target and how unique the target is.When contemplating a sale, the same considerations are appropriate. What is the family business worth to your family? What can you reasonably expect the family business to be worth to potential buyers? What strategies can you put in place today to help tip the negotiating leverage in your favor so you can extract more of the incremental value to the buyer? These are tough deliberations and the consequences of your final decision may affect your family for decades to come. Don’t make these decisions without a seasoned financial advisor in your corner. Give one of our professionals a call today to discuss your situation in confidence.

The rise of the family office has been one of the most significant themes in family enterprise over the last decade. Looking forward, we believe that the number of family businesses raising non-family equity capital will grow dramatically in coming years.We don’t think we are going too far out on a limb with this prediction. In this post, we take a quick look at the growing supply of capital seeking minority investments in family businesses, the sources of growing demand from family businesses for such investment capital, and how directors can best position their family businesses to thrive.Growing SupplyWith an abundance of dry powder to invest, private equity firms are increasingly willing to acquire non-controlling stakes in family businesses. Governance and exit mechanisms vary, but more and more PE investors are willing to ride in the passenger’s seat rather than the driver’s seat.Family offices also represent a growing source of capital for family businesses. Following the old investment adage of “Invest in what you know,” some enterprising families seek to diversify their portfolios by acquiring minority stakes in other family businesses.Finally, in last week’s post, we commented on Amazon’s strategy in acquiring equity warrants for minority investments in suppliers. While we focused on the issue of customer concentration in that post, it is also an example of strategically motivated capital available to family businesses.Growing Demand?But will there be demand for the supply of non-family equity capital? For decades, many families have perceived a stigma to using non-family equity capital. What factors could cause that stigma to fade?We sense an increasing willingness to consider using non-family equity capital in our discussions with clients. This inclination seems to be especially pronounced among shareholders in the third and subsequent generations. Among those members of the family, we find more of a tendency to evaluate risk and return from the family business in the context of other investment alternatives. In other words, many shareholders want to treat the family business as an important part of their personal portfolios but are not enthused about having all their investment eggs in the family business basket.These family shareholders tend not to be enamored by either of the traditional family business capital management strategies: (1) constrain growth to that which is supportable by retained earnings, or (2) rely on periodic "bet the farm" debt levels to fund more aggressive growth plans. Using non-family equity capital opens a third path along which businesses can grow without starving family shareholders of current income or using uncomfortable levels of debt financing.Finally, given the challenges of managing family dynamics, the need to prune the family tree of unaligned shareholders will probably never go away. Exchanging Uncle Joe for a non-family equity investor can ease family tensions without adding to the financing constraints facing the managers of the family business.Questions for Family Business Directors to ConsiderWhat questions should family business directors begin asking themselves about this trend? Let us suggest five:Where is your family business going? What is your strategy for meeting the challenges and opportunities that are likely to arise in your industry? If long-term sustainability and family control is your goal, what should your family business look like in ten years?What is the return profile of your family business? Investment returns come in two – and only two – forms: current income from dividends and capital appreciation. What mix of these return components are you providing to your family (or prospective) shareholders? How do those return components compare to other investment alternatives available to your shareholders?Who should own your family business? Your current shareholder list is likely of function of time and chance more than intention. If you could start from scratch today, who would your family shareholders be, and why? Are some of your existing family shareholders a better fit for the return profile of your family business than others?How will investors value your family business? What are the expected cash flows, risk factors, and growth prospects that are relevant to your existing shareholders? To a potential equity investor? Remember that your family business has more than one value.When will your family business need outside capital? For many years, our colleague, Chris Mercer, has been asking, “Is your business ready for sale?". Opportunities often arise unexpectedly, and Chris’ point to business owners is that there are significant benefits to being ready to sell even when you don’t intend to do so. The same idea applies to family businesses that may need outside capital: the time to prepare for that day is now. We don’t make a lot of predictions here at Family Business Director, but the growing use of non-family equity capital in family businesses is one that we are confident making. Family business directors would do well to begin thinking about how to leverage this trend to their benefit. Look for more on this trend in future posts.

With a new CEO ascending to power and an old CEO ascending to space, there has been no shortage of Amazon-related headlines this week. But amid the leadership transition news, a less-prominent Amazon story is equally relevant to family business directors. AWall Street Journal article revealed how Amazon uses its dominant negotiating position to extract warrants to purchase equity in suppliers.For years, our clients have told us how purchasing groups at Wal-Mart pushed aggressively for price cuts. Our clients were grateful for the business but knew that holding on to that business and earning a profit on it required them to identify and root out inefficiencies in their own operations. Several clients reported that the discipline of supplying Wal-Mart had spillover benefits on other areas of their business. Now Amazon has added a page to Wal-Mart’s playbook, seeking to capture a portion of the upside accruing to shareholders by acquiring warrants in those suppliers.A warrant gives the holder the right – but not the obligation – to purchase shares in a company at a fixed price at some future date. Because the price is established today, but doesn’t have to be paid until the future, the warrant holder shares in the benefit of upside with the shareholders but does not bear the burden of the downside. For example, if the warrant has a fixed price of $100 per share and the company performs well, pushing the stock price to $200 per share, the warrant holder will exercise her purchase right and realize a gain from the increase in value. On the other hand, if the company performs poorly and the share price falls to $50, the warrant holder will simply decline to exercise the purchase right and thereby avoid the loss borne by the shareholders.Since warrants have such an attractive investment profile, why are suppliers willing to give them to Amazon? Obviously, they think the opportunity to do business with Amazon is worth the dilution to future returns. Amazon’s negotiating leverage is an example of the perils of customer concentration.When we value family businesses, we focus on three things: expected cash flow, risk & growth prospects. Large customer concentrations can boost expected cash flows, but also increase the risk of those cash flows. All else equal, higher risk translates into a lower valuation multiple. For many clients, this is a “high class” problem: would you rather have a business with $100 of EBITDA and a 6x multiple, or $200 of EBITDA and a 5x multiple? The challenge for family business directors is to identify strategies for mitigating the risks of customer concentration while retaining the business of the large customer.We have observed two strategies that have worked well for our clients seeking to mitigate customer concentration risk.The first, and probably most obvious, is to leverage what you learn from dealing with the large customer into new business with other customers. Just as the most demanding teacher is probably the one that you learned the most from, the most demanding customer is probably the one to teach you the most about your own business. As we mentioned at the beginning of this post, several clients have confessed to us that, while selling to Wal-Mart was not exactly enjoyable, the challenge of doing so forced them to improve their processes and cost structure. As a result, they were in a better position to secure profitable business from other customers.Continuing our example, suppose the company leverages its experience with the large customer to capture additional profitable business from other customers and EBITDA grows from $200 to $300 (a 50% increase). As the customer concentration risk recedes in the wake of a more diversified customer base, the valuation multiple is restored to 6x, resulting in an 80% increase in value ($1,000 to $1,800).The second, and more difficult strategy, is to rebalance the negotiating leverage in the supplier/customer relationship. Does your customer have leverage because they can “push” your product through to the end user? This is how most large customer concentrations start. But some of our clients have been able to take back some of that leverage by investing effectively in their brand so that the end user “pulls” the product through the customer’s channel. Successful brands are less susceptible to the power of large customers because those customers need the brand as much (or more) than the brand needs them. Strengthening the family business brand to this point is likely the work of decades, not years, but can pay significant dividends in both higher cash flows and higher valuation multiples. Does your family business have a significant customer concentration that is reducing the valuation multiple? If so, what steps are you and your fellow directors taking to mitigate this risk? Give one of our valuation professionals a call today to discuss how customer concentrations are affecting the value of your family business.

Family business directors need the best information available when making strategic financial decisions that will help set the course of their business for years to come.This Benchmarking Guide is the resource directors need.Going beyond the basics of revenue growth, profit margins, and balance sheet composition data, this Benchmarking Guide equips family business directors with the information needed to make informed decisions regarding capital budgeting, capital structure, and dividend policy.Market data is transformed into meaningful information in this Benchmarking Guide for family business directors and their advisors. Also provided are questions and insights to help guide directors in their deliberations on these important decisions.

L. Paul Hood, Jr., JD, LL.M, CFRE, FCEP is a long time friend of the firm and an experienced and thoughtful estate planner. He has considerable experience working with family business continuity planning. A native of Louisiana (and a double LSU Tiger), after obtaining his law degrees in 1986 and 1988, Paul settled down to practice tax and estate planning law in the New Orleans area. Paul has spent over 30 years specializing in taxes and estate planning. He has taught at the University of New Orleans, Northeastern University, The University of Toledo College of Law and Ohio Northern University Pettit College of Law. The proud father of two Eagle Scouts and LSU Tigers, Paul has authored or co-authored seven books and over 500 professional articles on estate and tax planning and business valuation. We hope you enjoy this brief Q&A with Paul.Welcome, Paul. Tell us a little bit about yourself and your practice.Paul Hood: I like to describe myself in two ways. First, I’m a recovering tax lawyer. Second, I’m a purposeful estate planner. I believe in focusing much more attention on the human side of estate planning because it’s the most challenging part of estate planning, much more so than the tax planning and property disposition aspects of estate planning. But very few estate planners want to delve sufficiently deeply into the human side because it involves dealing with real human emotions, including our own.Along the course of my life, I’ve been a father, husband, lawyer, trustee, director, president, partner, trust protector, director of planned giving, expert witness, agent, professor, judge, juror and a defendant, and I use this life experience in these myriad roles to guide others. I help people pursue a "good estate planning result" in every case, whatever that looks like in each unique situation.You’ve written extensively about the "psychology of estate planning." In your experience, what is the single biggest psychological hurdle for family business shareholders to begin estate planning?Paul Hood: Perhaps the greatest hurdle to estate planning is most people lack sufficient self-awareness. By self-awareness, I mean that almost no one realizes the power that each of us has with respect to our estate planning decisions. One of my most important beliefs and philosophies about estate planning is that a person’s estate plan will have effects on the relationships of those who survive them, whether they want them to or not.One of the reasons why I preach the gospel of intergenerational communication from every pulpit that’ll have me is because the best estate plans I’ve ever witnessed all involved honest two-way communication between givers and receivers. Perhaps the biggest reason for post-death estate or trust litigation is the parties didn’t communicate about the estate plan.After the testator’s death, if an heir is unhappy about the estate plan, they too often entertain what I call the parade of horribles because what happened didn’t meet their expectations, and they immediately too often blame someone still alive and come out suing.A simple explanation of why the testator arranged their estate plan the way they did can eliminate a lot of post-death litigation and hurt feelings and ended relationships. A simple conversation could cut off heartbreak and family cutoff, yet most estate planners don’t implore their clients to have these essential conversations.Estate planning tends to focus primarily on minimizing transfer taxes. While that is a laudable goal, what other objectives should family business shareholders think about when it comes to estate planning?Paul Hood: A "good estate planning result" is one in which property is properly transmitted as desired, and family relations among the survivors aren’t harmed during the estate-planning and administration process.Notice that conspicuously absent from this definition is any mention of taxes. Taxes have always been the easiest piece of the estate-planning puzzle, yet the overwhelming majority of estate planners still focus their attention almost solely on the tax piece, probably because it’s easiest to solve and easiest to demonstrate quantifiable, tangible results. This misfocus has contributed to several problems for planners and clients alike.The sad fact is that perfectly confected and properly drafted estate plans render families asunder every single day in this country because the estate planners failed to address the human side of estate planning. Sadly, many of these problems are easily predictable. Frankly, I don’t know how some estate planners sleep at night.In one of your articles, you describe a "Path of Most Resistance" to achieving a good estate-planning results. Once a family business shareholder decides to engage in estate planning, what are the pitfalls that they need to watch out for?Paul Hood: The Path of Most Resistance is a model that I developed to illustrate graphically what has to happen in order to achieve the "good estate planning result" that I defined earlier. As the Path model illustrates, there are psychological machinations at work in every participant in the estate planning play, which includes the estate planners. As I have already discussed, intergenerational communication is essential in my opinion, particularly in a family business. Where there’s a family business involved, I view a frank and honest keep-or-sell discussion involving the entire family as perhaps the most important conversation that too few families in business ever have. Why is that? I view such a discussion as a means of gauging the family members’ individual and collective interests in continuing to be in business together. However, it’s a loaded question that can open up some family wounds, so caution is in order. Done correctly, the discussion can reinvigorate a business family’s overt commitment to the business in its current form. Unfortunately, lots can go wrong and can hasten or cause loss of the family business and family relationships because the keep or sell discussion can get very emotional and bring out hidden or suppressed feelings that have been harbored in silence and allowed to simmer past the boiling point upon their invitation to the surface. An estate plan should provide a system of checks and balances on power and authority, particularly in a family business. Estate planning necessarily involves a passing of the torch of leadership and control. As Lord Acton observed long ago, power tends to corrupt, and absolute power corrupts absolutely. Power shifts can expose people and leave them vulnerable to oppression, even to being terminated in employment or as a beneficiary through, for example, a spiteful exercise of a power of appointment (POA). The purposeful estate planner will build in a series of checks and balances that simultaneously allow exercise of authority and provide protection to those who are subject to that authority, which can be in the form of veto powers, powers to remove and replace trustees, co-sale or tag along rights, accounting rights or similar types of protections. Who are the different parties involved in the estate planning process? Do you have any tips for ensuring that all these parties work together for a successful outcome?Paul Hood: As the Path model illustrates, there are several "players" in the estate-planning play. I realize that most clients have more than two estate-planning professionals or advisors assisting them, but the larger point is that having more than one advisor itself creates potential obstacles in the path toward a good estate-planning result.In addition to the interested parties (the giver and one or more receivers), achieving a good estate planning outcome often involves one or more attorneys, an accountant, a valuation professional. Depending on the structure of the plan and the clients' needs, life insurance or other professionals may be involved in the process as well.The client should have as many advisors as he feels is necessary or appropriate. I’m a big believer in referrals and collaboration simply because it was my experience that clients get better service and a better estate plan. However, having more advisors creates a situation that must be watched and managed. I’ve seen estate-planning engagements fall apart because the advisors were incapable of cooperating and collaborating, which is a bad result for the client and can add to the negative experiences that the client will take to the next advisor, if any.Each of the estate-planning sub- specialties have their own ethical rules and conventions. These ethics rules impact subspecialties differently. The legal ethics rules insert some additional complexities in the estate-planning process, particularly in the areas of confidentiality and conflicts of interest. It’s imperative that the planner’s engagement letter permits complete and total access to all of a client’s advisors.Moreover, different advisors in the same subspecialty may have vastly different philosophies about estate planning. It’s critical that advisors check their egos and biases at the door before getting down to work with an open mind and collaboratively on a client’s situation. With collaboration comes diversity of professional backgrounds, educational and experiential pedigrees; different manners of training; and significant knowledge about a certain aspect of the client’s estate plan. This diverse strength of the group exceeds the strength of the sum of its individual members. This excess is called synergy.Estate planning is one of the most important tasks a business owner will face. Assembling the right team, and making sure they can work together, can increase the odds that you achieve a good estate planning result.

Italian artist Salvatore Garau made headlines last week with the reported sale of his invisible sculpture at an auction. It is probably not our place to wade into heady debates surrounding the ontology of art, but the reported winning bid of $18,000 is admittedly hard to evaluate relative to something which, in at least a material sense, does not exist. Nonetheless, the sculpture did come with instructions for its proper display.Mr. Garau’s innovation is in some ways the perfect embodiment of several valuation-related stories over the past year or so.Cryptocurrencies have been garnering headlines for several years, but the rise to prominence of Dogecoin during 2021 has been noteworthy, with spectacular daily price volatility and a year-to-day (as of June 7, 2021) return of over 7,500%. While other cryptocurrencies stress limited supply as support for value, Dogecoin eschews supply limitations and is described as "intentionally abundant" with a reported 10,000 new coins mined every minute.Interest in so-called meme stocks has ballooned in 2021, with retail investors buying shares in companies with less-than-inspiring fundamental stories in an effort to squeeze short sellers. While buyers of GameStop (up approximately 1,500% year-to-date) and AMC (capital appreciation of over 2,500% year-to-date) have certainly made shorting those stocks unprofitable, it remains to be seen whether the shares can hold onto current valuations over the long-term.NFT’s or non-fungible tokens blur the line between cryptocurrencies and real assets. NFTs are digital assets that represent ownership rights to digital artwork, highlight clips, music or the like. Unlike units of a cryptocurrency, NFTs are unique (hence the "non-fungible" element of the name). At the extreme end of the market, digital artist Beeple sold an NFT through Christie’s for $69.3 million. Despite not owning the NFT, you can view it here. What does the well-publicized market activity for cryptocurrencies, meme stocks, and NFTs suggest for the value of your family business? Valuation specialists like to distinguish between "price" and "intrinsic value." Prices can be observed in transactions; intrinsic values cannot. For some asset classes, there is no meaningful difference between the two notions. For example, individual investors in the U.S. treasury market are essentially price takers, so attempting to distinguish between price and intrinsic value doesn’t make much sense. Intrinsic value generally relies on a belief that there is a "fair" rate of return on an asset and it hard to argue that the "fair" rate of return on treasuries is anything other than the prevailing yield in the market. When we move to the market for publicly traded shares, there are two dominant schools of thought. The first argues that public stock markets are efficient enough that any differences between price and intrinsic value do not persist long enough for investors to reliably profit from them. The logical conclusion from this belief is that one should invest in passively managed vehicles (index funds and the like). Active managers, in contrast, believe that they can successfully identify instances in which price and intrinsic value diverge. We suspect that as one moves into more esoteric asset classes like crypto, meme stocks, and NFTs, the wild observed price volatility reflects the higher degree of difficulty associated with estimating intrinsic value. Investor returns come from cash flow yield and capital appreciation. When cash flow yield is negligible or not expected, value depends on expected future exit prices. Is GameStop a good investment at $280 per share? It is if you can sell it for $300 per share next week. If you can’t find that next buyer, it may prove to be a bad entry price for a long-term hold. Where do family businesses fit in to this picture? The sort of "momentum" investing that powers market moves in crypto and meme stocks depends on liquidity: an investor can buy today and sell tomorrow if his mood changes. This same liquidity does not exist for family businesses, much less for minority shares in them. As a result, when you are thinking about the value of your family business, it’s probably best to turn off CNBC and think about three fundamental factors:Cash flow. How much cash flow does your family business generate after necessary reinvestments to sustain operations?Risk. How does the risk of your family business compare to that of other investments? By other investments, we don’t mean crypto or NFTs, we mean alternative investments of broadly comparable risk. The market for those assets determines the return required by potential investors: the higher the risk, the lower the value.Growth. What opportunities are available to sustainably grow the cash flows generated by your family business over time? Higher expected growth rates result in higher values. The sale of Mr. Garau’s sculpture is a "man bites dog" sort of story and therefore generates a lot of headlines. For better or worse, the value of your family business is much more of a "dog bites man" story. Our advice is to ignore the headlines and keep focusing on the fundamentals: cash flow, risk, and growth.

It makes sense that stock prices reflect financial performance, and over the long run they do. So how to explain 2020, which saw corporate earnings devastated by the pandemic and stock indexes soaring to all-time highs? We’ve covered the pandemic’s affect on the operating, investing, and financing decisions made by public companies in our last three posts. This week, we conclude by examining shareholder returns.Chart 20 summarizes the performance of the Russell 2000 index (small cap shares) during 2019 and 2020. At the onset of the pandemic, the index fell precipitously. This is pretty easy to understand: investors don’t like risk, and risk was everywhere in the spring of 2020. During the second and third quarters, investors began to feel that they had a handle on the pandemic. In other words, investors grew increasingly comfortable that the long-term economic impact of the pandemic could be reasonably estimated. By the end of 3Q20, the index value had returned to pre-pandemic levels. When thinking about valuation, it is important to recall that the emphasis is always on the future. When the end of 3Q20 rolled around, it was clear that earnings for 2020 would be impaired because of the pandemic – so how could share prices be at the same level? Because the lower earnings for 2020 no longer mattered; the market was focused on earnings expectations for 2021 and beyond. Chart 21 shows that, while the market as whole had recovered by the end of 3Q20, not all companies did. Different industries fared differently. For example, healthcare shares increased sharply while energy shares were devastated. The storyline changes when we turn our attention to market performance in the fourth quarter of 2020. As shown on Chart 20, the index value surpassed pre-COVID levels by almost 20%. Chart 22 summarizes average share price changes by industry for the fourth quarter of 2020. In contrast to the share price performance during the first three quarters, the uplift in market prices during the fourth quarter was broad, with all sectors posting substantial average share price gains. Share prices change when earnings change and/or earnings multiples change. As shown in Chart 23, increasing earnings multiples played a significant role in the share price gains during the fourth quarter of 2020. Earnings multiples are defined by investor expectations for growth and returns. Growth. From the existing base, how fast are earnings expected to grow in the future? The faster the expected growth, the higher the earnings multiple. As visibility into vaccine pipeline increased during the quarter, investors may have been willing to credit companies with higher growth prospects.Returns. What return are investors demanding? Returns are the sum of the yield on risk-free assets plus a premium to compensate investors for taking risk. All else equal, investor returns are inversely related to earnings multiples. The increase in multiples during 4Q20 suggests that required returns decreased. Since risk-free returns increased during the period, the return premium received for taking risk likely fell more dramatically.Takeaways for Family Business DirectorsWhat does all of this mean for family business directors? The effect of the pandemic on business operations has been well-documented. However, for most family businesses it is time to move on from the survival mindset required during 2020.How will your family business grow in a post-pandemic world?One message from the stock market run-up during 4Q20 is that public market investors are expecting growth. Even if you think your family shareholders are different, public market sentiment likely shapes the behavior of your competitors and will influence what happens in your industry whether you want it to or not. In the wake of changes to supply chains and distribution channels, what new strategies will your family business need to adopt to compete and grow in the post-COVID world?How will you adapt to a lower cost of capital?The cost of capital is the price of money, and family businesses are ultimately price takers in the capital markets. While family shareholders may be protected from short-term public market volatility, public capital market trends do affect family businesses in the long-term. Regardless of whether you assign the cause to central bank actions or shifting investor sentiment, the overall cost of capital was probably lower at the end of 2020 than at the beginning of the year. This has significant implications for how family businesses evaluate and make distribution, investment, and capital structure decisions.These questions rarely have simple answers. Give one of our family business professionals a call to discuss what adjustments may be appropriate to help your family business thrive in the post-COVID world.

In previous posts, we analyzed the operating performance and investing decisions of the companies in our benchmarking universe. This week, we examine the financing decisions of those companies and apply those observations to family businesses.Big Picture FindingsThe difference between operating cash flow and investing cash flow creates a “gap” that is filled by financing activities.When operating cash flows exceed investing outflows, cash is available to distribute to capital providers, whether in the form of repaying debt, repurchasing shares, or paying dividends.When investing outflows exceed operating cash flows, a business must finance the resulting shortfall by borrowing from lenders or selling new shares to investors. A company’s cash balance serves as the release valve when financing cash flows do not perfectly align with the “gap” between operating and investing cash flows. Table 14 summarizes the aggregate sources and uses of cash for the small cap companies in the Russell 2000 during the three years ending with 2020. In “normal” years (i.e., 2018 and 2019), the small caps typically invest a bit more than cash flow from operations, leaving a net hole to be filled by financing activities. Of course, 2020 was far from “normal.”  As we have described in the previous two posts in this series, operating cash flow increased during the year despite weak earnings because of non-cash impairment charges and reduced working capital balances.  Meanwhile, companies were cautious on the investment front, curtailing both capital expenditures and M&A activity. The net result is that during 2020, operating cash flows exceeded investing cash flows by approximately $46.6 billion. So what did the companies in our universe do with this cash windfall? Net debt issuance. Although it was not necessary to fill a financing gap, the companies in our dataset continued to borrow money in 2020, albeit at a slower pace than prior years.  Rather than repaying debt, small cap public companies elected to borrow more funds during 2020.Net share issuance. During 2018 and 2019, the small caps were hesitant to issue net new shares.  However, in 2020 share repurchase volume fell over 20% (from $22 billion to $17 billion) while share issuance volume doubled from $22 billion to $44 billion.  The net result is that – as with debt – the companies in our dataset elected to raise new equity despite not “needing” it.Dividends paid. The companies in our sample also took a conservative posture regarding dividends paid.  In the aggregate, dividend payments fell by nearly one-third, from $13 billion to $9 billion. Aggregate financing inflows supplemented the positive financing gap to boost cash balances for the small caps by nearly $76 billion, compared to a net change of about $2 billion in 2018 and 2019.Digging a Bit DeeperTable 15 summarizes the same sources and uses of cash data, but on a quarterly basis during 2020.Net Debt IssuedAs the reality of the pandemic began to dawn on corporate managers in March 2020, the first action item for many companies was drawing down credit facilities to boost cash reserves to help weather a storm of unknown length. After loading up on proceeds from borrowings, the companies in our dataset returned some of the funds to lenders in the second half of the year as the economic impact of the pandemic became a bit more transparent. Net Share IssuanceAfter tapping the debt markets in the first quarter, companies turned their attention to the equity markets to secure pandemic funding over the balance of the year, as shown in Chart 17.In the second quarter, share repurchases slowed to a trickle while proceeds from share issuance more than doubled from Q1 levels.  Share issuance proceeds remained at elevated levels through the remainder of the year although repurchase volumes did approach more normal levels as corporate managers became more optimistic about the prospects for the economy. Dividends PaidChart 18 compares aggregate per share dividends paid in the fourth quarter of 2020 to the fourth quarter of 2019.During 4Q19, 336 small cap companies paid common dividends (approximately 30% of the total dataset).  During 4Q20, 103 of those companies (31%) either suspended dividends entirely or reduced the amount paid.  While 98 of the companies increased dividend payments, the typical increase was modest.  The remaining 135 dividend payors made no changes to the amount of per share dividends between the two periods.  On a net basis, the number of small cap companies paying common dividends shrank by approximately 20% from 4Q19 to 4Q20. Change in Cash BalancesAs shown in Chart 19, the small cap companies stopped hoarding cash in the third and fourth quarters of 2020.In total, the small cap companies in our sample added almost $76 billion to their cash offers during 2020.  As the economy recovers from the pandemic, we will monitor how management teams elect to put their cash stockpiles to work. Questions for Family Business DirectorsOur analysis of the financing decisions of public small cap companies during 2020 highlights some important questions for family business directors to deliberate during 2021.How did your lenders treat you during the pandemic? Were your existing credit facilities flexible enough to meet your needs, or should your family business be shopping for new lender relationships?  It continues to be a borrowers’ market, and now may be the time to lock in favorable rates.What does your family think about issuing equity to non-family investors? For many decades, this was an automatic “no” for most families, but we expect the increasing availability of capital from family offices and other potentially “friendly” equity investors to be one of the biggest trends in family business over the next decade.Have your family shareholders accumulated liquid wealth outside of their holdings in family business stock? Having a nest egg outside the family business can reduce the overall risk of the family even if it means using a prudent amount of leverage inside the family business.  When bad things happen (and COVID isn’t the last bad thing we will see), family shareholders with more diversified personal balance sheets tend to sleep a bit better.Do you have plans to deploy any excess cash balances that may have built up on the family businesses balance sheet? While rushing into ill-conceived investments is not a good idea, harboring lazy capital can weigh on long-term family returns. It is important for family businesses to make financing decisions with strategic intent rather than out of convenience.  Did the financing decisions your family business made in 2020 promote the long-term sustainability of the family business, or were they short-term decisions reflecting emergency conditions?  Use the more favorable business conditions of 2021 as an opportunity to make sure your financing decisions “fit” your family business.

Here at Family Business Director, we believe in the power of benchmarking for family businesses.  Done well, benchmarking provides managers and directors with valuable insight and context for evaluating the operating performance of the family business and the strategic investing and financing decisions made by the directors.  We published benchmarking guides in 2019: The 2019 Benchmarking Guide for Family Business Directors, and 2020: The2020 Benchmarking Guide for Family Business Directors.We are organizing the 2021 edition of our benchmarking guide using the statement of cash flows as our guide.This week, we review the components of cash flow from operations.Next week, we will consider investing activity, turning to financing decisions the following week.In our final installment, we will look at market performance and shareholder returns. It is no secret that COVID-19 was the story of 2020.  To assess more clearly the effect of the pandemic of the firms in our universe, we analyze results on a quarterly basis.  We’ve drawn our data this year from the SEC filings of revenue-generating companies in the Russell 3000 index (excluding financial institutions, real estate companies, and utilities).Operating PerformanceEverything good in business starts with revenue.  In Chart 1, we summarize aggregate revenue trends during 2019 and 2020. Chart 1 demonstrates that – in the aggregate – smaller companies felt more pain from the pandemic than their larger counterparts.  For the large cap companies, revenue fell less than 10% during the second quarter before resuming year-over-year growth in the back half of the year.  In contrast, revenue growth for the small caps turned negative in the first quarter, bottoming out with a nearly 20% reduction in the second quarter, with lower revenues persisting into the third and fourth quarters. Financial analysts refer to the relationship between the change in revenue and change in operating expenses as operating leverage.  Simply put, if some portion of a company’s operating costs do not vary directly with revenue (i.e., are fixed), revenue growth is likely to trigger expanding margins, while decreasing revenue reduces the operating profit margin. Chart 2 compares the relationship between change in revenue and change in operating expenses for the small cap companies in our data set for 2019 and 2020. Throughout 2019, expense growth outpaced revenue growth, causing operating margins to compress on a year-over-year basis.  This trend was exacerbated in the first half of 2020 before moderating in the second half of the year.  Chart 3 illustrates the impact of operating leverage on the operating margins of the large and small cap companies. Since the revenue shortfall in 2020 was greater for the small cap companies than the large caps, the negative effect of operating leverage was more pronounced for the small cap firms in 2Q20, with the aggregate operating margin for the group decreasing by 542 basis points from 2Q19, compared to a 218 basis point reduction for the large cap companies.Working Capital to the RescueIn contrast to operating income, net income is burdened by interest costs, income taxes, impairment charges, and other unusual items.  As shown in Chart 4, the small cap companies reported an aggregate net loss in the first two quarters of 2020.  After breaking even in the third quarter, the group crept back into the black in the fourth quarter. However, as shown in Chart 4, the earnings weakness in 2020 did not prevent these companies from generating more operating cash flow than in 2019 ($127 billion compared to $117 billion).  How was that possible? Table 5 summarizes the composition of operating cash flow for 2018 and 2019. Net income was $61 billion lower in 2020 than 2019 for the small cap companies in our data set.  However, $36 billion (60% of that difference) was attributable to non-cash charges to earnings (i.e., impairment charges).  The balance of the difference is primarily attributable to working capital.  One silver lining to the cloud of shrinking revenue is the release of working capital. As shown in Chart 6, cash provided by liquidating working capital was augmented by more diligent cash management practices, as the cash conversion cycle for small cap companies fell from 52 days at the end of 1Q20 to 39 days at the end of 4Q20. Of note, the large cap companies in our data set generally manage working capital more aggressively than their small cap counterparts, as shown in Chart 7. Questions for Family Business DirectorsThe benchmarking data raises some critical questions for family business directors as the U.S. economy continues on the path to recovery.It’s clear that larger firms fared better than smaller firms.  What is less clear is why.  Assuming your family business is not the size of a large cap public company, what steps did you take to preserve existing revenue sources and find new revenue sources in the pandemic?  If you found new revenue sources (for example, e-commerce), what steps are appropriate now to preserve those revenues as the pandemic recedes?Operating Leverage:  We suspect that operating leverage ultimately has more to do with flexibility, creativity, and ingenuity than the traditional dichotomy of “fixed” versus “variable” costs.  What did the pandemic teach you about your family business’s ability to adapt and manage operating expenses in the event of a negative shock to earnings?  Looking forward, are there any “austerity measures” that should probably become the new normal for your family business?Working Capital:  If your family business did generate less revenue in 2020, was it able to liquidate working capital accordingly?  Do you adopt any working capital management techniques during the pandemic that should continue?  If you are expecting revenue to recover in 2021, have you identified and secured the necessary financing sources to support the accompanying increase in working capital needs?  What appeared to be a large cash balance at the end of 2020 can be depleted quickly if strong revenue growth triggers larger working capital balances.The pandemic did not affect all industries equally.  As shown in Chart 8, revenue for some industry sectors actually increased during the year.ConclusionThe observations in this article relate to the data set as a whole.  For more targeted insights and observations, give one of our professionals a call to talk about a more customized benchmarking analysis for your family business.

Enterprising families elect to “prune the family tree” for manifold reasons.  For some, intra-family tensions have reached a breaking point, for others, there are different perspectives regarding the long-term prospects for the family businesses, and in yet others, different shareholder clienteles emerge with unreconcilable risk and return preferences.Regardless of the reason, significant shareholder redemptions are among the least understood corporate transactions.  In this week’s post, we consider the economics of family shareholder redemptions from three perspectives: the selling shareholder, the family business, and the remaining shareholders.  Balancing these competing perspectives is one of the greatest challenges of executing a significant redemption.In this week’s post, we consider the economics of family shareholder redemptions from three perspectives. Balancing these competing perspectives is one of the greatest challenges of executing a significant redemption.The Selling ShareholderWhen it is time for one or more shareholders to make a graceful exit, the economic interests of the selling shareholder diverge from those of the Company and the remaining shareholders.For the departing shareholder, sustainability of the family business ceases to be a guiding principle. The departing shareholder wants to maximize his or her proceeds from the sale of their stake, regardless of the burden such a purchase price could place on the business going forward.Most selling shareholders want cash when they sell their shares: trading one piece of paper (a stock certificate) for another (an interest-bearing note) is rarely perceived as a meaningful benefit. Selling shareholders presumably have some plan for deploying proceeds from a sale and receiving cash for their shares is likely an essential component of that plan. Knowing what selling shareholders want is just one-third of the picture, however, we also need the perspective of the company itself and the remaining shareholders.The CompanyWe use “the Company” to refer to the management team, employees, and other stakeholders who are not shareholders but do have a vested interest in seeing the family business grow and persist as an independent company.Cash used in a redemption is cash that is not available for investment in productive assets that can help the Company grow. If a redemption is going to occur, the Company is one of only two parties that can pay for it.  Companies pay for shareholder redemptions by either (1) not making corporate investments in productive assets that would otherwise be made, (2) using existing liquidity, or (3) borrowing funds.  Each of these options, in their own way, diminishes the Company’s ability to grow or flexibility to respond to emerging strategic opportunities or threats.From the perspective of the Company, these negative outcomes can be mitigated by paying the redemption price over time, using a note that is subordinated to all other corporate obligations, bears interest at a favorable (i.e., low) rate, and has flexible repayment terms.The redemption price matters to the Company because a price that is set too high may spark a “run on the bank” which leads to sale of the business. On the other hand, a price that is set too low may also prompt shareholders to explore selling the Company as the only way for those shareholders to “unlock” the value that has been created over the preceding years and decades.  Regardless of the path taken, the Company would generally prefer to avoid a sale of the business.Above all, the Company craves certainty. If there are going to be claims on corporate cash flow for redemptions, the Company wants to be able to plan around the amount and timing of those obligations. We were careful to distinguish between the Company and the remaining shareholders because – while there is significant overlap between the two – the interests of the two parties do not align perfectly.  So we need to consider the perspective of the remaining shareholders separately.Remaining ShareholdersIf the Company doesn’t pay for the redemption, the remaining shareholders must.  If there is no interest in bringing in a non-family source of equity capital, the remaining shareholders will pay for the redemption through diminished dividends or smaller ongoing redemption pools.There are only two potential sources of return for family shareholders: income return from dividends and capital appreciation from a growing value per share. From the perspective of family shareholders, funding a significant shareholder redemption reallocates at least a portion of their return from the income return bucket to the capital appreciation bucket.  Since the benefit of capital appreciation is deferred to the future (perhaps even to one’s heirs), many family shareholders value current income more highly than capital appreciation.  These shareholders find the prospect of trading away current income for greater capital appreciation distasteful.In view of this shift in return components, the remaining shareholders naturally want the increase in capital appreciation to exceed the decrease in current income associated with a significant redemption. How can this be accomplished?  By paying a discounted price and/or financing the redemption with a shareholder note, which is what the selling shareholders naturally want to avoid…The Great Balancing ActAs we said at the beginning of this post, enterprising families have a variety of reasons for pursuing a significant shareholder redemption.  Regardless of the reason, executing a large redemption is a great balancing act.  There are three parties to the transaction, each of which brings a unique perspective and set of needs and preferences to the deal.  Structuring a redemption requires each of those parties to understand the perspectives of the others and acknowledge that tradeoffs will be inevitable.  Careful modeling of the financial consequences of the redemption on each of the three constituencies is a necessary component of completing a redemption.Financial modeling of the transaction should be situated in a broader context of what the real goals of the transaction are and what tradeoffs each of the parties to the redemption is willing to make.Necessary, but not sufficient.  Financial modeling of the transaction should be situated in a broader context of what the real goals of the transaction are and what tradeoffs each of the parties to the redemption is willing to make.  Only when the goals and tradeoffs are identified will the parties be able to identify a financial model that supports the great balancing act that is a family shareholder redemption.ConclusionIf you suspect it might be time to prune your family tree, give one of our family business advisory professionals a call to discuss your situation in confidence.  Our professionals have the experience, modeling expertise, and perspective to help you get your redemption transaction.

Family Business Director is excited to be a sponsor of this week’s Transitions Spring 2021 conference produced by Family Business Magazine.  The theme for the conference is “Building the Future Family Business.”  The conference offers a wide range of sessions in support of that theme, including (to name just a few):Getting Past the PastDefining the Family for the FutureEffectively Transitioning Your Legacy and WealthNon-Family Executives: When Is the Right Time to Bring Them In?Killing the Goose? How to Avoid Laying a (Golden) EggDriving Diversity and Inclusion in the Family BusinessFamily Business Senior Executive Compensation Study Results The Transitions conferences are the perfect venue for enterprising families to gather and learn from the experiences of other families who have dealt with (or are currently dealing with) common challenges in a family business.  The sessions – led by both family business leaders and subject matter experts – are informative and relevant and cover timely topics.  And the opportunity to meet and build connections with other enterprising families is not easily replicated. We are looking forward to leading a breakout session on Wednesday (12:10-12:50 EDT) on the role of diversification in the family business.  As your family thinks about building the future family business, how should the concept of diversification be considered in your planning?  We hope to guide an interactive conversation among attendees around the following topics:What is diversification, and what are the benefits of diversification to family businesses?Are there any reasons for family businesses not to diversify?How does diversification affect investment decisions?From whose perspective should diversification be evaluated?How do diversification concerns affect leverage and dividend policy decisions?How does the “meaning” of your family business intersect with diversification decisions? While COVID appears to be on its way out of our lives, it is still not feasible to host large conferences on an in-person basis.  However, the staff at Family Business Magazine have done a great job of providing a virtual conference experience (complete with 1:1 networking opportunities) that promises to replicate some of the best features of in-person events.  Plus, you can wear your yoga pants.ConclusionIf you are attending, please look us up and reach out; my colleague Atticus Frank and I would enjoy meeting you and spending a few minutes with you.  If you’ve never attended a Transitions event before, this conference will be a great opportunity for you to try it out.  We have complimentary registration for the first four individuals who would like to attend.  Just shoot us an email at harmst@mercercapital.com and we will hook you up.We look forward to seeing you there!

Our family business advisory practice is focused on three strategic financial questions that weigh on family business directors and can keep them awake at night.In no particular order, the three questions are:1. What is the right dividend policy for our family business?We define dividend policy broadly, encompassing both how family businesses pay regular and special dividends and how they craft shareholder redemption programs.2. What is the right family business capital structure?Every family business has a capital structure, whether it is the product of intention or inattention. Capital structure for family businesses often reflects both business fundamentals and family risk tolerances and history.3. What is the right asset mix for our family business?Answering this question requires careful analysis of company strategy, how potential projects are identified, and the use of cash flow projections.Clients often solicit our advice because they are struggling with one of these questions. But, in our experience, the questions can’t really be tackled in isolation. Each question comprises one leg of the three-legged stool of the family business. As an engineering-minded client recently pointed out to us, while it is impossible for a three-legged stool to wobble, it can be crooked. If the three legs are not designed to work together, the stool won’t be level, and won’t hold anything valuable for long.We would like to use the following image to show how the three legs of the stool relate to one another.Relationship between Dividend Policy and Capital StructureWhether through dividends or share redemptions, returning capital to shareholders affects the capital structure of the family business. This is true if dividends are paid out of operating cash flow, or if a special dividend or redemption is paid out of incremental borrowings. As a result, dividend and redemption decisions cannot be made apart from capital structure decisions. This requires family shareholders to think through the inherent tradeoffs that often arise between the desire for more substantial dividends and a preference that the family business be conservatively financed.Relationship between Capital Structure and Capital BudgetingThe mix of debt and equity financing employed by the family business influences the weighted average cost of capital, which serves as the foundation for hurdle rates used in capital budgeting analyses. Setting the appropriate hurdle rate for capital investment requires more than a little finesse on the part of family business directors. Set the rate too high, and the growth of the family business may be stifled as the company continually loses out on investment opportunities to more aggressive bidders. If the hurdle rate is too low, the family business will be willing to make capital investments when returning capital to family shareholders would be the more prudent choice. A too-low hurdle rate can become a self-fulfilling prophecy, pulling down shareholder returns over time through over-investment in the business.Relationship between Capital Budgeting and Dividend PolicyShareholder returns come from two, and only two, sources: dividend yield and capital appreciation (i.e., growth in share price over time). While it may be only natural for family shareholders to want to maximize both sources of return, funds distributed as dividends or used for share redemptions are not available to finance capital investments that support future increases in share price. This tradeoff is unavoidable and suggests that dividend policy cannot be established in isolation from the investment opportunities available to the family business. Finding the right mix of dividends and reinvestment for future growth requires balancing what are often the competing claims and needs of different generations within the family, or even among different branches of the same generation.Keeping the Stool LevelNo, a three-legged stool will never wobble, but it won’t necessarily be level, either. No one would set an irreplaceable family heirloom on a stool that isn’t level. You can only keep the stool level if all three legs are working together.ConclusionWe assist our family business clients in making sure all three legs are working together by helping directors identify what the business means to the family, benchmarking key metrics to relevant peers, and improving shareholder communications.Give one of our senior professionals a call today to discuss how we can help secure a sustainable future for your family business.

Awaiting kick off on the afternoon of the big game, one of the perennial features of the interminable pre-game show is the obligatory head-to-head matchup segment, in which the network analysts go through the starting lineups position by position, comparing the relative strengths and weaknesses of the quarterbacks, linebackers, kickers, waterboys, etc.  The conceit of the segment is that, while both teams will field the same basic positions, not all cornerbacks are created equal.  If the analyst can reliably discern which team has the advantage at the most individual positions, perhaps that will reveal the winner ahead of time.  For our part, we predict that Kansas City Tampa Bay will win by 10 22 points.All of which got us to thinking about, well, EBITDA (earnings before interest, taxes, depreciation, and amortization).  In the world of family-owned and other private businesses, EBITDA is the most commonly cited performance measure.  Much like left tackles, every company has EBITDA, but some EBITDA is better than others.  Why is that?What Is EBITDA and Why Does It Matter?EBITDA is an example of a non-GAAP performance measure, meaning it is not a line item on audited financial statements.  EBITDA gets a lot of attention because it is a proxy for the operating cash flow that is, in turn, available for a broad variety of corporate purposes.  EBITDA is especially popular in the M&A markets because it is a measure of the discretionary cash flow available to a potential buyer of a business.EBITDA also promotes comparability across firms by “normalizing” for structural features of how those companies are organized, financed, and assembled.  This is best seen by considering the various adjustments to net income that are made to arrive at EBITDA.  We will start from the bottom of the income statement.Income Taxes - Many family businesses are organized as tax pass-through entities (S corps or LLCs) and report no corporate income tax expense.  Because taxes are excluded from EBITDA, all companies are on equal footing, regardless of their tax structure.Interest Expense - Financing operations with debt rather than equity does not directly influence the operating results of the business.  As with taxes, interest expense is excluded from EBITDA, allowing direct comparison of performance by different companies having different capital structures.Depreciation Expense - Depreciation expense is a non-cash charge that accountants use to allocate the cost of long-lived assets to the accounting periods during which the assets are expected to be used.  As you might guess, a lot of assumptions go into those calculations, each of which potentially impairs the comparability of reported earnings to those of other companies that may make different assumptions.  Since EBITDA ignores depreciation charges, it erases that potential obstacle to comparability.Amortization Expense - Some companies grow through acquisition, while others grow organically.  If acquirers pay more than the value of the net tangible assets of the target companies, they must write off the excess in the periods following the acquisition.  Companies growing organically do not have comparable amortization expenses.  Thus, EBITDA is comparable for businesses, whether they grow through acquisition or organically.Limitations of EBITDAThe following chart (Exhibit 9 from our whitepaper, Basics of Financial Statement Analysis) illustrates the five basic uses of EBITDA. Importantly, of these five uses, only three provide direct returns to capital providers: paying interest, repaying debt, and distributing to owners.  The other two, paying taxes and capital expenditures, do not directly accrue to the benefit of shareholders. This is generally obvious with regard to taxes but requires more finesse for capital expenditures.  We can divide capital expenditures (in the economic rather than accounting sense) into two groups: Maintenance Capital Expenditures - Family businesses focused on sustainability recognize that a portion of operating cash flow must be set aside each year to maintain productive capacity.  Depreciation expense is an imperfect proxy for this obligation.  The reality of this maintenance capex burden lies at the heart of legendary investor Warren Buffett’s infamous tooth fairy warning on EBITDA.Growth Capital Expenditures - But not all capex is maintenance capex.  Family businesses also invest to grow (whether through M&A or organic investments).  Since these investments should only be made if the expected returns exceed the company’s cost of capital, these “elective” expenditures are made in lieu of distributions to capital providers in the expectation that they will generate long-term benefits that more than makeup for the deferral in distributions. The point of all this is that a dollar of EBITDA is not just a dollar of EBITDA.  The quality of a dollar of EBITDA depends on how much of that dollar is allocable to taxes and maintenance capital expenditures.  Consider the two companies summarized in the following chart.Company A and Company B both generate the same amount of EBITDA, yet Company B’s EBITDA is of much higher quality because taxes and maintenance capital expenditures consume a much smaller portion of EBITDA than for Company A.  Accordingly, investors will likely assign a higher EBITDA multiple to Company B than Company A (all else equal).  This is borne out when we look at data for non-financial companies in the Russell 2000. The value assigned by the market to each dollar of EBITDA follows a predictable pattern as depreciation & amortization consumes a greater portion of EBITDA.  Ideally, we would look at depreciation only, but the data aggregation services generally only provide the aggregate number.  Even so, the point stands. ConclusionSo, should family business directors be as dismissive toward EBITDA as Warren Buffett?  We do not think so, although it is important for directors to take Mr. Buffett’s reservations to heart and understand that not every dollar of EBITDA is created equally.  This is important for two reasons.  First, doing so helps directors take EBITDA multiples with the appropriate grain of salt.  Since the value of a dollar of EBITDA depends on the quality of that dollar, quoted EBITDA multiples should be evaluated with due caution.  Second, this underscores the importance of incremental EBITDA.  Once taxes and maintenance capital expenditures have been covered, marginal dollars of EBITDA are of the highest quality (and therefore most valuable).  As a result, improving EBITDA margins can have a multiplicative impact on the value of your family business by both providing more EBITDA and justifying a higher multiple.And that is a winning game plan.

The tyranny of the urgent imposes itself on family business directors just as it does on everyone else.  In this series of posts, we offer various to-do lists for family business directors.  Each list will relate to a particular family business topic.  The items offered for consideration will not necessarily help your family business survive the next week, but instead reflect priorities for the long-term sustainability of your family business.In last week’s post, we reviewed the role of diversification in family businesses.  This week’s to-do list includes important tasks for family business directors seeking to discern whether – and how – to diversify the operations of the family business.  Thinking about diversification is essential for helping family business directors fulfill their duty to manage the risk of the enterprise.  For mature family businesses, prudent diversification can be one of the most important means to promoting sustainability.1. Estimate What Portion of the Family’s Overall Wealth Is Represented by the Family BusinessAs we discussed in last week’s post, attitudes toward the benefits of diversification depend on whether one takes a “business” or “shareholder” perspective.  When evaluating diversification opportunities, directors should have a clear understanding of which perspective they are taking and why.  If the family’s wealth is concentrated in the family business, the “business” perspective will likely be appropriate.  If, on the other hand, family shareholders have significant assets and sources of income outside the family business, the “shareholder” perspective is probably preferable.  It is not unusual for larger families to have a mix of diversified and undiversified shareholders, in which case directors need to develop strategies for simultaneously managing the different shareholder “clienteles” within the family. Family shareholders may chafe at disclosing personal financial information, so this needs to be approached with some tact.  First, keep in mind that this is not an accounting exercise that needs to tie to the penny: broad percentages are acceptable.  Second, family shareholders may be more willing to be transparent with a trusted third-party intermediary who can collect, analyze, and present aggregate shareholder data on a confidential basis.2. Identify the Primary Long-Term Strategic Threats to the Sustainability of the Existing Family Business OperationsWhat are the risks of failing to diversify?  Assessing the strategic threats to the family business can help directors evaluate the most fruitful avenues of diversification for the family business.  We find the Porter framework to be a helpful way to think systematically about the strategic position of your family business.  The Porter framework organizes strategy under the headings of five basic competitive forces.Threat of New Entrants. How easy is it for new firms to enter your markets?  What protects your family business from competition by new industry players?Supplier Bargaining Power. Where does your family business sit along the value chain from raw material inputs to consumers?  Is your family business susceptible to supply disruptions?  How well could your family business absorb or manage a price hike from your key suppliers?Rivalry Among Existing Competitors. What factors determine market share in your industry?  Why do customers choose your family business over competitors?Threat of Substitutes.Is your family business selling steak or sizzle?  What are other (existing or future) alternatives for your customers to get their sizzle?Customer Bargaining Power.How diverse is your customer list?  What does your family business provide that customers cannot get elsewhere and are, therefore, willing to pay for? Careful and objective analysis of the strategic threats to your family business can help directors evaluate whether to diversify, by how much, and in what direction.3. Establish a Family LLC or Partnership to Hold a Portfolio of Diversifying Assets (Real Estate, Marketable Securities, Etc.)Depending on family dynamics, it may be desirable to set up a mechanism for diversifying inside the family, but outside the family business.  A family holding company structure can deliver both family governance and estate planning benefits.  Directors should understand that, from an estate planning perspective, one of the principal benefits of such entities is the ability to transfer wealth at the fair market value of an illiquid minority interest in the family holding entity, which is generally determined net of discounts for the lack of control and lack of marketability inherent in such interests.  The use of such discounts for estate planning transactions is potentially at risk under the Biden administration, so it may be beneficial to move quickly.4. Create Opportunities to Provide Seed Funding to Family Members with Compelling Ideas for New Business VenturesEstablished families may be in a position to make seed investments in start-up ventures as a way to both reap diversification benefits and promote engagement on the part of rising next generation family members.  This should not involve providing a blank check for every harebrained-scheme your shiftless nephew hatches.  Venture investing won’t be right for every family.  Moreover, successful venture investing is a disciplined, and occasionally ruthless, process of identifying, funding, nurturing, harvesting, and – often – pulling the plug on unsuccessful ventures.  Not every family has the characteristics needed to manage an in-house venture fund, but for those who do, the rewards can be substantial.ConclusionDiversification is too important to keep putting off until next quarter or next year.  Give one of our professionals a call to help you get started on knocking out your to-do list today.

The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures

The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures

The intersection of family and business generates a unique set of questions for family business directors.  We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Should We Diversify?” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham “Diversification may preserve wealth, but concentration builds wealth.”  – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make as shown in Figure 5.Diversification to Whom?There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk—or variability of returns—of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice in this case should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough—or so the theory seemed to go—you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a—you guessed it—“core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions—ready liquidity and absolute shareholder freedom in constructing one’s portfolio—simply do not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.In Chapter 3, we discussed about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only dividend and reinvestment policy, but also the role of diversification in the business.So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.Potential Next StepsCalculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures

Family business directors will make plenty of difficult decisions in 2021, and many of those decisions will require assessing the value of the company’s shares, a particular business segment, or a potential acquisition target.  What should you and your fellow directors know about valuation?  In our experience, there are six basic valuation principles that can guide directors as they make tough valuation-related decisions in the coming year.1 – The Principle of ExpectationsThe view through the windshield matters a lot more than what you can see in the rearview mirror.  Of course, it is important to understand historical financial results, but investors pay for what will happen in the future.  If you must choose between explaining the past and projecting the future, stick to the future.  If profitable investment decisions could be made by studying history, we’d all be rich.  The principle of expectations reminds us to remain oriented to the future.2 – The Principle of GrowthBecause business valuation is based on expectations for the future, it stands to reason that growth is a key factor in measuring the value of a business.  How will your business grow?  To answer this question, it is often helpful to take a step back and situate your family business in the context of expected growth in the overall economy, industry, and local economy.  Do you expect to gain or lose market share?  What elements of your current (or potential) business strategy support growth expectations?  Is there a compelling growth narrative for your family business that would be convincing to potential investors?3 – The Principle of Risk and RewardFor investments, reward is measured in terms of return.  Return follows risk.  The principle of risk and reward suggests that an investor considering two possible investments, with one clearly riskier than the other, will require a greater expected return for the riskier investment.  Otherwise, there would be no incentive to make the riskier investment.You can think of risk in terms of the variability in future outcomes.  The future returns for an asset are always unknown, but some are more uncertain than others.  An asset that will return either +25% or -25% is riskier than one that will return either +10% or -10%.  In other words, directors need to think about the future not just in terms of a single base case, but also with reference to the range or dispersion of potential outcomes.4 – The Present Value PrincipleThe present value principle describes what is often referred to as the “time value” of money.  In short, a dollar to be received at a future date is worth less than a dollar already in-hand.  Since valuations are expressed in dollars today, directors need to consider the corrosive effect of time on dollars to be received in the future.  The present value principle is closely related to the principle of risk and reward since the riskiness of an investment determines how expected future dollars convert to present value.  The greater the risk, the lower the present value of a given amount of future cash flow.5 – The Principle of Alternative InvestmentsThe supply of potential investments exceeds the resources of any single investor.  As a result, every investment is ultimately made to the exclusion of some other investment that could have been made.  Economists use the term “opportunity cost” to describe the effect of alternative investments.  Valuations are never made in a vacuum but are always assessed relative to the risks associated with, and returns available on, alternative investments in the market.  The principle of alternative investments confirms that any valuation conclusion is specific to a particular date.  The value of any business changes over time in response to continual changes in the value of alternative investments.6 – The Principle of RationalityFinancial markets are vast.  Even for small family-owned businesses, there are enough market participants to generally keep everyone honest.  Yes, you should be on the lookout for that motivated seller or irrational buyer that could provide a windfall for your family business, but you should not blithely assume that such parties will show up when you need them.  Competition among buyers and sellers enforces a pretty strict discipline on valuations.  There is an underlying rationality to market transactions, even when that rationality may not be immediately obvious.ConclusionIn our experience, keeping these six principles in view is essential for directors as they deliberate, assess, critique, and develop valuation estimates.  For further thoughts on these principles and other elements of valuation, check out our new book, Business Valuation: An Integrated Theory, 3rd Edition, published late last year by John Wiley & Sons.Our colleagues here at Mercer Capital have completed over 12,000 valuation assignments over the past four decades.  If you have a specific valuation challenge that you and your fellow directors would like a second opinion on, give one of our valuation professionals a call to discuss your situation in confidence.

Family Business Director has a couple of colleagues who play chess at a high level.  Sadly, our admiration for the game far outstrips our ability to play it competently.  To our largely uncomprehending eyes, one of the things that makes the game fascinating is the unique attributes of the various pieces.  Those who can play the game well seem to have an innate sense not just of what each piece is capable of individually, but also of how the pieces interact with each other.  This understanding provides the experienced chess player with an expert feel for what the capabilities are of whatever collection of pieces may be at her disposal at any point in the game. In this week’s post, we conclude our series on taking a year-end strategic inventory in your family business.  Family business directors and managers need to think like a chess player when thinking about different business units within the company.  What are they capable of individually, and how do they work together? Consider a family business with the three operating units:Legacy manufacturing operations in a maturing, but still growing market.A real estate division that owns and manages commercial properties and provides related services to a small group of customers.A new venture that has developed a niche product gaining rapid acceptance in a developing market. Exhibit 1 summarizes relevant attributes of each business unit. In taking their year-end strategic inventory, the directors should evaluate the units along three dimensions: return, growth, and risk.  We address each in turn. ReturnThe best measure of return for most family businesses is return on invested capital, or ROIC.  We’ve discussed the merits of ROIC at length in other posts (here and here). ROIC is a measure of the efficiency with which a company deploys its capital to generate earnings.  ROIC is the product of two sub-measures:Capital turnover: How much revenue does the business generate from a dollar of invested capital?NOPAT margin: How much net operating profit after tax does the business generate from a dollar of revenue? For a multi-unit family business, it can be helpful to plot the ROIC of the various units using these sub-measures as coordinates, as shown in Exhibit 2. The dotted lines in Exhibit 2 illustrate capital turnover and NOPAT margin combinations that yield the same ROIC.  The legacy and new business lines have comparable NOPAT margins, but the legacy business generates more revenue per dollar of invested capital.  As a result, the legacy business currently earns a higher ROIC than the new venture. Mapping the ROIC coordinates for each business unit helps in thinking about what strategies are available and most likely to improve returns.  For example, if the goal is for the new business unit to eventually achieve a 12% ROIC, will that result from increasing turnover, profitability, or some combination of both?  Which “path” to 12% has the greatest likelihood of success? The real estate unit clearly has a different set of attributes.  Relative to the legacy and new businesses, it is a low turnover/high margin business, and as such likely presents a unique set of challenges for increasing or maintaining ROIC. GrowthROIC measures current returns, but just as an experienced chess player thinks multiple moves ahead, family business directors need to incorporate growth potential into their strategic inventory.  The goal is to think not just about what the business looks like today, but what it could, should, and might look like in the future.  A healthy family business provides capital appreciation opportunities for family shareholders in addition to current returns.The new business does not yet produce as robust an ROIC as the legacy business.  However, the capital allocation decision is dynamic.  Throwing more capital at the unit with the highest current ROIC may not promote the long-term sustainability of the family business.  Capital allocation needs to be calibrated to growth opportunities.  Over-allocating capital to the legacy business is likely to drive down capital turnover and hurt ROIC.  Likewise, under-allocating capital to the new business may prevent that unit from maturing into a business with a 12% ROIC, which would then pull up returns for the whole company.RiskRisk is not linear.  When dealing with a portfolio of multiple assets, you must consider not just how risky each unit is in isolation, but how the units correlate with each other.  If the legacy business is having a great year, what does that mean for the new business and real estate segment?  When correlations between business units are high, there is not much diversification benefit to the shareholders.  In contrast, units with low correlations reduce the overall risk borne by the family shareholders.  As noted previously in Exhibit 1, the real estate unit has a low correlation with the legacy and new business units.  As a result, the real estate division reduces the riskiness of the overall business.  The “job” of the real estate unit is not necessarily to increase return, but to reduce risk.Exhibit 3 illustrates the risk reduction benefits of business units with less-than-perfect correlation (“?”). If Units A and B move in lockstep (i.e., have a correlation of 100%), combining them does not reduce the risk to the family.  However, as the correlation falls, so does the overall risk of the portfolio.  Correlation is a matter of degree; no family business units will be perfectly correlated (whether positively or negatively).  Family business directors should instead think about correlations on a relative basis.  How does the risk of each operating unit interact with the risk of the other operating units? This is important, because focusing on risk and return for operating units on a standalone basis will fail to consider adequately the overall impact of the units on the risks and returns of family shareholders. ConclusionMercifully, 2020 is ending.  As family business directors look back on the year, they would do well to consider what pieces are left on the chess board, where they are, and how they fit together.  For a fresh set of eyes and a new perspective, call one of our family business professionals today to discuss your business in confidence.Thank you for reading our Family Business Director this year.  We look forward to continuing the conversation with all of you in 2021.  Happy holidays!

Upon emerging from Chapter 11 bankruptcy, companies are required to apply the provisions of Accounting Standards Codification 852, Reorganizations. Under this treatment, referred to as “fresh start” accounting, companies exiting Chapter 11 are required to re-state assets and liabilities at fair value, as if the company were being acquired at a price equal to the reorganization value. As a result, two principal valuation-related questions are relevant for companies in bankruptcy:Reorganization Value - As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” (ASC 852-05-10) Discounted cash flow analysis is the principal technique for measuring reorganization value. In certain cases, depending on the nature of the business and availability of relevant guideline companies, a method under the market approach may also be appropriate. A reliable cash flow forecast and estimate of the appropriate cost of capital are essential inputs to measuring reorganization value.Identifiable Intangible Assets - When fresh-start accounting is required, it may be appropriate to allocate a portion of the reorganization value to specific identifiable intangible assets such as tradenames, technology, or customer relationships. We discuss valuation techniques for identifiable intangible assets in the remainder of this article.Measuring the Fair Value of Identifiable Intangible Assets When valuing identifiable intangible assets, we use valuation methods under the cost, income, and market approaches.The Cost ApproachThe cost approach seeks to measure the future benefits of ownership by quantifying the amount of money that would be required to replace the future service capability of the subject intangible asset. The assumption underlying the cost approach is that the cost to purchase or develop new property is commensurate with the economic value of the service that the property can provide during its life. The cost approach does not directly consider the economic benefits that can be achieved or the time period over which they might continue. It is an inherent assumption with this approach that economic benefits exist and are of sufficient amount and duration to justify the developmental expenditures.Methods under the cost approach are frequently used to measure the fair value of assembled workforce, proprietary software, and other technology-related assets.The Market ApproachThe market approach provides an indication of value by comparing the price at which similar property has been exchanged between willing buyers and sellers. When the market approach is used, an indication of value of a specific intangible asset can be gained from looking at the prices paid for comparable property.Since there is rarely an active market for identifiable intangible assets apart from broader business combination transactions, valuation methods under the market approach are not commonly used to value identifiable intangible assets.However, available market data, such as observed royalty rates in licensing transactions, is an important input in valuation methods under the income approach such as the relief-from-royalty method. Other market-derived data helps to inform estimates of the cost of capital and other valuation inputs, as well.The Income ApproachThe income approach focuses on the capacity of the subject intangible asset to produce future economic benefits. The underlying theory is that the value of the subject property can be measured as the present worth of the net economic benefits to be received over the life of the intangible asset.Using valuation methods under the income approach, we estimate future benefits expected to result from the subject asset and an appropriate rate at which to discount these expected benefits to the present. The most common valuation methods under the income approach are the relief from royalty method and multi-period excess earnings method, or MPEEM.The relief from royalty method seeks to measure the incremental net profitability available to the owner of the subject intangible asset by avoiding the royalty payments that would otherwise be required to enjoy the benefits of ownership of the asset. When applying the relief from royalty method requires specification of three variables: 1) The expected stream of revenue attributable to the identifiable intangible asset, 2) An appropriate royalty rate to apply to that revenue stream, and 3) An appropriate discount rate to measure the present value of the avoided royalty payments. The relief from royalty method is most commonly used to value tradename and technology assets for which market-based royalty rates may be observed.The MPEEM is a form of discounted cash flow analysis that measures the value of an intangible asset as the present value of the incremental after-tax cash flows attributable only to the subject asset. In order to isolate those cash flows, we first develop a forecast of the expected revenues and associated operating costs attributable to the asset.Next, we apply contributory asset charges to reflect the economic “rent” for use of the other assets that must be in place to generate the projected operating earnings. In other words, the MPEEM recognizes that the subject identifiable intangible asset generates operating earnings only in concert with other assets of the business.Finally, we reduce the net after-tax cash flows attributable to the subject identifiable intangible asset to present value using a risk-adjusted discount rate. The indicated value is the sum of the present values of the “excess earnings” of the expected life of the subject asset. We often apply the MPEEM to measure the fair value of customer relationship and technology intangibles. ConclusionThe valuation techniques for identifiable intangible assets are rooted in the fundamental elements of business valuation, cash flow and risk, under the cost, market, and income approaches. However, when valuing identifiable intangible assets, we use valuation methods adapted to the unique attributes of those assets.

Last week, we introduced a series of posts about taking a strategic inventory of the assets of your family business.  As the calendar turns to December and 2020 (thankfully!) comes to an end, it is an appropriate time for family business directors and managers to take stock of just where their family business is at this stage in the pandemic.  Doing so can help give needed context to discussions about where the family business should be headed. We tend to think of a family business’s primary assets under seven broad headings.  In this week’s post, we offer a checklist for directors and managers.1. LiquidityHow effective have the company’s efforts at liquidity preservation been during the pandemic?How have your ideas of a prudent level of liquidity changed because of the pandemic?What is the status of your borrowing base, or other measures of available capacity, under current credit facilities?Are there any debt covenants that need to be renegotiated or addressed considering current company performance?2. Net Working CapitalHow have collections held up during the pandemic? Have your credit monitoring efforts with clients kept up with changing conditions?Is there obsolete or aging inventory that can be liquidated? Amid cash preservation efforts, is the company maintaining an acceptable order fulfillment rate, or are persistent backorders straining customer relationships?Is the company maintaining appropriate relationships with suppliers? Is the company taking advantage of available financing options in a financially responsible way?3. Property & EquipmentIf the family business has deferred maintenance or capital expenditures during the pandemic, have the deferred items been prioritized for the return of sufficient liquidity?Are there any unproductive operating assets that should be sold?Are there opportunities for the company to acquire existing production capacity from struggling competitors at advantageous prices?If assets are leased from a related entity, do the lease terms reflect market rates?Are there opportunities to negotiate more favorable lease terms on upcoming renewals with third party landlords?How has the pandemic changed the company’s real estate strategy and needs? 4. Workforce IntangiblesIf the family business borrowed money under the PPP loan program, has it properly documented eligible expenses and initiated the approval process for loan forgiveness?How has the family business’s workforce held up during the pandemic? What investments are necessary/appropriate to enhance or sustain long-term productivity, morale, etc.?How has the family business adapted to the work from anywhere model? What opportunities or threats does such a labor model present to the family business?How has the pandemic affected succession planning at key positions throughout the company? Have expected transition dates for senior executives been accelerated or deferred?5. Technology IntangiblesWhat investments in technological infrastructure are necessary for the family business to remain competitive in a “contactless” world?What investments in technological infrastructure are necessary for the family business to remain competitive in a “work from anywhere” world?Has the pandemic accelerated the economic obsolescence of any of the family business’s core technology assets?Is the company’s enterprise resource planning software up to date, and does it provide the right information to the right managers in the right format at the right time?Has the family business deferred any maintenance or development spending to preserve cash during the pandemic? If so, does the company have concrete plans for keeping its technology assets up to date?6. Marketing IntangiblesHow has the family business’s overall brand fared during 2020? Are customers and prospects more, or less, aware of the brand than they were a year ago?Does the family business have a cohesive social media strategy, and is it executing that strategy in a disciplined way?How have traditional marketing channels been influenced by the pandemic?Are there any legacy brands or product lines that are no longer viable and should be eliminated?What opportunities are there for brand extensions or new product lines to meet market demand?Are there new geographies or markets that could prove hospitable to the company’s brand?7. Customer IntangiblesHow have customer retention trends been influenced by the pandemic?What is the trend in the overall cost to identify, attract, and retain new customers?Are there any new emerging customer concentrations facing the family business?Does the company have any customer relationships that are currently unprofitable? What steps can be taken to improve the profitability of those relationships?  Has the company analyzed the financial and strategic impact of pruning those customers?Does the family business have appropriate tools in place to measure and manage customer engagement and satisfaction?Is the existing sales organization adequate to meet the current challenges facing the family business?Is the company’s customer relationship management software up to date, and is there a process for capturing new customer data as it is being generated? Of course, this checklist is just a starting point and needs to be tailored to the specific challenges facing your family business.  Some of your family business’s most important assets likely don’t show up on the balance sheet.  Taking a deliberate inventory of all the company’s assets – both tangible and intangible – can be a great way for directors to assess the health of their family business and chart a course for the future.  In next week’s post, we will take a business unit perspective for your year-end strategic inventory.

Tactics win battles, strategy wins wars.  - Pierce BrownFor family businesses, 2020 has been, first and foremost, a battle against the COVID-19 pandemic.  As a result, directors and managers have rightly focused on tactics: what steps do we need to take today, next week, and next month to ensure the health of our employees and customers and ensure our family business survives?As glimmers of hope emerge that the pandemic will eventually end, December is a natural time to catch up on some of the strategic thinking that has been put on hold by the coronavirus.  While focusing on tactics has been essential to surviving 2020, many family businesses would do well now to turn their attention to strategy.  If tactics are about short-term viability, strategy is about long-term sustainability.My wife and I were recently discussing the mix of personalities, temperaments, skills, and interests represented in our extended family.  She astutely observed that each person contributes something unique to the family, and that the characteristics that one sometimes finds irksome are often paired with corresponding strengths that would otherwise be missing in the family.  This observation readily applies to family businesses.  So the first step in your strategic thinking may need to be taking an “inventory” of the assets of the family business.This inventory process fits well with our preferred “asset manager” perspective on family business, depicted below. Under this perspective, directors and managers are stewards of family capital.  Much like professional asset managers select investments on behalf of their clients in order to meet the financial objectives of those clients, family business directors and managers are tasked with allocating family capital to a mix of operating assets that will provide an appropriate combination of risk and return for family shareholders. One way to re-start a strategic planning process for your family business is to take an inventory of just what assets your family’s capital is currently allocated to, and thinking about what those assets bring to the family business in terms of risk profile and reward potential. We find that four questions can help spur strategic thinking about your business: What assets are currently in our portfolio?What are the return and risk attributes of each asset?How do the different assets our family business owns correlate to one another?What assets should be in our portfolio to help ensure the long-term sustainability of our family business? You can answer the first question from either of two complementary perspectives.  First, you can think about your existing asset allocation with respect to broad asset classes (working capital, property & equipment, etc.).  Or, you can address the asset allocation question from the perspective of business units or segments: what collection of divisions, segments, or branches comprise our family business today?  The following table summarizes these perspectives. As illustrated above, these perspectives are complementary because the asset class perspective can be readily applied to individual business units.  In next week’s post, we will consider the asset class perspective, and the following week we will adopt the business unit perspective. As the year winds down, we recommend setting aside time to look beyond survival tactics and re-engage in some strategic thinking about your family business.  Much like an asset manager would review the portfolio they have constructed with their client, family business directors should review the current asset allocation in their family business.  Doing so can help uncover fresh insights and challenge conventional thinking that is due for an update.

Due to the popularity of this post, we feature it again this week.  In this post, we discuss return on invested capital, how it's calculated, and why it's important for your family business. The management team at your family business has been hard at work growing revenue and profits by 50% over the past five years, so the value of your shares must have increased, right?  Not necessarily. Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story.  As a family business director, you need the whole story.  We’re not aware that Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital, because it tells you the rest of the story.What Is Return on Invested Capital?Return on invested capital (ROIC) relates the operating performance of a business to the amount of capital used to support the operations of the business.  In other words, it measures the efficiency with which family capital is used in the family business.  In last week’s post on capital budgeting, we likened the directors and managers of a business to stewards responsible for selecting the capital projects in which to invest family resources. Return on invested capital measures how well directors and managers are handling their stewardship of family resources.  ROIC allows family shareholders to see how much income is being generated per dollar of investment. How Is Return on Invested Capital Calculated?Exhibit 2 illustrates how to calculate ROIC for your family business. We need to unpack a couple of the terms in Exhibit 2 that may not be familiar. Net Operating Profit After Tax (NOPAT) is a measure of earnings that excludes interest expense. Analysts often segregate interest expense from the other expenses of the business for at least two reasons.  First, interest does not directly relate to the operations of the business.  In other words, interest expense does not fluctuate with revenue and does not compensate employees, pay vendors or suppliers, or otherwise contribute to the operations of the business.  Second, interest expense is a function of financing decisions that are often made by someone other than the person bearing operating responsibility.  As a result, it is not appropriate to evaluate performance with respect to that expense.Since interest expense is not deducted, NOPAT is like the more common measure of EBIT, or Earnings Before Interest and Taxes.  The difference is that NOPAT is reduced for taxes.  NOPAT is therefore equal to EBIT less taxes at the effective tax rate.  Sadly, Uncle Sam is the first one in line for returns, and NOPAT takes the tax burden into account.  Some analysts like to make additional adjustments to derive NOPAT, such as adding back research & development costs.  Such adjustments may have merit in certain circumstances, but they do add complexity to the calculations that aren’t essential to gaining the primary insights offered by ROIC.Invested Capital is the sum of all capital provided by shareholders (both common and preferred) and lenders. Since the purpose of ROIC is to measure the efficiency of management’s stewardship of family resources entrusted to the business, invested capital is traditionally measured with respect to book values rather than market values.  The average balance for the year in question is the preferred denominator since NOPAT is earned over the course of a year, and a point-in-time snapshot of invested capital may not fully capture the family’s true investment over the course of the year.  As with NOPAT, some analysts propose a laundry list of custom adjustments to invested capital.  These adjustments may have their place for some companies, but the basic calculation is generally a sufficiently reliable guide.Why Is ROIC Important?Now we’re ready for the rest of the story.  Management has worked diligently to increase operating income by 50% over the past five years.  Yet, the value of your family shares has been stuck in neutral over that same period.  What gives?Focusing on profit alone will not reveal the answer.  But a quick calculation of ROIC shows us what has gone wrong.  Exhibit 3 presents the ROIC calculations for 2013 and 2018. As revealed in Exhibit 3, the 50% increase in profitability did not boost the share value because the amount of invested capital used in the business also increased by 50%.  In other words, the return on invested capital was unchanged.  Since the weighted average cost of capital for your family business is also 10.0%, the incremental earnings did not boost per share values.  Knowing that profitability has improved is not enough to know whether the value of the shares in your family business has increased.  Earnings are critical but are only half of the story when it comes to management performance and shareholder value.  As a director, it’s your responsibility to know the rest of the story when it comes to the financial performance of your family business, and ROIC is the perfect tool to do so.

One obstacle many families face when it comes to selling the family business is the potential loss of identity, culture, and jobs that such transactions often leave in their wake.  Even if it is the right time for the family to sell, there may be a reluctance to do so for fear that a sale will trigger adverse developments for the company’s employees and communities.If the family business is sold to a competitor, the buyer may elect to discontinue the company’s brand, eliminate “redundant” corporate overhead positions, or close operating facilities in a quest to achieve the cost savings that will help drive returns.Private equity buyers may not take such aggressive actions in the short-run but will look to “flip” the business to another buyer within five years or so. This “exit-driven” mentality is foreign to the sustainability focus of many family businesses and can undermine the family culture that made the business successful in the first place. A recent article by Paul Sullivan in the New York Timeshighlighted an option available to family shareholders: selling the family business to the employees.  Doing so has the potential to avoid the negative outcomes typically associated with corporate sales. As noted in the article, there are approximately 6,500 employee-owned businesses in the United States and some observers believe that number could increase in the coming years if capital gains tax rates rise under the Biden administration. Why would a family consider selling all or a portion of their family business to employees?  The article identifies three potential benefits.Benefit #1 – Selling to Employees Allows the Family Business to Remain Intact. When the family business is sold to employees, the existing management team will remain in place and the family culture will likely persist in the family business.  This is often a critical concern for family shareholders who are wary that a buyer will disregard, or potentially destroy, the legacy of the family among long-time employees and within the communities in which the family business operates.Benefit #2 – Tax Benefits for the Seller and the Company. Sellers in ESOP (employee stock ownership plan) transactions may be eligible to defer capital gains, and potentially avoid taxes that would otherwise be due.  Like all tax matters, it’s not always that straightforward, and the specific eligibility rules are beyond the scope of this post.  However, we note that many sellers do qualify for these benefits, which can materially enhance the overall economic benefit to the seller from the transaction.Following the transaction, there are tax benefits for the company as well since contributions made (and dividends paid) by the company to the ESOP are tax-deductible.  The resulting tax savings increases the company’s cash flow available for reinvestment and growth opportunities.Benefit #3 – Retirement Benefits for Employees. If the company performs well following the transaction, the contributions and dividends from the company, when coupled with growth in the value of the company’s shares, can provide retirement benefits for employees that exceed what would otherwise be available from traditional 401k or profit sharing programs. Of course, every silver lining has a cloud.  There are two primary drawbacks to ESOP transactions for family shareholders.Drawback #1 – Fair Market Value. Whether selling to a competitor or a private equity fund, such buyers may be willing and able to pay a premium price because of the cost savings or revenue synergies that they expect to achieve by implementing the types of corporate changes described at the beginning of this post.Because an ESOP doesn’t anticipate making such changes, the nominal transaction price when selling to employees – known as fair market value – may be less than a strategic or private equity buyer is willing to pay.  Depending on the circumstances, the tax benefits described above may offset this potential drawback.Drawback #2 – Regulatory Burden. Because ESOPs are qualified benefit plans, they fall under the purview of the Department of Labor.  So in any transaction with an ESOP, the DOL is a not-so-silent third party tasked with ensuring that the ESOP protects the interests of the employee participants.  Depending on the complexity of the ESOP, selling stock to employees may require a small raft of attorneys, accountants, trustees, and other advisors to ensure that the transaction and subsequent administration of the ESOP do not run afoul of DOL regulations. If your family is considering a sale of the family business, don’t overlook your employees as a potential buyer.  ESOP transactions are not right for every family but can generate benefits for a broad range of stakeholders. To discuss the fair market value of your family business and whether an ESOP transaction might be a good fit for your family, give one of our family business professionals a call.

Earlier this month, Christie’s auctioned off a 40-foot long T-Rex named Stan.  We were not aware there was an active market for such items, but an unnamed investor paid $32 million for Stan’s bones.  That’s remarkable in itself, but our interest in the story was piqued upon learning why and how Stan was sold.According to this story in the Wall Street Journal, Stan was found in the South Dakota hills by brothers Peter and Neal Larson in 1992.  The brothers had been partners in their fossil-hunting enterprise since the mid-1970s.  As happens all too often, unresolved disagreements between the brothers eventually found their way into the courtroom.  The broad outlines of the disagreement are familiar to those involved with family business.Peter is the older of the two brothers and owned a controlling (60%) stake in the family business. Younger brother Neal owned a 35% stake, while a non-family partner owned the remaining 5%.In 2012, Peter suspended Neal and subsequently fired him for reasons that are less than clear.In 2015, Neal sued Peter claiming shareholder oppression. Neal’s preferred remedy in the suit was to liquidate the company and split the proceeds.It turns out that fossil-hunting businesses tend to be illiquid. In view of the company’s financial position, the judge ordered that Neal receive Stan in exchange for his 35% interest, with Peter and the other owner retaining all other assets of the business.At the time, Stan had an appraised value of $6 million, which according to the court’s ruling provided a “premium” to Neal.A couple of weeks ago, Neal sold Stan at auction for the aforementioned $32 million, which was 4x Christie’s high-end estimate prior to the sale. Peter and Neal reportedly continue to live in the same small South Dakota town.  The town is small enough that avoiding each other is not practical, but they do not speak.  The story of Peter, Neal, and Stan highlights some of the challenges family businesses face when redeeming a significant shareholder.The Challenges of Redeeming Family ShareholdersMany shareholder redemptions occur under circumstances comparable to that of the Larson brothers.  One shareholder or family branch will continue to own and operate the business, while the other will have the opportunity to redeploy their net proceeds from the redemption however they choose.  Oftentimes, that is truly the best outcome for the family, and may even preserve a modicum of family harmony, since the jointly-owned business is no longer a potential irritant.However, when it comes to family business, it is probably never really over.  Even after going separate ways, human nature is to continue looking over one’s shoulder to see how the other guy is doing.  In the event of a shareholder redemption, there are three potential outcomes, two of which will create economic winners and losers in the redemption’s wake.Scenario 1: The family business thrives and/or is sold at a premium to a strategic acquirer. Sometimes, unexpected industry or economic tailwinds cause the family business to outperform expectations at the time of the redemption.  Or, the remaining shareholders may eventually sell the business to a strategic acquirer who is motivated and able to pay a substantial premium to the redemption price paid by the family business.  In either case, the portion of the family that stayed in the business enjoys the benefit of the company’s success, while the family members who were redeemed will naturally feel like the redemption price was unfairly low.  Unless they prove to be savvy investors, the redeemed shareholders will fall behind the rest of the family economically.  This can add unbearable strain to already tense family relationships.Scenario 2: The family business performs in line with expectations and remains family-owned.If the family business performs in line with expectations and remains family-owned following the redemption, there is a greater chance that both family groups will remain on broadly comparable economic footing, bringing with it an increased likelihood that family relationships can be maintained or even repaired over time.Scenario 3: The family business struggles following the redemption. In other cases, the family business founders following the redemptions.  Whether through management miscues, adverse economic and industry dynamics, or because of the leverage used to fund the redemption, returns for the remaining family shareholders can be negative following the redemption.  When this happens, the family shareholders that were redeemed become the “haves” and those who stayed in the business become the “have nots.”  The family members who go down with the ship are likely to feel that the subsequent underperformance of the family business was attributable, in some measure, to an inflated price paid to the selling shareholders. As with the first outcome, family relationships prove hard to sustain when this happens.Fairness and RiskSo what is fair in a family shareholder redemption?The “fairness” of a redemption transaction cannot be evaluated by looking at the long-term outcomes for the two parties.  The challenges encountered in executing a family shareholder redemption reveal the limitations inherent to a point-in-time valuation of any business.The value of a family business at any given time is a function of expected cash flows and risk.When an investor buys a bond from the U.S. treasury, the expected cash flows are known with certainty. Under almost any conceivable future state of affairs, the owner of the bond will receive interest payments when due and will receive the principal payment at maturity.Investors evaluating a family business face a very different situation. However reasonable their projection of cash flows is at the time it is made, it will almost certainly turn out to be wrong, sometimes wildly so.  This is the essence of risk.  Risk is simply the width of the range of potential future outcomes.  The greater the risk – the wider the range of potential outcomes – the lower the value of a business.  The lower the value of a business, the higher the potential future returns to shareholders.  Investors weigh risk when deciding how much to pay for a given business. In a risky environment, a bad outcome does not necessarily mean that there was a bad investment decision.  In the same way, when Scenarios #1 and #3 above occur, that does not necessarily mean that the shareholder redemption price was “wrong.” To illustrate, consider the diverging fates of two well-known consumer brands during 2020.  The following chart compares share prices for Marriott International (MAR) and Domino’s Pizza (DPZ).  The onset of the pandemic was devastating to business and leisure travel.  When not traveling, people stay at home and eat pizza. Does the preceding chart indicate that the share price for either company was “wrong” at the beginning of 2020?  No.  The shares of both companies trade in a deep and liquid market, and investors in both companies knew that a global pandemic was a possibility (albeit one to which they evidently assigned a low probability).  The actual occurrence of the pandemic benefited DPZ shareholders and devastated MAR shareholders.  But these differing outcomes do not mean that investors overpaid for MAR shares or underpaid for DPZ shares in January 2020.  The buyers of MAR probably regret their purchase, but that possibility is the essence of investing in a risky asset.  You may actually earn the higher expected return associated with a risky investment.  Those who sold DPZ shares in January are likewise filled with regret, but that does not mean that they received an unfair price.  They took their economic chips off the table, avoiding the risk of a massive food safety scandal that could have, but did not, materialize. ConclusionYour family business probably doesn’t own a T-Rex skeleton.  Even so, a family shareholder redemption has the potential to trigger future wealth disparities in your family.  Redemptions can make sense for a lot of reasons, but before executing a significant share buyback, directors and family leaders need to be aware of the potential pitfalls and make sure that all of their shareholders are educated about the risks that accompany any transaction.  A regular process of recurring valuations can be instrumental in educating family shareholders to the risks that accompany ownership of a family business, provide greater clarity, and help set expectations when a redemption is called for.Give us a call today to talk about how to get that process started for your family business.

It is harvest time in rural America.  Farmers are working long hours gathering the crops that have been planted, fertilized, watered and worried over since springtime.  While the cycle of planting and harvesting is an annual one on the farm, for family businesses, the cycle can span decades or even generations.There are many different ways to classify family businesses, but one simple distinction that we find ourselves coming back to often is that between planters and harvesters.Planters are family businesses that are currently investing more cash flow in future growth than their existing operations generate. Since these companies are focused on sowing the seeds for future growth, family shareholders should expect near-term returns to come primarily in the form of capital appreciation.In contrast, harvesters generate more cash flow from current operations than they are investing for future growth. While there likely will still be some degree of expected capital appreciation for these firms, they offer their family shareholders the potential for greater current income. So what time is it for your family business?  Is it planting season or harvesting season?  You can easily tell by taking a look at the statement of cash flows.  This generally underappreciated financial statement has three sections.The operating section summarizes the sources of cash flow from existing operations (principally earnings, depreciation and other non-cash expenses, net of changes in working capital).The investing section details the cash flows allocated toward corporate investments, the most significant components of which are capital expenditures and business acquisitions.The financing section reveals whether the company is a net borrower or lender, has issued or repurchased equity shares, and whether or not it pays dividends to shareholders. We can classify family businesses as either planters or harvesters by simply comparing the first two sections of the statement of cash flows.  For planters, total investing outflows exceed operating inflows.  Harvesters, on the other hand, generate more operating inflows than investing outflows. Once you determine whether your family business has been a planter or harvester in the past, it is time as a director to determine whether a change is appropriate in the future.  To help us think about the characteristics of planters and harvesters, we examined statements of cash flow for companies in the S&P 600 (small-cap) and S&P 400 (mid-cap) indexes.  After screening out financial and real estate businesses, we were left with a sample of 741 companies having median revenue in 2018 of about $1.5 billion.  We classified each firm based on aggregate cash flows from 2013 through 2015; 40% of the companies were planters and 60% were harvesters.  Exhibit 1 summarizes some characteristics of each group. In the aggregate, planters invested $1.94 per $1.00 of operating cash flow, compared to $0.57 for harvesters.  Harvesters tended to be more profitable, with a median operating margin of 10.0%, compared to 6.9% for planters.  The net effect of more aggressive investing was a combination of faster revenue growth and improving profit margins for planters.  Of course, return is the ultimate test for shareholders, and over the following three years (2016 through 2018), harvesters generated higher returns than planters (7.8% compared to 3.5%). Peril and PromiseIt is easy to determine whether your family business has been a planter or harvester in the past.  The real question for directors is assessing whether it should be harvest time or planting time for your family business now.  Neither planting nor harvesting is inherently superior to the other.  Directors need to read the calendar for their family business, understanding the peril and promise of each time.Planting Time: PromiseThe promise of planting time is the opportunity for a greater future harvest.  As families grow over time, directors should evaluate the appropriate relationship between family and business growth.  Planting time offers the promise that the growth of the business can keep pace with, or potentially exceed, the growth of the family, fueling per capita growth in family capital.  What’s more, prudent planting can create opportunities for family members to assume roles of increasing responsibility in the business and promote shareholder engagement.Planting Time: PerilBusiness would be easy if planting decisions could be deferred until harvest outcomes are known.  Sadly, that is simply not the case.  You have to plant before you harvest.  As a result, the principal peril of planting time is the risk that the harvest will turn out to be less attractive than expected.  Referring back to Exhibit 1, the planters’ investments did contribute to faster revenue growth and improving margins.  However, it is not clear that the incremental benefits from investment were truly sufficient relative to the investment made.  The weaker observed stock returns for planters suggest that – for many of the companies – the harvest was not as robust as planned.  In other words, the market concluded that at least some of the companies in our sample misread what time it really was, planting when they should have been harvesting.Harvest Time: PromiseIt is nice to be rich, but it’s even better to have money.  The promise of harvest time is that the family will finally reap the benefits of the risks and investments of previous generations, turning the “paper” wealth of illiquid business value into liquid, readily diversifiable wealth.  Harvest time can facilitate the transition from being a business family to an enterprising family.  Harvest time can allow families to reduce their economic risk profile by moving at least some of their hard-won eggs into new baskets.  As families grow, diversifying family wealth can be a critical component of overall family harmony and sustainability.Harvest Time: PerilOne of the biggest perils of harvest time is complacency.  An over-emphasis on harvesting can starve the family business of needed investment.  If the family business does not keep up with the growth of the family, the resulting pressure on per capita wealth and earnings can add stress to family relationships and erode shareholder engagement.  Even from the perspective of the family business, the positive impact of investing for growth can be easily overlooked.  As shown on Exhibit 1, the harvesters experienced some margin decay over the following three year period, suggesting that at least some harvesters allowed their competitive advantages to wither during the harvest.  Directors need to take a balanced view of the long-term reinvestment needs of the business.ConclusionWhile there is some persistence in companies’ investing behavior over time, the companies in our sample did evolve.  We reclassified each of the companies in our sample based on cash flow data for the three years from 2016 and 2018.  Approximately half of the original planters became harvesters in the succeeding period.  Harvest time is not a final destination, however, as about 30% of harvesters turned into planters.  From this evidence, we conclude that your family business is never “stuck.”  Family business directors need to regularly check what time it is for their family business, and not assume that the characteristics of the past year or decade are appropriate today.  So, what time is it for your family business?

One of the hottest topics in the financial press these days are special purpose acquisition corporations, or SPACs.  According to one report, SPACs have already raised almost 3x the capital for investment during 2020 as they did during all of 2019.  SPACs, also known as “blank check companies,” are publicly traded entities that raise capital from investors to acquire one or more companies.  As noted on the SEC’s website, the promoters of SPACs have often not yet identified the company to be acquired at the time of the capital raise.SPACs are not new, and there are a few potential explanations for their popularity this year.  We suspect that at least part of their appeal, however, can be traced to the willingness of investors to accept more risk to generate higher nominal returns.Despite a few cyclical upticks, interest rates have steadily ground downward over the past decade, with the so-called risk-free rate, or return on long-term Treasuries, falling from about 4.5% in early 2011 to less than 1.5% today. The incremental return premium for investing in stocks instead of bonds, known as the equity risk premium or ERP, eludes direct observation, but Aswath Damodaran – a widely respected finance professor – estimates that the ERP currently stands somewhere between 3.4% and 5.8%.  Adding the two components together, let’s assume the current cost of equity for large public companies is around 7.0%.On the debt side, borrowing costs for corporate borrowers are also quite low, with the current yield for BBB-rated issues at less than 2.5%. Adjusting for the tax deductibility of interest payments, the after-tax borrowing cost for investment-grade borrowers is currently less than 2.0%.Assuming a moderate capital structure composed of 20% debt and 80% equity, the resulting weighted average cost of capital for large cap public companies is 6.0%. For public companies, the almost endless supply of cheap capital (as evidenced by the proliferation of SPACs) is a boon. The low cost of capital makes it easier to justify investment opportunities (whether for capital spending or acquisitions) financially, and investors are willing to provide capital in search of higher returns. For many family businesses, however, the era of cheap capital may not be an unqualified good.  Many families have a deep-rooted cultural aversion to relying on non-family equity capital.  The abundance of equity capital searching for a good home is therefore not a benefit they can access, at least not through traditional channels.  Such constraints on family capital can also limit practical access to cheap debt financing.  As a result, many family businesses cannot load up at the capital buffet as readily as their public counterparts. As a result, cheap capital can create trigger pressure and tensions in both the business and the family.For the managers of the family business, the reality is that they are competing with firms who are aggressively taking advantage of the low cost of capital. Holding the line on the family business’s hurdle rate for capital investment will likely result in lost opportunities and slower growth.  As one of my colleagues is fond of saying, it is an alternative investment world.  Family businesses cannot set their hurdle rates and return expectations in a vacuum.  Of course, the cost of capital for most family businesses remains well north of 6.0%.  However, the returns available to family businesses are influenced by the returns available in the public capital markets.  Directors need to be intentional about either (1) accepting lower prospective returns on potential capital investments, or (2) acknowledging that the family business could lose share to competitors.Family shareholders may need to re-calibrate their expectations for the long-term returns on the family business. If a rising tide lifts all boats, the opposite is also true.  Shaving 100 or 200 basis points off annual return expectations has a profound effect on per capita wealth over the course of two or three decades, as illustrated in the following chart.  Compounded over 30 years, a 1.5% decrease in annual capital appreciation reduces the family’s future wealth by 34%.This can have far-reaching consequences for the family’s lifestyle, community impact, and philanthropic ambitions.  Return follows risk.  Family business directors need to be closely attuned to family shareholders’ risk preferences and return objectives.  If shareholders’ return objectives do not align with their professed risk preferences, there are likely some hard conversations ahead.  Candid shareholder communication today can forestall family dissension tomorrow.Selling the family business can serve as a release valve for these building pressures.  However, selling the family business does not make all of the family’s problems go away and can even introduce a few new ones.  How will your family business adapt to this era of cheap capital?

Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Is there a ticking time bomb lurking in your family business?”When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses.Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one?Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.”Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future.Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business?Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements.Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution?Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements.Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes?Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs.   One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process.Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties.Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses?Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes.Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements?Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!”ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.For more information or help with your buy-sell agreement, don't hesitate to contact us.

Drug maker Abbvie is reported to have spent $460 million on television ads for Humira during 2019.  Like all pharmaceutical ads, the TV spots for Humira try to accomplish two things: demonstrate the benefits of taking the drug and acknowledge the risks of taking the drug. In one 60 second ad, the risk disclosures begin at the 27 second mark, meaning that slightly more time is spent on risk disclosure than on drug benefits. And yet, how effective is the risk disclosure? Do ad viewers have any basis for knowing how to incorporate the fact that “blood, liver, and nervous system problems” have happened into their decision-making process?Communicating risk effectively is not just a challenge for drug companies. All companies deal with risk and uncertainty.  Making too much of the risk can alienate customers and erode the credibility that might be critical when a threat actually materializes (i.e., “Chicken Little” and “The Boy Who Cried ‘Wolf’”). On the other hand, insufficient risk disclosure can result in liability that threatens the company’s existence.  A recent article in the Harvard Business Review addressed this challenge in customer communications. The authors of “The Art of Communicating Risk” offer three suggestions for communicating risk to customers more effectively. In this post, we will review those suggestions, and think about how they might apply to communicating risk to family shareholders.#1 – Stop ImprovisingShareholder communications in many family businesses can best be described as haphazard. Managers and directors attempt to communicate with family shareholders when they feel like there is something important to say or when they have the time. This lack of structure builds uncertainty into the very fabric of a process that should exist to reduce uncertainty. The frequency of shareholder reporting will be different for each family; dependability is ultimately more important than frequency. Do your family shareholders know when they should expect to hear from you next?  Furthermore, do you have a consistent format for communicating with family shareholders? Do they know what they can expect to hear from you? Following a consistent reporting format, even when management doesn’t think there is anything especially “newsy” to report signals that directors take the rights and needs of family shareholders seriously. Over time, this builds credibility with family shareholders.#2 – Change the Metric for Success, and Measure ResultsWhat constitutes success for family shareholder communication? Engagement is critical – if a shareholder risk is communicated but no one receives the message, does it really exist? For digital communications, families can easily measure engagement by tracking open and click-through rates over time. Relevance fuels engagement. What are the risk factors that matter most to family shareholders, and are those factors most prominent in your reporting? What risks should your family shareholders be concerned about? And do they know why those risks are important?#3 – Design for Risk Communications from the BeginningThose ubiquitous risk disclosures in pharmaceutical ads that we discussed at the outset are certainly regular (consumers know when they will appear in the ad) and are rigorously consistent (avid TV viewers may have them memorized). But do they actually help consumers? Similarly, we suspect that the laundry list of “Risk Considerations” in SEC filings is not terribly illuminating for many public company shareholders. So the challenge for family business directors is to convert vague warnings about abstract risks into concrete measures of the factors that give rise to risk and the historical frequency of occurrence. This will require carefully considering not only what risks need to be disclosed, but also how those risks can be quantified and put into context.Companies with commodity exposures offer a ready example.  Consider a family business whose earnings and financial condition are correlated to the price of zinc. If the company’s gross profit declines when the price of zinc falls below $2,000, a risk disclosure to the family shareholders might include both the percentage of time zinc has traded below that level in the past 20 years, and the frequency with which the price has fallen below $2,000 from the current price during the subsequent three months as shown below.Framing the risk in this way helps provide more intuitive context for family shareholders to evaluate the risk of adverse zinc prices having a negative impact on the earnings and financial condition of the family business.ConclusionCommunicating with family shareholders about risk is not easy, but it is inevitable. Choosing not to communicate about risk is still a communication strategy, just not a very good one. The goal of risk communication is to promote positive shareholder engagement, which is critical to sustaining the family business when adverse events happen.

Family business leaders cannot afford to ignore estate taxes.  While it is true that the legal burden of the estate tax falls to individual shareholders rather than the family business itself, many family shareholders have not accumulated sufficient liquidity to pay estate taxes without some action on the part of the company.  The required actions may range from a shareholder loan to a special dividend to sale of the business.  As we’ve noted numerous times in the past few months, there are good reasons to focus on estate planning right now.The fair market value of many family business ownership interests is depressed because of the negative impact of the pandemic.Applicable federal rates are quite low, which increases the effectiveness of many of the more sophisticated estate planning techniques.Political uncertainty is high, and the Biden campaign has indicated that estate tax reform would be a priority if elected. In this week’s post, we provide a to-do list of important tasks for family business directors seeking to help prevent, or at least minimize, unhappy surprises resulting from the estate tax.Review the Current Shareholder List / Ownership Structure for the Family BusinessIn family businesses, the lines between family membership, influence, employment, economic benefit from the business, and actual ownership can be blurry.  Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?  Are there potential ownership transfers that would not only alleviate estate tax exposure, but also accomplish broader business continuity, shareholder engagement, and family harmony objectives?Obtain a Current Opinion of the Fair Market Value of the Business at the Relevant Levels of ValueA current valuation opinion is essential to quantifying existing exposures as well as facilitating the desired intra-family ownership transfers.  If you don’t have a satisfactory, ongoing relationship with a business appraiser, the first step is to retain a qualified independent business valuation professional (we have plenty to choose from here).  You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).The valuation report should demonstrate a thorough understanding of your business and its position within your industry. It should contain a clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support.  You should be able to recognize your family business as the one being valued, and when finished reading the report, you should know both what the valuation conclusion is and why it is reasonable.The appraisal should clearly identify the appropriate level of value.  If one of your family shareholders owns a controlling interest in the business, the fair market value per share of that controlling interest will exceed the fair market value per share of otherwise identical shares that comprise a non-controlling, or minority, interest.  Having identified the appropriate level of value, the appraisal should clearly set forth the valuation discounts or premiums used to derive the final conclusion of value and the base to which those adjustments were applied.For example, many common valuation methods yield conclusions of value at the marketable minority level of value.  In other words, the concluded value is a proxy for what the shares of the family business would trade for if the company were public.  Some refer to this as the “as-if-freely-traded” level of value.If the subject interest is a minority ownership interest in your privately-held family business, however, an adjustment is required to reflect the lack of marketability inherent in the shares. All else equal, investors desire ready liquidity, and when faced with a potentially lengthy holding period of unknown duration, investors impose a discount on what would otherwise be the value of the interest on account of the incremental risks associated with holding a nonmarketable interest.  In such a case, the appraiser should apply a marketability discount to the base marketable minority indication of value.On the other hand, if the subject interest represents a controlling interest in the family business, a valuation premium may be appropriate. The “as-if-freely-traded” value assumes that the owner of the interest cannot unilaterally make strategic or financial decisions on behalf of the family business.  If the subject interest does have the ability to do so, a hypothetical investor may perceive incremental value in the interest.  Such premiums are not automatic, however, and a discussion of the facts and circumstances that can contribute to such premiums is beyond the scope of this post. We occasionally hear family shareholders express the sentiment that, since gift and estate taxes are based on fair market value, the lower the valuation the better.  This belief is short-sighted and potentially costly.  For one, gift and estate tax returns do get audited, and the “savings” from an artificially low business valuation can evaporate quickly in the form of incremental professional fees, interest, penalties, and sleepless nights when the valuation is exposed as unsupportable.  Perhaps even more importantly, an artificially low business valuation introduces unhealthy distortion into ownership transition, shareholder realignment, shareholder liquidity, distribution, capital structure, and capital budgeting decisions.  The distorting influence of an artificially low valuation can have negative consequences for your family business long after any tax “savings” become a distant memory.  While the valuation of family businesses is always a range concept, the estimate of fair market value should reasonably reflect the financial performance and condition of the family business, market conditions, and the outlook for the future.Identify Current Estate Tax Exposures and Develop a Funding Plan for Meeting Those Obligations when They AriseWith the appraisal in hand, you can begin to quantify current estate tax exposures and, perhaps more importantly, begin to forecast where such exposures might arise in the future if expected business growth is achieved.  Are shareholders prepared to fund their estate tax liability out of liquid assets, or will shareholders be looking to the family business to redeem shares or make special distributions to fund estate tax obligations?  If so, does the family business have the financial capacity to support such activities?  The most advantageous time to secure financing commitments from lenders is before you need the money.  What is the risk that an estate tax liability could force the sale of the business as a whole?  If so, what preliminary steps can directors take to help ensure that the business is, in fact, ready for sale and that such a sale could occur on terms that are favorable to the family?Identify Tax and Non-Tax Goals of the Estate Planning ProcessAs suggested throughout this post, while prudent tax planning is important, it can be foolish to let the desire to minimize tax payments completely overwhelm the other long-term strategic objectives of the family business.  If there was no estate tax, what evolution in share ownership would be most desirable for your family and business?  The overall goal of estate planning should be to accomplish those transfers in the most tax-efficient manner possible, not to subordinate the broader business goals to saving tax dollars in the present.The professionals in our family business advisory services practice have decades of experience helping family businesses execute estate planning programs by providing independent valuation opinions.  Give one of our professionals a call to help you get started on knocking out your to-do list today.

One of the hallmarks of family business has been the deliberate accumulation of capital over many years.  Two recent developments indicate that the landscape for family capital may be evolving, albeit slowly.Who Now Qualifies as an Accredited Investor?On August 26, 2020, the Securities and Exchange Commission relaxed long-standing rules defining who qualifies as an accredited investor. This is significant because only accredited investors can invest in privately placed securities.  Since private issuers are not subject to the same disclosure requirements as public issuers, the SEC limits such issues to investors who are presumed to have a degree of financial sophistication and the ability to bear the financial risks that accompany illiquid investments with potentially long holding periods.One of the stated purposes of the rule change is to promote capital formation for smaller businesses.  The practical minimum size threshold for a public securities offering is well out of reach for most family businesses.By loosening the requirements for accredited investors, the rule change increases the number of investors eligible to participate in private offerings.What remains to be seen is whether the larger pool of accredited investors will encourage more family businesses to raise equity capital through private placements.  We suspect that only family businesses not having a long-standing aversion to non-family investors will be affected by the rule change.Over the longer-term, however, we will not be surprised if the taboo against non-family capital wanes, and the distinction between private and public companies diminishes.The Long-Term Stock Exchange DebutsThe Long-Term Stock Exchange (“LTSE”) debuted on September 9, 2020. Issuers qualify for listing on the LTSE under a principles-based approach that would appear to align pretty well with family business culture.  The LTSE requires listed companies to publish policies around five core principles:Long-term focused companies should consider a broader group of stakeholders and the critical role they play in one another’s success.Long-term focused companies should measure success in years and decades and prioritize long-term decision-making.Long-term focused companies should align executive compensation and board compensation with long-term performance.Boards of directors of long-term focused companies should be engaged in and have explicit oversight of long-term strategy.Long-term focused companies should engage with their long-term shareholders. As with the change in the accredited investor definition, we suspect that the presence of the LTSE will have little in the way of immediate impact on family businesses.What Do These Two Developments Mean for Family Businesses?If the near-term impact of these two developments is likely to be limited, why bring them up?  Because both developments illustrate how attitudes toward family capital are changing, and family business directors need to be thinking about this shift in perspective."... capital markets for family businesses will, over time, look more like public capital markets."In the past, family business leaders could assume that they would enjoy continued access to family capital.  In other words, family businesses didn’t always feel the competition for investment capital that other businesses face.  Since the business had created the family’s capital, one could safely assume that the business would always have access to that family’s capital to fund operations and new investments.In our view, the loosening of the accredited investor definition and the formation of the LTSE are manifestations of a broader trend, which is that capital markets for family businesses will, over time, look more like public capital markets.The rise of the family office as a source of investment capital for other businesses is the best evidence that families are comfortable looking outside the family business to generate returns on family capital.Just as liquid naturally flows to the lowest point, capital naturally flows to its highest and best use.  The viscosity of family capital is high, so it may take longer to move, but it eventually will.3 Things for Family Business Directors to Begin Thinking AboutIn the context of this broader trend, we propose three things for family business directors to begin thinking about.Are there growth opportunities available to your family business for which it would be worth obtaining non-family equity capital? Regulators seem to be focused on making such capital more readily available.Does your family business provide a compelling case for maintaining its allocation of the family’s capital? In other words, does your legacy business generate sufficient returns to prevent family capital from flowing to competing alternatives?What is your family’s overall capital allocation? Does that allocation meet the characteristics, needs, and risk preferences of your family?  If you have a family office, does it have a process for identifying and screening potential investments? These are not simple questions to answer, but it is important to begin thinking about them now.

Due to the popularity of this post, we feature it again this week.  In this post, we explore why the "value" of a family business can be a matter of perspective.  The value of the business to a strategic buyer is different from the value to the family, and different yet from the value of a single share in the business. It is understandably frustrating for family business directors when the simple question – what is our family business worth? – elicits a complicated answer.  While we would certainly prefer to give a simple answer, the reality a valuation is attempting to describe is not simple. The answer depends on why the question is being asked.  We know that sounds suspect, but in this post, we will demonstrate why it’s not.  Let’s consider three potential scenarios that require three different answers.What Is Our Family Business Worth to Our Family?This is the most basic question about value, and the answer revolves around the expected cash flows, growth prospects, and risk of the family business on a stand-alone basis.  This does not mean that the status quo is assumed to prevail indefinitely, only that a combination with a strategic buyer's business is not anticipated.  The family business may have plans for significant changes to operations or strategy, and if it does, the value should reflect such changes.The value of the family business to the family depends on three principal factors: expected cash flows, growth prospects, and risk.This perspective on value is especially important to family business directors weighing long-term decisions regarding dividend policy, capital structure, and capital budgeting.  The value of the family business to the family depends on three principal factors:Expected Cash FlowsIdentifying the expected cash flows of the business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business.  Revenue and earnings are important, but future cash flows also depend on how much the business will need to spend on capital expenditures and working capital to execute on the business plan.Growth ProspectsAll else equal, the faster a business is expected to grow, the more valuable it is.  Cash flows can grow because of increasing market share, a growing market, or improving profitability.  The assessment of growth prospects should take into account each of these potential factors and the sustainability of each.RiskThe value of a business is inversely related to the risk.  Investors crave certainty, and risk is just another word for not knowing what the future holds.  The wider the range of potential outcomes for your family business, the riskier it is, and the less enthusiastic investors will be about committing capital to the business.  When investing in riskier businesses, investors pay less.  Risk is evaluated relative to comparable investments or businesses.Whether using a discounted cash flow method or using methods under the income approach, the value of the family business to the family is a function of these three attributes of the business itself.  This measure of value is often likened to the perspective of stock market investors or private equity buyers that look to the operations of the business to drive return apart from a strategic combination with another business.If this first question deals with the value of the family business assuming it continues being a family business, the second question addresses the value of the business once it stops being a family business.  In other words, what is the value of the family business to a strategic buyer?What Is Our Family Business Worth to a Strategic Buyer?Families occasionally decide they don’t want to own the family business anymore.  Families can reach this decision for different reasons.  Sometimes, the family friction associated with managing the family business has reached an unsustainable level.  In other cases, the family may be approached by a buyer of capacity with what appears to be a very enticing offer.  Or, perhaps, an enterprising family decides that a “fresh start” with proceeds from the sale of the legacy business could unlock new opportunities for the family.  In any event, when the decision to sell, or at least consider selling, has been made, directors naturally turn their attention to maximizing the sales price.A strategic buyer is one that will combine the operations of the target company with their existing operations.A strategic buyer is one that will combine the operations of the target company with their existing operations in a bid to increase the earnings and cash flow of the target and/or the newly combined entity as a whole.  Strategic buyers are most commonly competitors of the target, but they could also be suppliers or customers.  The essential attribute is that a strategic buyer has the ability to change how the target operates, resulting in either higher earnings, better growth prospects, or reduced risk (or some combination thereof).Exhibit 1 illustrates potential earnings enhancements available to a strategic buyer (in this case a competitor). By combining the target with their existing operations, the larger strategic buyer will be able to achieve purchasing efficiencies, which will contribute to a higher gross margin.  In addition, there are redundant general and administrative expenses, which can be eliminated by the buyer.  As a result, the strategic buyer anticipates generating an EBITDA margin of 22%, compared to the 16% EBITDA margin available to the target company on a stand-alone basis.  Stated alternatively, the strategic buyer anticipates EBITDA that is 38% higher. Does that mean that the target company is worth 38% more to the strategic buyer?  Not necessarily.  The amount that a strategic buyer will, in fact, pay for the target company depends on how many other strategic buyers they are likely bidding against and how unique the target company opportunity is. The magnitude of strategic benefits available and the likely negotiating dynamics for a family business tend to be very fact-specific.  So, assessing the value of your family business to a strategic buyer will require that you and your fellow directors consider the following questions: Who are the competitors, suppliers, or customers with whom our family business would provide the most compelling strategic “fit”?What opportunities would such buyers have for increasing earnings and cash flow, improving growth prospects, or reducing the risk of the family business?How unique is our family business? Are there other similarly situated businesses that can provide comparable strategic benefits to buyers? A potential strategic sale is not the only context in which family business directors need to think about the value of the family business.  We’ll consider the final variation on the question of value in the next section.What Is a Share of Stock in Our Family Business Worth to an Investor?The final question relates to the value of an interest in the family business, rather than the family business itself.  Minority shares in a family business are often considered unattractive from an investment perspective for a number of reasons.  As a minority shareholder, one has no direct influence or control over business strategy or other long-term business and financial decisions: one is simply along for the ride and subject to decisions made by others.  Furthermore, since it is a family business, there is likely no ready market for the shares.  As a result, one is effectively stuck, and, potentially, for a long time.So, from this perspective we need to think about all the things that influence what the family business is worth to the family plus some additional considerations that relate to the unique position of being a minority shareholder in a private company.  This perspective is critical for gift and estate tax planning.Are There Any Dividends?Regular cash flow dulls the pain of illiquidity.  If there is a reasonable expectation that investors will receive dividends while owning the shares, that helps to mitigate the burden of being unable to sell the shares.  Since many family businesses are set up as S corporations, it is important to clarify that the dividends that matter are those in excess of any tax liabilities that are passed through to shareholders.What are the Prospects for Liquidity?Even though there is no ready market in which to sell minority shares in a family business, there are still opportunities to sell the shares from time to time.  For example, the family business could be sold, the company may repurchase shares from select shareholders, or other family members may be willing to acquire the shares at a favorable price.  While future liquidity opportunities cannot be predicted with precision, it is possible to establish a range of likely holding periods by analyzing relevant factors.  The longer the period until a liquidity event can be anticipated, the less attractive the investment.What are the Growth Prospects for the Investment?When liquidity does come, what proceeds can be reasonably expected?  In other words, at what rate would one anticipate the value of the business to the family to grow from the current level?  If the family business has a track record of reinvesting earnings in attractive capital projects, investors will view the growth prospects more favorably than if management has a propensity to accumulate large unproductive stockpiles of cash or other assets in the business.What are the Relevant Risks?As with the business itself, the value of a minority share is inversely related to the attendant risks.As with the business itself, the value of a minority share is inversely related to the attendant risks.  The risks of a minority share include all the risks associated with the family business plus those associated with the illiquidity of a minority interest.  In other words, the focus is on identifying those risks (including, potentially, lack of access to financial statements, uncertainty as to the ultimate duration of illiquidity, uncertainty regarding future distribution decisions, and the like) that are incremental to the risks of the family business itself.The combination of expected dividends, holding period, expected growth, and risk factors determine the value of a share in the family business relative to the corresponding pro rata portion of the value of the business as a whole to the family.ConclusionThere is no simple answer to “What’s our family business worth?” because the question is never quite as simple as that.  The answer depends on exactly how and why the question is being asked.  From transaction advisory services to gift and estate tax compliance to corporate finance decisions, our valuation professionals have the experience and expertise to help you ask the right questions about the value of your family business and get the right answers.  Call us today.

Is it time for your family business to make an acquisition?Growing through acquisition has a bad reputation because countless studies have shown that buyers tend to overpay for businesses.  In other words, the real winners in many corporate transactions are the sellers, not the buyers.That said, there is some evidence that acquisitions during a recession are more likely to be accretive.  A recent study by Brian Salsberg of global accounting firm EY indicates that companies making acquisitions in the depths of the 2008 financial crisis generated superior returns for shareholders than peer companies that waited until the storm passed before making acquisitions.  Not surprisingly, the study attributes the superior returns to the ability of buyers to pay bargain prices during the crisis.  Motivated sellers and fewer competing bidders tip the negotiating scales in favor of eventual buyers.  As our colleague Jeff Davis is fond of saying: “Bought right, half right.”In our experience, many family businesses are reluctant acquirers.  In addition to the fear of overpayment, family businesses are wary of the cultural challenges that can arise in the integration phase.  Since families often avoid having non-family shareholders, traditional equity financing is assumed not to be available, so if the family is debt-averse, significant acquisitions may not be financially feasible.  However, these concerns need not be absolute obstacles for your family business making an opportunistic acquisition while others sit on the sidelines to wait out the pandemic.We recommend that directors cast a wide net when evaluating potential acquisitions.  As we noted in last week’s post, directors should take this opportunity to think more broadly about the portfolio of assets owned by their family business.  Are any pieces extraneous?  Are there any pieces that are missing?  For family businesses that have hesitated to make acquisitions in the past, the missing pieces do not have to be big, nor do they have to be existing competitors.  It may be helpful to expand your list of potential acquisition opportunities to include five categories of targets (with an obvious nod to Michael Porter’s five forces framework).Competitors.  Competing firms are the most obvious acquisition candidates.  Competitors offer the opportunity both to cut costs and enhance revenue through improved pricing power.  The downside is that because the potential benefits are transparent, a competitor may be able to extract a larger purchase price.Suppliers.  All of us who have shopped in vain for toilet paper or Lysol during the past six months have a new appreciation of the importance of having a reliable supply chain for critical inputs.  Are there risks to your supply chain that can be mitigated by an acquisition?Customers.  Where does your family business sit in the value chain from raw material to the end user?  Would an acquisition of a customer allow one of your business segments to capture a greater proportion of the overall value created in your industry?Substitute Products/Services. Your family business competes against both other companies that provide the same product or service you do, and companies that offer products or services that your customers could reasonably substitute for what you offer.  Acquiring such a company can help to round out your product line/service offering and reduce the risk of your family business.Innovators.  This requires a higher degree of risk tolerance, but are there companies developing a product or service that could disrupt your business in three or five years?  If you can’t beat ‘em, you may want to buy ‘em.  While the unicorn tales populate the headlines, they are rare.   Many innovators are intrigued by the opportunity to sell now rather waiting years for a unicorn-type event that, statistically speaking, will likely never materialize.  Especially during a downturn, you may be able to reap the benefits of someone else’s development efforts at a reasonable price. Of course, it is possible to make a bad acquisition, even during an economic downturn.  Your family shareholders may not have the appetite for a “transformative” deal, but a smaller acquisition that enhances your overall portfolio may well be doable.  The main thing is to be deliberate.  Even if you are not ready to cut a check today, you and your fellow directors should be thinking about your acquisition strategy.  Call one of our experienced professionals for some outside perspective.

We are not about to predict when the pandemic will end.  However, we are confident that it will end.  And we do know that it is closer to being over today than it has ever been.Two recent articles have reminded us that it is not too early to begin thinking about what the eventual end of the pandemic will mean for your family business.The first, entitled “More Wealthy Families Are Throwing a Lifeline to Distressed Businesses,” appeared in the New York Times a few weeks ago. Direct investment in businesses has been an emerging theme in the family office space since the end of the last recession, and according to the article, the trend is only accelerating in the current financial crisis.  With public markets back at – or even above – pre-pandemic levels, patient families are seeking out the potential for more attractive long-term returns by providing capital to private companies that need a financial lifeline through the recession.  Since many enterprising families possess unique industry expertise and insight, they may be better equipped to separate the wheat from the chaff when evaluating investment opportunities.The second, from the global accounting firm PWC, summarizes the results of a survey of 18 family offices: “Gauging the Deals Outlook for Family Offices.” According to PWC, nearly all family offices they spoke with are planning to make a strategic acquisition over the coming year, while only one-third plan to be sellers during that period.  Of note in the article is the emphasis on proper and thorough due diligence processes for acquisitive families. Surviving the pandemic has been the top priority for many family business leaders for the past six months.  Is it time for you and your fellow family business directors to switch from a reactive to a more proactive footing?  Here are four potential agenda items to consider for your next board meeting:1) Positioning OwnershipOwnership is the ultimate “given” in family businesses.  When did you as a board last review your family business’s shareholder list?  If you were starting from scratch, which shareholders would promote your family business thriving over the next 10-20 years?  If there is a difference between your “actual” and “ideal” shareholder lists? This is a uniquely favorable time to engage in intra-family transactions to get closer to the ideal ownership structure.  The fair market value of ownership interests is depressed for many businesses, interest rates are at historical lows, and lifetime exemption levels and gift tax rates are relatively favorable.  In short, this is a great time to ensure that the ownership of your family business is oriented toward tomorrow, not yesterday.  Don’t miss it.See our posts on the topic:Opportunity Times Two?Now Is a Great time to Transfer Stock to Heirs2) Evaluating Capital Needs and SourcesFamily businesses have been very diligent in short-term cash and working capital management through the pandemic.  But what about the longer-term?  How much availability do you have on existing credit facilities?  Are existing facilities sufficient for likely post-pandemic needs?  Are family shareholders willing to provide additional equity capital to the business, either through direct contributions or temporary distribution cuts?  Are there non-traditional financing sources that could be advantageous, such as joint ventures or similar structures?  As noted in the two articles linked at the beginning of this post, disillusionment with the public markets could begin to open up new sources of competitively priced long-term capital for family businesses.  The sources and structures may not be traditional, but as more investors look to put capital to work, opportunities for favorable access to long-term capital are likely to emerge for families that have a plan for how to put it to work.3) Rebalancing Your PortfolioIf you were unburdened by your family business’s existing portfolio of operating assets, what would you want to own today?  Are there legacy assets that are no longer a good “fit” with your family business?  Are there other investors to whom such assets are more valuable?  If so, do you have a plan for monetizing that incremental value?  Conversely, is your family business puzzle missing some pieces that would make for a prettier picture?  Like the family offices discussed above, are you evaluating investment opportunities that are either currently available, or likely to become available over the next 6 to 12 months?  The dislocations triggered by the pandemic will result in attractive investment opportunities for family businesses that have their eyes open.  Having a clearly defined hurdle rate, investment criteria, and due diligence processes in place is essential to ensuring that such acquisitions are productive uses of family capital.4) Selecting a New DestinationOur GPS navigation systems are amazing.  But when you get in the car, it can still be a bit cumbersome to input the address for a new destination; it is much easier to scroll through the list of previous destinations.  But if you’ve never been where you want to go before, selecting one of the previous destinations saved to your system won’t cut it.  The Great Disruption of 2020 provides a natural opportunity for you and your fellow directors to re-evaluate just where it is your family business needs to be going.  What will the long-term ramifications of the pandemic be for your segment of the market?  How will you need to change your interactions with suppliers, customers, competitors, and regulators?  Are there secular trends that you can get in front of, and use to enhance the long-term sustainability of your family business?  This is not the time to default to previous destinations.  Selecting a new destination may be just what your family business needs for it to continue serving the needs of your family for generations to come.Family directors have rightly been focused on keeping their people safe and healthy, and taking the steps necessary to help their businesses survive the pandemic.  It will eventually be time to look ahead, however.  When that time comes for your family business, what will you be thinking about?  Contact one of our family business professionals today to help kick-start that conversation.

One thing in short supply thus far in the pandemic has been perspective.  We know that GDP fell by more than 30% during the second quarter, but how does that translate into the actual financial performance of businesses?  Family business directors have been flying blind over the past few months, with no reliable way to benchmark the performance of their businesses.Earnings season for the second quarter of 2020 gives us the first opportunity to see how the COVID-19 pandemic is affecting businesses.  We normally don’t get too concerned about reported results for a particular quarter, but this is an obvious exception.  By the time the second quarter started on April 1, many regions of the country were already in quarantine, with the rest to follow shortly thereafter.  While the pandemic started to weigh on results in 1Q20, it was hard to get an accurate feel for the impact, since January and February were essentially “normal.”In this post, we elaborate on four themes that emerge from the data.Theme #1 – Smaller companies have been more adversely affected than larger companies.Revenue and earnings for smaller companies fell more sharply than for larger companies.  In the aggregate, revenue for the companies in the Russell 1000 fell 12% relative to 2Q19, compared to a 23% shortfall for the companies in the Russell 2000.  The size effect is most pronounced for companies in the communication services and health care industries.It is not possible to tease out from the data precisely why larger companies fared better during the pandemic.  However, investors did successfully predict the phenomenon, as returns for the small cap index have lagged those of large cap names since the pandemic struck.Questions for Family Business DirectorsHow does your performance compare to that of the public companies in your industry?In your specific industry niche, do the larger players have a natural advantage? If so, what steps can you take to turn your smaller size into a competitive advantage?  Can you be more responsive, nimbler, than larger competitors?How will your family business preserve profitability if the pandemic-induced recession persists?Theme #2 – Smaller companies are prioritizing cash flow.In the aggregate, the Russell 2000 companies in our sample reported a net loss of $17.8 billion during 2Q20, compared to net income of $3.6 billion during the prior year period.  The negative effects of the 23% revenue shortfall experienced by those firms cascaded down the income statement, growing to a 58% reduction in EBITDA, and triggering net accounting losses after taking into account impairment charges, depreciation and amortization, and interest expense.However, when we turn to the statement of cash flows, operating cash flow increased in 2Q20 compared to 2Q19, in large measure to the cash freed up from lower working capital balances.   While not a sustainable source of cash flow, careful management of working capital levels is an important source of precious cash flow during a downturn, and the public companies in our sample have been diligent in maximizing cash from working capital.Questions for Family Business DirectorsHow have your cash collections been holding up through the downturn? Are there any problematic accounts lurking in your receivables list?  Do you have a strategy for dealing with customers that encounter financial distress of their own?How are you managing inventory? Are there specific portions of inventory that have a heightened risk of becoming obsolete?What is your strategy for managing payables? Are any vendors offering discounts for prompt payment?Theme #3 – Smaller companies are building cash.The pandemic has featured a recurring cycle of positive developments followed by setbacks.  As a result, no one has a good handle on how long these conditions will persist.  Facing this uncertainty, managers and directors of the public companies in our sample have been accumulating cash as a hedge against a potentially extended period of underperformance.  If the downturn persists into 2021, financial flexibility will be critical.  As one of our long-time family business clients once observed: “You make better decisions when you don’t need the money.”As shown below, the companies in our sample added to cash balances, in part, by becoming much more selective investors.  Cash outlays for M&A activity evaporated, and capital expenditures were cut by 40%.  In fact, capital expenditures represented just 75% of depreciation and amortization charges, which are a good proxy for the “maintenance” level of spending.  This is not a sustainable practice for family businesses, but deferring non-essential capital expenditures can be a prudent move in the short-term when the outlook for the future is especially cloudy. Questions for Family Business DirectorsHow has the downturn affected the size of your capital budget? Are you using a higher hurdle rate on potential investments, taking a haircut to pre-COVID cash flow projections, or using some other mechanism to ration capital?Have you been deferring “maintenance” capital expenditures? If so, it is important to carefully monitor what has been deferred, and identify what the priorities for catching up will be when more normal conditions return.Are there any idle assets on the balance sheet that don’t have a strategic role to play in your family business and can be converted to cash?Theme #4 – Shareholders are being patient (for now).Finally, we can see that the shareholders of the smaller companies in our sample are doing their part as companies seek to conserve cash.  Combining dividend payments and amounts spent on share buybacks, total payments to shareholders fell by more than 60% from $5.3 billion in 2Q19 to $1.9 billion in 2Q20.  Repurchases fell by more than 80%, while aggregate dividend payments were cut by 33%.  Of the 224 small cap companies in our sample paying dividends at this time last year, 44 (20%) have suspended their dividends entirely.Questions for Family Business DirectorsHow have you communicated the business impact of the pandemic to your family shareholders?What adjustments to dividends are appropriate/necessary considering the performance of your family business? How can you prepare shareholders for those changes?If you have a share redemption program, is the valuation up-to-date? If it is not, the remaining shareholders may end up inadvertently subsidizing the shareholders that elect to cash out.Is there consensus within your family regarding what the family business “means”? In other words, do family members view the business as an economic growth engine for future generations, a source of wealth accumulation, a store of value, or a source of lifestyle?  How does the prevalent “meaning” of the business influence your dividend deliberations?ConclusionIt’s a horrible cliché, but these really are pretty unprecedented times.  Up to now, family business directors have had little context for evaluating how their companies are performing, and how their strategic decisions are stacking up against those made by others.  Give one of our professionals a call today to discuss the benefits of a customized benchmarking analysis for your family business or how the value of your family business has likely changed as a result of the pandemic.  For many successful multi-generation family businesses, this a uniquely opportune time for tax-efficient estate planning.  Don’t let it pass by without taking advantage – the future generations will thank you.For a deeper dive, download our COVID Benchmarking Update (August 2020) below.August 2020COVID Benchmarking UpdateDownload Guide

The economic effects of the COVID-19 pandemic are dire, and family businesses are not immune to the economic fallout from the virus. Yet we are confident that family businesses are best positioned to survive and lead in the post-pandemic economic recovery.For family shareholders who are optimistic about the resilience of their family businesses and focused on the long view, this is an ideal time to execute intrafamily transfers in pursuit of estate planning objectives.Coronavirus and Fair Market ValueThe precipitous decline in public equity markets has been well documented. From its Feb. 19 peak, the S&P 500 index lost nearly 24% of its value by the end of the first quarter. Small-cap stocks in the S&P 600 index suffered even more, falling approximately 33% over the same period.What caused the significant drop in public stock prices? Stock prices reflect three factors.Cash Flow. Stock prices are based on the future, not the past. Historical earnings and cash flows can provide important perspective, but investors are much more focused on what’s visible through the windshield than what is in the rearview mirror. For most public companies, the pandemic has caused investors to reassess the amount of cash flow those companies will generate in the coming year. Lower expected cash flows result in lower stock prices.Risk. When fog or other conditions reduce visibility, smart drivers slow down. Investors do the same thing. The pandemic has caused the range of potential cash flow outcomes for the coming year to be much wider than normal. In other words, stock investors are facing more risk than normal. When risk goes up, stock prices come down.Growth. The growth component describes how fast cash flows are forecast to increase in subsequent years. Theories abound as to whether the economic recovery curve from the pandemic will look a “V” or a “U” or a “W” (or some other letter). To the extent investors expect the negative effect of the pandemic to weigh on cash flows for a prolonged period, stock prices will be cut. It is impossible to dissect the observed change in stock prices to discern how much of the decrease is attributable to expected cash flow, risk, or growth. What matters is that the three factors, in combination, have caused the reduction in public stock prices. What does all this have to do with the fair market value of illiquid minority interests in private companies? The value of such interests depends on the same three factors. Business appraisers determine the fair market value of shares for gifting or other intrafamily transfers using a two-step process.First, appraisers estimate the value of the business as if the shares were publicly traded. In other words, they consider how public market investors would view the shares if they had the opportunity to purchase them on the stock market. In doing so, they develop expectations regarding the cash flow, risks, and growth prospects of the family business. If a particular family business is better positioned to weather the COVID-19 storm than its peers, the negative impact on value may be muted. For many family businesses, however, an assessment of these three factors in the midst of the pandemic will likely result in a materially lower value than would have been the case in mid-February.Next, appraisers consider the appropriate discount, or reduction in value, to account for the fact that the shares in the family business are not publicly traded. All else equal, investors prefer to have liquidity. In order to accept the illiquidity inherent in private company shares, investors require a marketability discount. The size of the marketability discount depends on the specific attributes of the shares, including the likely holding period until a favorable opportunity for liquidity is expected, the amount of expected interim distributions from owning the shares, the expected capital appreciation over the holding period, and the incremental risk associated with illiquidity. The impact of the pandemic on the magnitude of the marketability discount is more ambiguous than the effect on the as-if-freely-traded value. Some of the factors are likely to be neutral relative to the pre-pandemic environment, while others may be negatively or positively affected. In short, the fair market value of minority shares in family businesses is likely lower today than it was just a couple months ago. It does not matter if your family has no intention of selling the family business at a reduced value; the fact is that – if you were to sell an illiquid minority interest now – the value would reflect current market conditions. The IRS itself makes this clear in Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.The potential silver lining to the cloud of depressed market values is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.Case Study: Decisive vs. Hesitant PlanningWe can illustrate the significance of the current opportunity with an example.  Consider a family business having a pre-pandemic value on an as-if-freely-traded basis of $25 million. Although the long-term prospects of the business remain unchanged, the dislocations caused by coronavirus have triggered a temporary reduction in fair market value of 25%. The founder has yet to do any estate planning and continues to own 100% of the shares.Exhibit 1 depicts the expected value trajectory for the family business both before and after the pandemic.Because of the resilience of the family business, the value trajectory resumes its pre-pandemic path after three years. The founder’s tax advisers suggest that – since the long-term prospects of the business are unimpaired – the current depressed fair market value provides an excellent opportunity to begin a program of regular gifts. The current lifetime gift tax exclusion is approximately $12 million, and the founder and his advisers devise a strategy of making an initial gift of $6 million, followed by annual gifts of $1 million in each of the following six years.We’ll examine two scenarios. In the first, the founder begins the gifting program immediately (the “Decisive” scenario). In the second, the founder defers the gifting program until the uncertainty associated with the pandemic has passed (the “Hesitant” scenario). In both cases, the shares gifted represent illiquid minority interests, so a 25% marketability discount is applied to derive fair market value.Since the annual gifts are for fixed dollar amounts, lower per-share values result in more shares being transferred, which reduces the amount of shares in the future taxable estate, all else equal. Exhibit 2 summarizes the shares that are transferred under the gifting program for the Decisive and Hesitant scenarios.Because the gifts under the Decisive scenario were made while share prices were depressed because of the coronavirus, a larger portion of the shares were transferred than in the Hesitant scenario. As a result, the founder retained just 33% of the total shares after using the $12 million lifetime exclusion, compared with 58% under the Hesitant scenario. As shown in Exhibit 3, the effect on the resulting taxable estate is compounded because, under the Hesitant scenario, the 58% retained interest represents a controlling position in the shares and the value is not reduced for the marketability discount. In fact, although not shown in Exhibit 3, a control premium to the as-if-freely traded could be applicable, which would exacerbate the disparity. In our example, failing to take advantage of the estate planning opportunity presented by the depressed asset prices added $7.2 million to the eventual estate tax bill. Procrastination can be costly. Estate Planning and ControlOur preceding example was relatively simple. Estate planners often use a variety of strategies involving trusts and other vehicles to accomplish estate planning and other goals. However, our simple example illustrates what is often perceived as a “cost” to aggressive estate planning: the senior generation’s loss of voting control.In the Decisive scenario, the founder’s ownership percentage fell below 50% in 2022. So, from that point on, the founder could no longer unilaterally make significant corporate decisions. We have seen a variety of strategies used to mitigate this outcome, such as establishing voting and non-voting share classes. These techniques can delay the eventual loss of control, but every business leader will eventually relinquish voting control of their company, whether through estate planning, death, or sale of the business.In our experience, deferring estate planning to accommodate a desire to maintain voting control is rarely worthwhile. When the desire to maintain control is especially strong, that is often a clue that there are other underlying family issues that need to be addressed. If, as the controlling owner advances in age, the loss of voting control remains unpalatable, that could signal that the family dynamics are such that selling the business might be the best outcome for everyone.Strike While the Iron Is HotFamily business leaders are currently facing many pressing issues. Amid the uncertainty, however, family shareholders should know that the estate planning opportunities triggered by lower valuations may not last. Schedule a quick call with your estate planning advisers to see if there are steps you can take to help reduce the burden of future estate taxes on your family and business.This article originally appeared in Family Business Magazine (April 2020) and was republished with permission.

In the depths of the stock market pullback, we wrote about the opportunity to take advantage of depressed share values. When the Applicable Federal Rate fell to historic lows, we wrote about the “double opportunity” afforded by low values coupled with low interest rates.Which leads us to last week. During our webinar on the estate planning opportunities in the current environment, fellow panelist Brook Lester reminded us that – in addition to all the other fun stuff going on in 2020 – there’s a presidential election in November.We possess no political clairvoyance. However, if a Biden administration were to assume power in January 2021, we know that adverse changes to the current estate tax regime would be likely. As November draws near, advisors are urging family shareholders to mitigate the political risk by implementing significant transactions now.In this week’s post, we have assembled some helpful resources we have come across that provide helpful insight on the estate planning opportunities and strategies available to family business owners during 2020.Written in a pre-COVID world, the 2020 Wealth Planning Outlook from Northern Trust still offers valuable perspective for family business leaders.Published in June 2020, this whitepaper from our friends at Diversified Trust provides timely insights for family shareholders evaluating their planning needs in the wake of COVID-19.This article sheds some light on how wealthy families are pursuing estate planning goals with renewed vigor under the shadow of COVID-19.Attorney and Forbes.com columnist Matthew Erskine offers a compelling case for using one’s unified credit sooner rather than later.Finally, this article from CNBC’s website digs deeper into the Biden campaign’s tax proposals, including the elimination of the “step-up” in basis currently available to heirs. It is generally a bad idea to let the tax tail wag the dog. However, the combination of depressed asset values, low interest rates, and political risk means that family shareholders should accelerate work on the business and family issues that pave the way for effective estate planning. If your family has avoided having those conversations, it’s not too late, but the time to start really is now. A well-reasoned and supported business valuation is fundamental to any estate planning strategy. Call one of our professionals today to started on a valuation of your family business.

All fair market determinations involve assumptions regarding how buyers and sellers would behave in a transaction involving the subject asset. In a recent Tax Court case, the IRS appraiser applied a novel valuation rationale predicated on transactions that would occur involving assets other than the subject interests being valued. In its ruling, the Court concluded that this approach transgressed the boundaries of what may be assumed in a valuation.BackgroundAt issue in Grieve was the fair market value of non-voting Class B interests in two family LLCs.The first, Rabbit, owned a portfolio of marketable securities having a net asset value of approximately $9 million.The second, Angus, owned a portfolio of cash, private equity investments, and promissory notes having a net asset value of approximately $32 million. Both Rabbit and Angus were capitalized with Class A voting and Class B non-voting interests. The Class A voting interests comprised 0.2% of the total economic interest in each entity. The Class A voting interests were owned by the taxpayer’s daughter, who exercised control over the investments and operations of the entities.Valuation Conclusion – TaxpayerThe taxpayer measured the fair market value of the Class B non-voting interests using commonly accepted methods for family LLCs. The net asset value of each LLC was deemed to represent the value on a controlling interest basis.Since the subject Class B non-voting interests did not possess control over either entity, the net asset value was reduced by a minority interest discount. The taxpayer estimated the magnitude of the minority interest discount with reference to studies of minority shares in closed end funds.Unlike the minority shares in closed end funds, there was no active market for the Class B non-voting interests in Rabbit and Angus. As a result, the taxpayer applied a marketability discount to the marketable minority indication of value. The taxpayer estimated the marketability discount with reference to restricted stock studies. The combined valuation discount applied to the Class B nonvoting interests was on the order of 35% for both Rabbit and Angus, as shown in Exhibit 1. Valuation Conclusion – IRSThe IRS adopted a novel approach for determining the fair market value of the Class B non-voting interests.Noting the disparity in economic interests between the Class A voting (0.2%) and Class B non-voting interests (99.8%), the IRS concluded that a hypothetical willing seller of the Class B non-voting interest would sell the subject interest only after having first acquired the Class A voting interest. Having done so, the owner of the class B non-voting interest could then sell both the Class A voting and Class B nonvoting interests in a single transaction, presumably for net asset value.If the dollar amount paid of the premium paid for the Class A voting interest is less than the aggregate valuation discount applicable to the Class B non-voting interest, the hypothesized series of transactions would yield more net proceeds than simply selling the Class B non-voting interest by itself. The sequence of transactions assumed in the IRS determination of fair market value is summarized in Exhibit 2.Tax Court ConclusionIt is certainly true that – if the Class A voting interests could, in fact, be acquired at the proposed prices – the sequence of transactions assumed by the IRS yield greater net proceeds for the owner of the subject Class B non-voting interests than a direct sale of those interests. However, is the assumed sequence of transactions proposed by the IRS consistent with fair market value?The Tax Court concluded that the IRS valuation over-stepped the bounds of fair market value. The crux of the Court’s reasoning is summarized in a single sentence from the opinion: “We are looking at the value of the Class B Units on the date of the gifts and not the value of the class B units on the basis of subsequent events that, while within the realm of possibilities, are not reasonably probable, nor the value of the class A units.” Citing a 1934 Supreme Court decision (Olson), the Tax Court notes that “[e]lements affecting the value that depend upon events within the realm of possibility should not be considered if the events are not shown to be reasonably probable.” In view of the fact that (1) the owner of the Class A voting interests expressly denied any willingness to sell the units, (2) the speculative nature of the assumed premiums associated with purchase of those interests, and (3) the absence of any peer review or caselaw support for the IRS valuation methodology, the Tax Court concluded that the sequence of transactions proposed by the IRS were not reasonably probable. As a result, the Tax Court rejected the IRS valuations.The Grieve decision is a positive outcome for taxpayers. In addition to affirming the propriety of traditional valuation approaches for minority interests in family LLCs, the decision clarified the boundaries of fair market value, rejecting a novel valuation approach that assumes specific attributes of the subject interest of the valuation that do not, in fact, exist. As the Court concluded, fair market value is determined by considering the motivations of willing buyers and sellers of the subject asset, and not the willing buyers and sellers of other assets.Originally appeared in Value Matters™, Issue No. 3, 2020

The old bromide assures us that “You’ve got to spend money to make money.”  Although obviously true at some level, how much should you spend, and what should you spend it on?Investment DecisionsWe tend to think of family business investments in terms of a series of three decisions.What investments do we need to make to maintain our productive capacity?How much capital should we allocate to growth investments?Should we grow by building or buying?#1 – What investments do we need to make to maintain our productive capacity?Maintenance capital expenditures are rarely exciting.  But they are important.  Successful families resist the urge to defer the unglamorous expenditures needed to maintain and enhance the productivity of their businesses.  Companies that failed to make the necessary investments to keep their information technology infrastructure up-to-date and compatible with the latest remote work applications experienced a rude awakening when the pandemic sent their employees home.Companies are not required to disclose which of their investments are for maintenance purposes rather than for growth.  However, depreciation expense is probably a decent proxy for maintenance capital expenditures.  In the 2020 Benchmarking Guide for Family Business Directors, we examined maintenance capital expenditures for the companies in our sample.  Over the period analyzed, maintenance investments accounted for nearly 20% of EBITDA (a proxy for cash from operations) and approximately 2.5% of revenue.#2 – How much capital should we allocate to growth investments?The investment decisions get progressively harder.  After setting aside funds for maintenance capital expenditures, family business directors must allocate capital to incremental growth investments.  Answering this question well requires directors to balance a variety of concerns, which include:Can we identify growth investments that align with our broader business strategy?Do the growth investments we identify present an attractive relationship between risk and reward?Do we have access to the capital required for the investments we identify?How do our family shareholders prioritize growth relative to current income? Risk influences the willingness of directors to commit capital to growth investments.  The companies in our sample reduced spending on growth investments by more than 10% in 2019 compared to 2018.  This may reflect some wariness on the part of directors regarding the durability of the economic expansion which was entering its second decade.  Growth investments also fell in 2016, perhaps reflecting uncertainty regarding that year’s presidential election. #3 – Should we grow by building or buying?Growth investments come in two varieties: organic (building additional capacity from scratch) and acquisitions (buying existing capacity from someone else).As growth strategies, building and buying present their own set of risks and potential benefits.Companies opting to build avoid the risk of overpaying for someone else’s goodwill and are assured that the default culture will be that of the family business. On the risk side of the ledger, builders should be concerned about whether the market really needs the additional capacity they are building.  Builders also bear the opportunity costs of what are often extended investment periods during which more nimble competitors may be able to seize the first-mover advantage.Acquirers, on the other hand, often overpay for target companies and struggle to integrate the culture of the acquired entity. However, acquisitions can present opportunities for cost savings and revenue synergies that are not available with organic growth investments.  Further, acquirers can begin capitalizing on the perceived market opportunity immediately. The public companies in our sample tend to allocate more of their growth capital to acquisitions than organic capital expenditures.  Across all industries, acquisitions outpaced growth capital expenditures by a more than 2-to-1 margin during 2019.  However, this relationship varied significantly by industry, as shown below. Companies in the consumer staples, health care, and information technology sectors rely much more heavily on acquisitions than capital expenditures for growth. We suspect that family businesses are, in general, less acquisitive than their publicly traded counterparts.  While we have plenty of clients that grow by acquisition, our sense is that the cultural hurdles associated with acquisition cause other family businesses to prefer organic growth strategies. ConclusionTo be sustainable, family businesses need to invest capital wisely.  As directors, the answers you give to the investment questions today will help define what the family business looks like for future generations.  Before making a significant investment decision that will be hard to reverse, it is a good idea to evaluate how other companies in your industry are answering the investment questions for themselves.  If your answers are different, articulating why they are different and testing those reasons can help directors gain comfort that they are on the right path.2020 Benchmarking Guide for Family Business DirectorsDownload Guide

In a recent Wall Street Journal article, Professor Alex Edmans of the London Business School offers an impassioned plea for public companies to stop prioritizing dividend payments. In “Why Many People Misunderstand Dividends, and the Damage This Does,” Dr. Edmans contends that investor aversion to dividend cuts causes public companies to make irrational investment and expense management decisions. Furthermore, Dr. Edmans postulates that over-reliance on dividends encourages an unhealthy degree of investor passivity.Is dropping the regular dividend a viable option for closely held family businesses?Rather than paying a stout, maintain-at-all-costs regular dividend, the author suggests that companies rely on share buybacks and non-recurring “special” dividends to provide returns to shareholders. Perhaps this is the proper prescription for public companies – after all, shareholders can readily “replace” the lost dividend income by simply selling a portion of their holdings. Doing so is really no different than receiving a dividend, which reduces the value of the shares owned. But is dropping the regular dividend a viable option for closely held family businesses?Unlike public company investors, family shareholders do not have access to ready liquidity for their shares. This can have profound implications for dividend policy. Family shareholders cannot easily create their own “synthetic” dividend by simply selling a portion of their holdings. Opportunities to sell shares in the family business may come only sporadically and may be on disadvantageous terms. For example, family shareholder liquidity programs – when they exist – often allow for transactions just once per year, have hard caps on the total repurchase budget, may occur at a discounted price, or may provide consideration in the form of a multi-year note. In short, despite being an important part of the shareholder engagement toolbox, family shareholder liquidity programs are no substitute for the freely traded shares of a public company.Five Things to Keep in MindSo how should family businesses think about dividend policy? Here’s a non-exhaustive list of five things to keep in mind while evaluating your family business’s dividend policy.1. Dividends Are Not a Substitute for Freely Traded Shares, But They Do HelpA predictable dividend stream does not provide the near-instantaneous liquidity that public shareholders enjoy, but it does provide access to liquidity over time. Since family shareholders cannot easily sell small portions of their holdings to fund major life purchases, they instead rely on dividend income to supplement other sources of cash flow as personal needs arise.2. Dividends Help Reduce the Risk Faced by Family ShareholdersA long-time client of ours endured a significant business crisis several years ago. In order to survive, the company had to raise capital from outside investors, which diluted the ownership position of the family.  In short, the wealth of the family – as represented by the value of the family business – fell materially. However, prior to the crisis, the family business had a long history of paying regular and substantial dividends to shareholders, which provided many of them the opportunity to diversify their overall personal balance sheets. As a result, the sharp drop in the value of the family business’s shares, while certainly unpleasant, was not as devastating as it would have been in the absence of the outside wealth accumulation permitted by the prior dividend payments.3. Dividends Provide a Signal Regarding the Health of the Business That All Shareholders Can UnderstandPositive shareholder engagement is critical to the sustainability of any family business. We are firm believers in the benefits of clearly communicating financial results to family shareholders. Yet, the surest way to communicate with shareholders is through the dividend. Financial reports and management letters may or may not get read, but dividend checks always get cashed.A regular dividend that fluctuates in response to the performance of the business may be the most effective communication tool available.Public companies allocate about twice as much to share buybacks as dividend payments each year. They do so, in part, to uncouple the dividend from the inevitable year-to-year fluctuations in business performance; during boom years they simply repurchase more shares, and during lean years, they cut the repurchase budget.For many family businesses, share redemptions cannot provide a comparable release valve on shareholder distributions. As a result, family business directors should consider “training” their shareholders to anticipate year-to-year fluctuations in dividend payments that track the underlying health of the family business.4. Dividends Can Help Managers Be More Selective in Making Capital InvestmentsThe natural tendency of corporate managers toward “kingdom building” is well-documented. We suspect that family business managers are not immune to this urge. Forcing corporate investments to compete with dividend payments for scarce capital can be a very helpful antidote to the tendency of corporate managers to over-invest. In fact, some researchers have concluded that the investment discipline associated with paying dividends actually contributes to better returns on capital and higher earnings growth.5. Dividends Help Bring the Trade-Off Between Future Growth and Current Income Out Into the OpenWhen asked if they want to maximize cash flow for current shareholders or growth for future generations, many shareholders respond with an emphatic “Both!” But in the economic world that we live in, that’s not really a feasible posture.Dividends are the most tangible manifestation of what the family business really means to the family. Identifying and – if needed – adapting the meaning the family business to the family is one of the most important tasks for senior leaders of the family.ConclusionProfessor Edmans makes some provocative suggestions in his Wall Street Journal article. While they may have some merit for public companies (which were, in all fairness, the professor’s intended audience), his suggestions do not translate well to most family businesses.Give one of our family business professionals a call to discuss the challenges you face in setting a dividend policy for your family business.

For many enterprising families, owning real estate is a cornerstone of family wealth.Here is a story that is common to many families:Once upon a time, the family business had grown to the point that it needed a new facility from which to operate. Rather than leasing the needed real estate, the first-generation shareholders cobbled together a down payment and took out a mortgage for the rest to buy the property. The owners then leased the property to the family business. The rent payments received from the family business were sufficient to service the mortgage debt and maintain the property. Decades passed, and steady capital appreciation in the real estate along with the debt retirement funded by rental payments from the family business resulted in the owners owning an attractive parcel of commercial real estate with no debt. Rinsing and repeating as necessary over the life of the family business, the value of the accumulated real estate portfolio became a significant portion of the family’s total wealth. Once the real estate holding was sufficiently deleveraged, the family elected to reinvest cash flow from the real estate portfolio in yet more real estate.Accumulating real estate seems to be a natural strategy for many family business owners.  After all, real estate is generally assumed to be less risky than the operating business of the family.  Further, so long as the real estate has a reasonable range of alternative future uses, the returns to the real estate portfolio often have a low correlation to the returns from the operating business.If the observable returns on publicly traded real estate investment trusts (REITs) are any indication, the current coronavirus-induced economic downturn may put those beliefs to the test.  While, through the end of mid-June, broader market indices have regained much of the value lost during late February and March, REIT shares have lagged, as shown in Exhibit 1. To the extent public market behavior is a guide to broader valuation trends for family businesses, the data presented in Exhibit 1 suggests that – rather than providing stability to family wealth – real estate holdings may have actually contributed to overall volatility.  We were intrigued by this, so we decided to take a closer look at the data. As summarized in Exhibit 2, we examined share price data for the 167 REITs in the Russell 3000 index for which comprehensive data was available through Capital IQ.The overall average price change was -22% over the period. Receipt of distributions during the first five months of the year would enhance the total return for most REITs by about 2%, give or take.Performance was driven by property type. Unsurprisingly, hospitality and retail REITs underperformed, falling 47% and 38%, respectively, while industrial REITs led the way with an average price increase of 3%.Apart from the hospitality and retail sectors, REITs announcing dividend increases outnumbered those instituting cuts by a nearly 2-to-1 margin (33 increases to 16 decreases). On a combined basis, the hospitality and retail sectors saw 28 dividend reductions, compared to just 4 increases.  Of those announcing dividend cuts, over half (19) were REITs that totally suspended dividends.REIT share prices are closely tied to dividend expectations. As shown in Exhibit 2, the average price change for the 44 REITs cutting dividends was -43%, compared to -19% for those with no announced changes and -4% for the 37 REITs which increased dividends.TakeawaysWhat should family business leaders think about with respect to their current (and future) real estate holdings considering the performance we have reviewed in this post?The pandemic may have fundamentally changed the demand for real estate in our economy. Consider the office sector: even though only one REIT announced a dividend cut, the share price for the average office REIT fell 24% from the end of 2019.  This occurred despite a decrease in interest rates, as the 10-year treasury yield fell from 1.92% to 0.75% over the same period.  This suggests that the market is concerned about longer-term trends in demand for space and lease rates following a lengthy mandatory “work from home” experiment.  In contrast, the (relatively) strong performance of industrial REITs suggest that the market may perceive a future trend toward more domestic manufacturing, as well as the increased need for warehouse space to meet the fulfillment demands of web-based retail.Correlations between real estate and the performance of your operating business may be higher than previously assumed. For example, the move toward on-line shopping has been such a pervasive trend that owning a portfolio of commercial real estate zoned for retail is probably not much of a hedge for struggling family businesses in the retail space.  For families contemplating additional real estate investments, it may be worthwhile to balance the temptation to “invest in what you know” against opportunities to better diversify the family balance sheet by looking outside your industry for real estate investments.  For example, a family in the manufacturing business may look to reinvest cash flow in health care or residential properties rather than taking on more exposure to the industrial economy.Perhaps even more than politics, all real estate is local. We have not attempted to discern any geographic trends in the data we analyzed for this post.  Family business leaders should carefully evaluate the local market dynamics that are influencing the value of real estate portfolios.For families with real estate held outside the family business, this may be a fortuitous time for estate planning strategies involving real estate holdings. Consult your tax advisor to see if real estate transfers could make sense for you.How do rents paid by the family business compare to the current market? If there are significant differences from market rents, that can introduce distortions among family members that own differing proportions of the family business and the family’s real estate holdings.Finally, it may be a good time to evaluate your overall real estate strategy. Do you have one?  What economic role does real estate play in your family’s overall balance sheet?  What role should it play?  More broadly, what does your family business “mean” to your family?  Is there alignment among your family shareholders regarding that meaning?  How well do your family’s real estate holdings align with that meaning? Of course, markets move every day, and the market signals regarding commercial real estate may be quite different a month or a year from now.  We are not recommending knee-jerk reactions, but we do think real estate strategy would be a worthwhile addition to your next board meeting agenda.

In last week’s post, we demonstrated how critical getting the level of value right is for family businesses for estate planning, acquisitions, and divestitures. We conclude our series on the levels of value this week, by turning our attention to shareholder redemption transactions.Shareholder RedemptionsA shareholder redemption is a purchase by the family business of shares from a family shareholder.  As with our corporate development and divestiture examples from last week’s post, shareholder redemptions reflect an inherent tension between buyers and sellers, as illustrated in Exhibit 1.In a shareholder redemption transaction, the buyer and seller do not share the same perspective.The selling shareholder owns an illiquid minority interest in a private business. As a result, the fair market value – the amount that a hypothetical willing buyer would pay – reflects a marketability discount.  In other words, the nonmarketable minority level is relevant.However, in a shareholder redemption transaction, the buyer is not a hypothetical party, but the company that issued the shares in the first place. The family business is not burdened by the illiquidity of the shares in the same way a shareholder is.  As a result, the value of the shares to the family business is consistent with the marketable minority level of value. It strikes us as a bit perverse to evaluate transactions between family shareholders and family businesses in terms of relative negotiating leverage.  Instead, we prefer to frame the decision in terms of family business objectives: What is the purpose of the redemption? The “correct” price at which to conduct a shareholder redemption transaction is always a bit ambiguous.  Consider the alternatives:Nonmarketable Minority Level. This seems straightforward – after all, that is the fair market value of what the shareholder owns.  Why should the family business pay any more than that?Marketable Minority Level. On the other hand, this is the value of what the redeeming company is acquiring.  Why should the family business pay any less than that? From an economic perspective, a redemption at the nonmarketable minority level is accretive to the non-selling shareholders.  Redeeming at the marketable minority level provides a windfall to the selling shareholder relative to the fair market value of their shares.  There is no simple escape from this dilemma.If the family business wants to discourage redemption requests, the nonmarketable minority level of value may be preferable.If the family business is designing a shareholder liquidity program with a view to promoting positive shareholder engagement, it may be desirable to conduct redemptions at the marketable minority level of value. However, in such cases it is essential to set limits on the amount of redemption requests the family business will honor in a given period; otherwise, the liquidity program could trigger a “run on the bank,” crowding out corporate investments critical to the long-term sustainability of the family business.If the objective of the redemption is to “prune” the family tree of unwanted branches, it may be necessary to pay a redemption price at the marketable minority / financial control level of value. Depending on state statute, it may be a legal necessity.  In any event, the departing shareholders are likely to demand such pricing to exit the family business.ConclusionIn this series of posts, we have explained what the levels of value mean.  Your family business has a different value at each level of value because of differences in expected cash flows and risk factors.  Considering four common corporate transactions, we have illustrated why the level of value matters to family businesses:When transferring minority interests among family members in furtherance of estate planning objectives, the fair market value of the interests transferred is properly measured at the nonmarketable minority level.When considering a potential acquisition, family businesses should evaluate both the marketable minority / financial control level of value (what the target is worth to the existing owners) and the potential strategic control level of value (what the target is worth to the family business). These two values for the target define the relevant range for negotiating a transaction price.When divesting a business, the dynamics are reversed. The relevant negotiating range is set by the difference between the marketable minority / financial control level of value (in this case, what the business is worth to the family) and the strategic control level of value (what the business is potentially worth to the buyer).  The family can improve its negotiating leverage in these situations by differentiating the business from other available targets and exposing the business to multiple motivated buyers.Finally, shareholder redemptions can occur at either the nonmarketable minority or marketable / minority financial control levels of value. The appropriate level for a given transaction should be selected with a view to the objectives of the redemption for the family business. These transactions can have profound and long-lasting economic implications for the family business and its shareholders.  When the stakes are high, it’s a good idea to measure twice and cut once.  When your family business is preparing for any of these transactions, give one of our valuation professionals a call. See Part 1 of this series here. See Part 2 of this series here.

In last week’s post, we defined the three principal levels of value and explained that the levels reflect differing perspectives on expected future cash flows and risk.  This week, we turn our attention to the importance of the levels of value for family businesses. One of the great strengths of a family business is the ability to take the long view.  Unburdened by the quarterly reporting cycles of publicly traded companies, family businesses can make investing and operating decisions for long-term benefit without worrying about the effect on next quarter’s earnings.  One of the foundations of this long-term perspective is the stability of ownership within the family. With an indefinite holding period, why does the value of the family business even matter?  While the family may have an indefinite holding period, the fact of mortality means that individual shareholders do not.  So, even for committed families, transactions will occur, and valuation will matter.  In our next two posts, we consider four potential transactions in which getting the level of value right matters a lot.Estate PlanningMany family shareholders will determine that it is advantageous to transfer wealth to heirs while still living.  Regardless of the specific technique used, the value of shares in the family business is a cornerstone of estate planning.  Under the IRS’ definition of fair market value, the appropriate level of value depends on the attribute of the block of shares being transferred.  Since estate planning almost always involves transactions of minority interests in the family business, the nonmarketable minority interest level of value is relevant.Measuring the value of shares in the family business at the nonmarketable minority interest level of value is a two-step process.  First, we consider what the shares would be worth if they were traded on an exchange (i.e., the marketable minority level of value).  Second, we determine an appropriate discount to apply to that value to reflect the unfortunate side effects of owning a minority interest in a private company.  The magnitude of that discount depends on factors like the expected duration of the holding period until a liquidity event, the level of interim distributions, and the expected pace of capital appreciation.  When combined with an assessment of the risks facing the investor, these factors determine the marketability discount, which, in turn, defines the fair market value of the shares on a nonmarketable minority interest basis.Corporate DevelopmentFamily businesses have two basic pathways for growth: organic growth through capital expenditures (“build”) or non-organic growth through acquisitions (“buy”).  The pathways are not mutually exclusive.  Some families are culturally averse to acquisitions, while for others a disciplined acquisition strategy is part of the family’s business DNA.For family business acquirers, developing an appropriate valuation of the target is essential.  As one of our colleagues is fond of saying: “Bought right, half right.”  Regardless of the strategic merits of a proposed acquisition, overpayment will weigh on the returns available to future generations of the family.  When formulating a bid price for a potential target, acquirers should seek to answer two questions.What is the business worth to the existing owners? Selling their business to you means that the existing owners will be giving up the future cash flows they expect the business to generate under their stewardship.  This reflects the financial control level of value, which as we noted in last week’s post, is probably not much different from the marketable minority value.What is the business worth to us? To answer this question, acquirers need to carefully evaluate how the target “fits” with their existing business.  Will the combination of the two businesses generate revenue synergies (i.e., 2 + 2 = 5)?  Or are there duplicative costs that can be eliminated as a means of generating higher margins for the combined entity?  Perhaps the combination will reduce the risk of the family business, or perhaps the family has access to lower cost capital than the existing owners.  In any event, family business acquirers should develop forecasts for the pro forma combined entity using well-supported inputs that reflect the strategic case for the acquisition to determine what the business is worth to them. The difference between these two values defines the “space” over which negotiations will center.  The ultimate purchase price will reflect the relative bargaining power of the two parties.  As illustrated in Exhibit 1, bargaining power is a function of the number of likely buyers for the target, and whether the target represents a generic or unique opportunity for buyers.To avoid overpaying, savvy family business acquirers focus not just on what the target could be worth to them, but also what the target is worth to its current owners, along with a careful assessment of the factors that influence the relative bargaining power of the parties.DivestituresAt some point, many families transition to being enterprising families.  In other words, they are defined by the fact that they pursue economic opportunities together, rather than by continued ownership of the legacy family business.  In pursuit of broader portfolio management objectives, enterprising families may sell businesses from time to time.  In this case, the dynamics described in the preceding section are reversed.As the seller, you won’t have direct access to what your business could be worth to the buyer. However, knowing how your industry is structured and how your business operates, you should be able to estimate potential revenue synergies and cost saving opportunities available to the buyer.In order to achieve a sales price closer to the value of your business to the buyer, it is important to identify the attributes of your business that differentiate it from other potential acquisition targets available to buyers. Further, generating interest from a larger pool of buyers is essential to reaping greater proceeds from a divestiture.ConclusionIn this week’s post, we have demonstrated how critical getting the level of value right is for family businesses for estate planning, acquisitions, and divestitures.  Next week, we will look at the levels of value in the context of shareholder redemption transactions.  If you could benefit from an outside perspective on a pending transaction for your family business, give one of our experienced valuation professionals a call.See Part 1 of this series here.See Part 3 of this series here.

Family shareholders are occasionally perplexed by the fact that their shares can have more than one value.  This multiplicity of values is not a conjuring trick on the part of business valuation experts, but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives.  As shown in Exhibit 1, there are three basic “levels” of value for a family business.Each of the basic levels of value corresponds to different perspectives on the value of the business.  In this post, we will explore the relevant characteristics of each level.Marketable Minority Level ValueThe marketable minority value is a proxy for the value of your family business if its shares were it publicly-traded.  In other words, if your family business had a stock ticker, what price would the shares trade at?  To answer this question, we need to think about expectations for future cash flows and risk.Expected cash flows. Investors in public companies are focused on the future cash flows that companies will generate.  In other words, investors are constantly assessing how developments in the broader economy, the industry, and the company itself will influence the company’s ability to generate cash flow from its operations in the future.Public company investors have a lot of investment choices.  There are thousands of different public companies, not to mention potential investments in bonds (government, municipal, or corporate), real estate, or other private investments.  Public company investors are risk-averse, which just means that – when choosing between two investments having the same expected future cash flow – they will pay more today for the investment that is more certain.  As a result, public company investors continuously evaluate the riskiness of a given public company against its peers and other alternative investments.  When they perceive that the riskiness of an investment is increasing, the price will go down, and vice versa. So when a business appraiser estimates the value of your family business at the marketable minority level of value, they are focused on expected future cash flows and risk.  They will estimate this value in two different ways.Using an income approach, they create a forecast of future cash flows, and based on the perceived risk of the business, convert those cash flows to present value, or the value today of cash flows that will be received in the future.Using a market approach, they identify other public companies that are similar in some way to your family business. By observing how investors are valuing those “comps,” they estimate the value of the shares in your family business. While these are two distinct approaches, at the heart of each is an emphasis of the cash flow-generating ability and risk of your family business. We started with the marketable minority level of value because it is the traditional starting point for analyzing the other levels of value.Control (Strategic) Level of ValueIn contrast to public investors who buy small minority interests in companies, acquirers buy entire companies (or at least a large enough stake to exert control).  Acquirers are often classified as either financial or strategic.Financially-motivated acquirers often have cash flow expectations and risk assessments similar to those of public market investors. As a result, the control (financial) level of value is often not much different from the marketable minority level of value, as depicted in Exhibit 1.Strategic acquirers, on the other hand, have existing operations in the same, or an adjacent industry. These acquirers typically plan to make operational changes to increase the expected cash flows of the business relative to stand-alone expectations (as if the company were publicly traded). The ability to reap cost savings or achieve revenue synergies by combining your family business with their existing operations means that strategic acquirers may be willing to pay a premium to the marketable minority value.  Of course, selling your family business to a strategic acquirer means that your family business effectively ceases to exist.  The name and branding may change, employees may be downsized, and production facilities may be closed.Nonmarketable Minority Level of ValueWhile strategic acquirers may be willing to pay a premium, the buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value.  All else equal, investors prefer to have liquidity; when there is no ready market for an asset, the value is lower than it would be if an active market existed.What factors are investors at the nonmarketable minority level of value most interested in?  First, they care about the same factors as marketable minority investors: the cash-flow generating ability and risk profile of the family business.  But nonmarketable investors have an additional set of concerns that influence the size of the discount from the marketable minority value.Expected holding period. Once an investor buys a minority interest in your family business, how long will they have to wait to sell the interest?  The holding period for the investment will extend until (1) the shares are sold to another investor or (2) the shares are redeemed by the family business, or (3) the family business is sold.  The longer an investor expects the holding period to be, the larger the discount to the marketable minority value.Expected capital appreciation.  For most family businesses, there is an expectation that the value of the business will grow over time.  Capital appreciation is ultimately a function of the investments made by the family business.  Public company investors can generally assume that investments will be limited to projects that offer a sufficiently high risk-adjusted return.  Family business shareholders, on the other hand, occasionally have to contend with management teams that hoard capital in low-yielding or non-operating assets, which reduces the expected capital appreciation for the shares.  All else equal, the lower the expected capital appreciation, the larger the discount to the marketable minority value.Interim distributions. Does your family business pay dividends?  Interim distributions can be an important source of return during the expected holding period of uncertain duration.  Interim distributions mitigate the marketability discount that would otherwise be applicable.Holding period risk. Beyond the risks of the business itself, investors in minority shares of public companies bear additional risks reflecting the uncertainty of the factors noted above.  As a result, they demand a premium return relative to the marketable minority level.  The greater the perceived risk, the larger the marketability discount.ConclusionThe so-called “levels” of value reflect the real-world concerns of different investors in different circumstances.  Having provided a brief overview of what each level of value means, we will turn our attention in next week’s post to why the levels of value matter for family shareholders.See Part 2 of this series here.See Part 3 of this series here.

From time to time, Family Business Director will interview family business leaders or experienced advisors to get their perspective on important questions common to family businesses.  In this installment, we talk with Ralph Jones, Executive Chairman of Jones Family of Companies.  Ralph offers great insight that we know our readers will profit from.Brief Overview2020 starts our 84th year of manufacturing textile products and yes, textiles are still made in the United States.  Our company began as a yarn spinner founded by two brothers (my grandfather and great uncle) who grew up around textiles.  Their dad had been a journeyman specialist in weaving fabrics.  The brothers began spinning yarns in 1936 made from recycled textile byproducts for use in string mops, and today we continue that tradition but with a long story of morphing and changing throughout our history.  We continue to spin yarn domestically and source internationally, but have moved from a yarn centric company to one now led by production of nonwoven fabrics with manufacturing on both U.S. coasts.  We continue to use recycled fibers from the textile and ginning sectors for much of our production as well as other globally sourced man-made fibers.  Today we are led by a team of professional managers with our Executive Chairman (3G) being the sole family member involved day-to-day.1. What roles in the family business have you fulfilled over your career?I am the grandson of one of the founding brothers, and like many in a family business, I began my work while in high school working menial summer jobs in the manufacturing plants.  I joined the firm immediately after graduating from college and over my 40-year career, I have led most every aspect of the business including sourcing, sales management, business development, export development, growth, rightsizing, downsizing, strategic planning, M&A, succession planning, and eventually serving as President, CEO, and now Executive Chairman.  The one role I regret not having held was Plant Management.  In manufacturing, this is where the rubber meets the road.2. Does the family business still operate in its original industry, or has it pivoted/diversified into another? And what is the biggest challenge your family business has ever faced? Did being a family business make it easier or harder to meet the challenge?We were fortunate to put together a string of years of significant growth in domestic yarn spinning until the Asian currency crisis of the late 1990s decimated the U.S. textile industry.  This closed many U.S. textile companies and over one million domestic jobs were lost which made it difficult, if not impossible, to compete globally.  This timeframe became the greatest challenge our company had faced in its history.  Customers moved offshore or closed.  Over the course of time, we closed 5 yarn spinning plants and attempted to develop a greenfield facility in India.  We eventually learned that the distance to India was too great to manage, and we then developed strategic partnerships to source yarn products in order to maintain our competitiveness.  In the late 1980s we had acquired a small nonwovens facility and found that we could compete globally due to the low labor cost component and high freight cost barrier for our type nonwovens.  As our core yarn business shrank, we pivoted to nonwovens and added another acquisition, repurposed a yarn plant, added a West Coast facility and began growing this sector successfully in the 2000s.  Nonwovens manufacturing has now become our core business sector while continuing to operate a much smaller yarn spinning operation.  This transition was both a challenge and a blessing.3. How often does your family business communicate to family shareholders and in what form? How have your communication practices evolved over the years?Our family business ownership is now made up of 1-2G, 3-3G, and 16-4G owners and scattered across the country. Quarterly, I provide a state of the company communication to family shareholders, and we hold an annual Family Assembly.  The state of the company provides a general update on operations and business conditions.  It has grown in the amount of detail provided as the 4G family owners have matured and now that a 5th generation is among us.  We focus our Family Assembly on business education, business updates, and family fun.  We recently executed a legal reorganization and restructuring which will help the entire family better understand their ownership interests and, with intentional education, become more adept at being engaged family owners.  Included in our restructuring, we set aside 5% of our ownership for use as a long-term incentive for key managers.  Our current focus is on shareholder education and engagement.4. Does your family business have any independent (non-family) directors?  If so, when did you first add an independent director?  What are the challenges/benefits of having independent directors?In the early 2000s, as we were morphing into another type of company and our remaining 2G family member was retiring, we engaged two outside professional advisors for an advisory board.  They were not friends of the family but truly two individuals with strong business acumen that had run large family and non-family businesses.  They served our purpose for 15 years, but it soon became apparent that we were approaching another crossroad.As the lone 3G family member involved in the business, I began a conscious journey of succession planning.  This journey led me to the place of determining that I could serve the best interest of the company and family by stepping aside but not down.  My succession plan has led to the hiring of a professional CEO and instituting a full fiduciary board made up of 3 independent outside directors, our CEO, 2-4G family shareholders, and myself.  This gives us 4 non-family directors and 3 family directors.  My wife also sits in on board meetings as an observer.Before family members can serve on the board, they must commit to furthering their family business education at a highly acclaimed short course.  In this initial case, our 2-4G members, my wife, and I spent a week at Harvard’s Families in Business program. Of our three independent directors, two have family business experience and one has industry experience while each of them currently serve on either family business boards or public boards.  They are engaged and committed to seeing us succeed and are fully committed to our Judeo/Christian value system.I think we outkicked our coverage on these board members!  These last two years have brought us a professional non-family CEO and a majority non-family board that have certainly pushed management to adjust and learn to accept change.  Through it all, we have communicated to our associates and our family that our culture is becoming much more accountability-based but our values are sacrosanct!  They are all rising to the occasion!5. What is your best advice for other family business leaders?I have a few comments here: start your succession planning sooner rather than later (I wish I had), don’t fear the use of independent directors and/or professional managers but make sure your value systems are aligned and they bring the giftedness you need (we did and I wish I had done it sooner), educate your next-generation family board members on expectations of board membership (you can’t prepare them enough), and have your children work outside the business before joining it (I wish I had and now mine are)!

“All models are wrong; some are useful.”  George E.P. Box“When the facts change, I change my mind.  What do you do?”  Winston ChurchillFamily businesses devote time and resources to creating forecasts and budgets to guide resource allocation and strategy decisions.  Yet, the forecasts and budgets for 2020 that many family businesses spent months creating are now worthless.  So managers and directors face the task of revising and updating those forecasts amid a uniquely uncertain environment.The pandemic has caused businesses to reassess all sorts of practices – should your family business re-think how it makes forecasts?Granting that all models are wrong, what can family business leaders do to make their forecasts more useful?  After all, anyone can put anything into an Excel spreadsheet.  Useful forecasts are products of careful analysis.  Our English word “analysis” derives from the compound Greek word “ana-luein” which literally means to “loosen up” something.  So a useful forecast is one that “loosens” the whole into its constituent parts for better understanding.  In the remainder of this post, we provide some ideas of how to “loosen up” forecasting models to make them more useful.RevenueWhat are the component parts of revenue for your family business?  The most obvious place to start for many of our clients is by breaking revenue into physical volume and unit pricing.What are the economic factors that drive demand for your family business? How has historical sales volume been correlated to some broader, objective, measure of economic activity?   How has the pandemic influenced that relationship?What trends do you expect in unit pricing over the forecast period? Is your family business typically a price leader or price responder in your industry?  Do you propose lower pricing in order to secure more volume in the current environment?  Or, are you considering increasing price to help offset the revenue impact of reduced volumes? Some of our clients forecast revenue by constructing a sales funnel.  By examining prospect activity, they develop sales forecasts that are rooted in objective measures of the business activities that lead to sales.  For example, by examining historical conversion data, one can assign probabilities to revenue at various points along the sales funnel (X% of outstanding proposals turn into sales, and Y% of 2nd meetings turn into proposals, etc.). In any event, the goal is to reduce the general (revenue) to the specific (price/volume, lead generations, etc.).  By “loosening up” total revenue into its constituent parts, family business leaders can have more meaningful conversations at the appropriate level of detail to develop objective forecasts.ExpensesThere are multiple ways to “loosen up” expenses into various components.Fixed vs variable costs. While it is true that all expenses are variable in the long run, your family business is likely committed to incurring some expenses in the short-run (rent, depreciation, etc.).  Classifying expenses as fixed or variable can help identify the “breakeven” level of sales volume and can provide important perspective for long-term strategic decisions in the current environment.Expenses by functional area. Sometimes it is more fruitful to segregate expenses into functional areas (manufacturing, selling, distribution, research and development, general and administrative, etc.).  This perspective allows managers and directors to focus on what resources are necessary to fulfill the functions of the business, and may highlight opportunities to explore alternative models for executing certain functions.Expenses by nature. For many businesses, operating costs can be associated with either people or “stuff.”  Or somewhat more elegantly, costs can be divided into compensation and non-compensation expenses.  On the compensation side of the ledger, one can then isolate headcount and compensation rate factors.  This perspective can help managers and directors make strategic decisions regarding the relative use of labor and capital as means of production. Regardless of the perspective adopted, managers should also consider whether to forecast using a percentage change relative to the prior period or a zero-base.  Some advocate zero-base budgeting on an annual basis.  That has always struck us as a bit extreme, but the potential value from a zero-base budgeting process is probably heightened in the current operating environment. Useful forecasts do not focus exclusively on the trees.  It is important to keep the forest in view by assessing the operating margins implied by a forecast to assess the overall reasonableness of the underlying assumptions.Cash FlowCash flow is especially critical in difficult operating environments.  A useful forecast will make explicit the necessary assumptions regarding working capital management, capital expenditures, and financing obligations.  Doing so will highlight just where managers and directors may be able to exercise discretion to help conserve cash and preserve liquidity during the downturn.ConclusionDoes your family business generate useful forecasts?  Usefulness is not the same thing as accuracy.  A forecast can be very useful even if it turns out not to be accurate, just as a forecast that – by chance – turns out to be accurate may not be terribly useful.  A useful forecast is one that Churchill would approve of: one that can adapt to changing facts.  A useful forecast brings the key operating and strategic decisions that your family business needs to make out of the background and into the foreground, and helps frame those decisions appropriately.Over the past two months, our family business professionals have been assisting our clients in reviewing forecasts and assessing their usefulness.  If you could benefit from a fresh perspective on your forecasts, give one of our professionals a call to discuss your situation in confidence.

If a window of opportunity appears, don’t pull down the shade. – Management guru Tom PetersAs family business leaders tackle the many operating challenges thrust upon them by the COVID-19 pandemic, it is tempting to let tasks like estate planning fall to the bottom of the to-do list.  While estate planning may appear to be less pressing than other issues, the positive impact of effective planning on the long-term health of both the family and the family business is hard to overstate.  If you are confident in the long-term resilience of your family business, you should not miss the current opportunity for tax-efficient estate planning activity.We’ve discussed the impact of coronavirus on fair market value in a recent post.  While the S&P 600 small cap index has gained a bit over 20% since we wrote that post, the index remains nearly 30% below its February peak.  So valuations for many family businesses remain favorable for tax-efficient planning. Normally, stock prices and interest rates are inversely related.  In other words, lower stock prices are often correlated with higher interest rates.  However, thus far in 2020, we have witnessed both lower stock prices and lower interest rates.  As described in a recent article from law firm Baker Hostetler, low interest rates further increase the efficiency of estate planning techniques such as intra-family loans, sales to grantor trusts, grantor retained annuity trusts, and charitable lead annuity trusts. The IRS publishes monthly tables identifying what is known as the applicable federal rate, or AFR.  The AFR is significant for estate planning because it established the threshold interest rate for private loans.  Exhibit 2 summarizes monthly AFR rates in 2020. Mid-term AFR rates (applicable to loans with terms up to nine years) have fallen from 1.75% in February to 0.58% in May.  A quick example will illustrate the “double opportunity” for family shareholders provided by lower valuations and lower interest rates.First, assume that a family shareholder sells shares having a fair market value of $10 million to a family member in exchange for an eight-year note at the AFR rate of 1.75%.  The expected total return on the shares at that date was 8.0%.  Exhibit 3 presents the net shares transferred to the family member over the life of the note, assuming that shares are used to repay the note.Since the appreciation on the family business shares exceed the AFR, the borrower is able to service the debt and repay the note at the end of the term using only a portion of the shares owned, retaining approximately $6.6 million worth of shares in the family business.Exhibit 4 assumes that a similar transaction is undertaken in May 2020, with three differences:Because the share value is lower ($75 per share, compared to $100 per share in Exhibit 3), the acquirer is able to purchase a greater number of shares for the same $10.0 million price (133,333 shares, compared to 100,000 shares in Exhibit 3).Since the family business is assumed to be resilient, the current lower share price is expected produce higher future capital appreciation (10%, versus 8% in Exhibit 3). Under this assumption, the terminal share value in Exhibit 4 ($160.77) remains approximately 13% less than the corresponding value in Exhibit 3 ($185.09).  Expected annual appreciation of 12% would result in equivalent terminal share values.The lower AFR reduces annual interest expense on the note by $117,000, which reduces the drag on returns from the family business shares.The hypothetical May transfer results in an additional $4.1 million of value transferred relative to the hypothetical February transfer.  Approximately 68% of this increase is attributable to the lower share value (and correspondingly higher expected returns), with the balance attributable to the reduction in the AFR.ConclusionWe are not tax advisors, and the simple example in this post is intended only to illustrate the relative contribution of lower share values and lower interest rates on potential estate planning outcomes.  Consult your tax planning professionals today to discuss how best to take advantage of the “double opportunity” presented by depressed share prices and low interest rates.  Many strategies will require a current valuation of your family business, and our professionals are here to help.For those families that are confident in the ability of their family business to survive and thrive in a post-COVID 19 world, the window of opportunity is clearly open.  Don’t pull the shade.

Earlier this week, the Wall Street Journal featured an article on the challenges of succeeding at succession in family businesses.  Author Cheryl Winokur Munk made five recommendations to help families thrive during generational transfers:CommunicateStart earlyCreate a written planPlan a post-succession lifeLet go when it’s time This is a great list.  While families that are nearing a generational transfer have some very specific communication challenges, effective communication is essential regardless of where the family business is in the corporate life cycle.Communicating Dollars and CentsPositive engagement is enhanced when family shareholders receive regular communication.When it comes to financial matters, family business directors need to treat family shareholders as, well, shareholders.  One of the ironies of family business is the generally unspoken assumption that family shareholders are not entitled to adequate financial disclosure and transparency.  In other words, family shareholders are often entrusted with far less information than stockholders in public companies.  Whatever benefits such secrecy generates are very quickly overwhelmed by the suspicion, distrust, and discontent that naturally develops when communication fails.Positive engagement is enhanced when family shareholders receive regular communication under five primary headings.Financial ResultsPosting annual financial statements to a family portal is not the same thing as communicating financial results to family shareholders.  Communicating financial results means translating financial data into a coherent narrative that describes and illustrates the operating and financial performance of the family business over time and relative to appropriate benchmarks.StrategyCommunicating strategy complements the financial results provided to family shareholders.  The family business’s strategy provides the best lens through which to view the family business’s financial results.  Public companies provide a great template for distinguishing strategy from day-to-day operational decisions.  The task of investor relations for public companies is to ensure that current and prospective shareholders know what the strategy of the company is, not to expose every decision management makes to public scrutiny.  If your strategy is not easy to communicate, that may be a sign that your strategy could use some refining.ValueNo one with an investment portfolio would tolerate an investment advisor who refused to provide timely updates on the value of the portfolio.  Yet it is often assumed that family shareholders do not need to know the value of their investment in the family business.  For many family shareholders, their shares represent a large allocation of their personal portfolio.  Failing to communicate value forces those shareholders to make important decisions regarding the rest of their personal balance sheets with one eye closed.  There is simply no need for that.ReturnsAnnual return is how shareholders measure the performance of their investments.  Family shareholder returns come from (after-tax) dividends and changes in value of their shares.  Too many family business managers shy away from providing return data to family shareholders.  Failing to measure the return to your family shareholders does not keep the returns from happening.  The returns are accruing (or not) regardless of whether you are measuring them.  Measuring returns can introduce a potentially uncomfortable level of accountability to family business managers.  But what is the alternative?  Family shareholders will eventually calculate returns themselves.  It is better for the family business to provide a regular and consistent return calculation for the family shareholders, along with appropriate benchmarks and commentary regarding the sources of superior or lagging returns.ExpectationsDo your family shareholders know what “the long view” is for your family business?One of the greatest advantages family businesses possess is their ability to take the long view.  Do your family shareholders know what “the long view” is for your family business?  Avoiding the quarterly earnings treadmill is a good thing, but taking the long view should not be a smoke screen for hiding underperformance or failures to execute.  How does your family business’s strategy translate into expectations for revenue, earnings, and cash flow in future periods?  If the family business has made a conscious decision to forego current earnings, what is the expected payoff from that decision?ConclusionIf you want to build your family business to survive across multiple generations, you have to take communication seriously.  Generational transfer requires positive shareholder engagement.  And that, in turn, requires treating your family shareholders as shareholders when it comes to financial disclosures and transparency.  Doing so requires trust and, probably, some education.  In our experience, that investment is worthwhile.  Family shareholders who aren’t treated like shareholders won’t want to be shareholders for long.  And that could spell the end of your family business.

If the senior generation of your family business has not yet crafted their estate tax plan, today is the best day to start.  A new decision handed down from the Tax Court last week provides a timely reminder that the costs of procrastination can be very high.The case Moore v. Commissioneraddresses the estate of Howard Moore, who passed away in March 2005 at the age of 89.[1]  Mr. Moore was a classic self-made man, building an approximately 1,000 acre farm in Arizona (“Moore Farms”) which he sold for $16.5 million shortly before his death.  As described in the opinion, Mr. Moore and his family were a rather colorful cast of characters.The PlanIn a deft bit of foreshadowing, the introductory paragraphs of the Court’s opinion described the genesis of Mr. Moore’s ill-fated estate plan:“Howard Moore was born into rural poverty but over a long life built a thriving and very lucrative farm in Arizona.  In September 2004 he began negotiating its sale, but his health went bad.  He was released from the hospital and entered hospice care by the end of that year.Then he began to plan his estate.”One of the principal elements of the estate plan was the formation of the Howard V. Moore Family Limited Partnership (“the FLP”), to which Mr. Moore contributed an 80% interest in Moore Farms.  The plan included a number of other moving parts that we will ignore for the sake of brevity.The FLP included various restrictions on transfer.  Through a living trust, Mr. Moore sold his ownership interest in the FLP to an irrevocable trust at a 53% discount to the pro rata net asset value of the FLP.  Although the opinion does not directly say so, the discount was presumably a combined discount for lack of control and lack of marketability.  Upon Mr. Moore’s death, the tax return filed by the estate included the proceeds from the sale to the irrevocable trust among the estate’s assets.The ProblemsIn general, the Court was troubled by the timeline of events from late 2004 through Mr. Moore’s death in March 2005.In September 2004, Mr. Moore began negotiating the sale of Moore Farms to its eventual acquirer.In December 2004, Mr. Moore suffered a serious health setback, resulting in his entering hospice care.Following the beginning of his hospice care, Mr. Moore retained an attorney to prepare an estate plan. Within a matter of days in late December 2004, Mr. Moore set up the FLP, a charitable foundation, and a series of trusts.Within a few days of contributing Moore Farms to the FLP, Mr. Moore executed a contract for the sale of the farm.The sale of Moore Farms closed on February 4, 2005. The Court acknowledged that families often use partnerships such as the FLP.  However, to be effective for estate planning, there needs to be evidence of a “legitimate and significant nontax reason for creation of the family limited partnership and the transfer of assets to it” (page 31).  The Court rejected the estate’s contention that the principal reason for the FLP “was to bring the Moore family together so that they could learn how to manage the business without [Mr. Moore]” (page 32).The Court concluded that the sale of Moore Farms – which was contemplated prior to the formation of the FLP and executed within days of the FLP’s formation – undermined the estate’s argument.Further, following the sale of Moore Farms, the members of the FLP never met to discuss management of the FLP’s remaining assets.The estate also cited the need for creditor protection as a nontax motivation for the FLP, but at trial, none of the FLP members could identify either creditors or potential litigation threats.The Court found that Mr. Moore’s health problems and the short time from the implementation of his estate plan to Mr. Moore’s death undermined the purported nontax reasons for the FLP.The Court also concluded that the absence of any arm’s length negotiations among the members of the FLP as to its principal terms or relative ownership allocation indicated that the FLP was, in substance, a testamentary instrument for Mr. Moore.Finally, following the transfer of Moore Farms to the FLP, Mr. Moore continued unilaterally to manage the operations of the farm and live on the farm until his death. The Court found that, even though Mr. Moore was not the general partner of the FLP, he continued to make all decisions regarding the FLP’s operations.  With respect to the FLP itself, Mr. Moore used FLP assets to pay personal expenses. In short, the Court found that the FLP did not have any bona fide nontax purpose, and therefore, Mr. Moore’s estate properly included the proceeds from the sale of Moore Farms prior to his death.The PainIn the case of the Moore estate, the valuation discounts applied to determine the fair market value of the interest in the FLP were ultimately irrelevant, and the Court does not address the value of the FLP interests transferred in its opinion.  Instead, the Court found that the estate included the value of Moore Farms as if the FLP did not exist (and, essentially, as if the estate plan had never been made).The moral of the story?  By waiting too long, Mr. Moore’s estate plan was ineffective, and the expenses of creating and executing the plan, which were not insubstantial, were wasted.  With an earlier start to the planning process, it seems much more likely that the nontax purposes for the formation of the FLP could have been demonstrable and convincing.  Had the Court found the FLP to be valid for estate purposes, the savings to Mr. Moore’s heirs would have been substantial.ConclusionProper estate planning is a priority for well-run multi-generation family businesses.  Don’t wait until it’s too late to plan.  As we pointed out a few weeks ago, there’s a good chance we will look back on the current period of depressed asset prices as a uniquely efficient opportunity to accomplish estate planning goals.  We understand that may family businesses are facing very pressing and difficult challenges, but try not to let this opportunity pass you by.[1]     We are not attorneys, and our summary of the case and the conclusions that follow are offered from a strictly lay perspective.

We’ve made no secret of the fact that Family Business Director likes data.  We are not economic forecasters, so we are not attempting to make any predictions about the coronavirus or its economic effects.  However, in an effort to provide some context for ourselves, this week we decided to go back and examine some data from the Great Recession.Specifically, we analyzed the performance of a group of small- and mid-cap public companies over the period from 2006 through 2011.  This period allows us to see “normal” conditions prior to the crisis (2006 and 2007), two years of crisis performance (2008 and 2009), and two years of recovery (2010 and 2011).The group we selected for analysis consisted of 554 companies having median revenues in 2006 of $853 million.  We started with the current (March 2020) roster of companies in the S&P 1000 index (the sum of the S&P 400 Mid-Cap Index and the S&P 600 Small-Cap Index).  We then removed financial institutions and real estate companies so that we were considering the performance of “operating” businesses.  Finally, we removed companies that were not publicly traded through the entire period.  There is a potential selection bias, as our sample includes only those companies that continue to be publicly traded 10+ years later.  Nonetheless, it is the best we can do with our data resources, and we think the resulting data is still instructive.We constructed an aggregate income statement and statement of cash flows for the group.  You can see the detailed data here.  Sifting through the data, we make five observations regarding how businesses persevered through the Great Recession.Operating leverage can be managed. The first thing that struck us is how effectively companies were able to manage operating expenses to maintain profit margins.  The textbooks tell us that, because some costs are fixed in the short-term, margins expand as revenues grow and shrink as revenues fall.  While this is undoubtedly true, the data suggests that companies were able to manage costs more effectively than the theory would anticipate.Exhibit 1 summarizes annual growth in revenue and expense for the years analyzed.  In the face of a 15.6% drop in revenue during 2009, the companies in our sample trimmed expenses by 15.2%.  As a result, EBITDA margin fell only modestly that year, from 12.0% in 2008 to 11.5% in 2009.Exhibit 1 Annual Growth in Revenue and Operating ExpensesWhat steps can your family business take today to help preserve profit margins during a temporary revenue shortfall?  How do you balance the near-term benefit of such steps against the long-term sustainability of your family business?Working capital really is a source of cash during a downturn. Cash management takes on extra importance during a recession.  However, the data shows us that companies focused on working capital management can free up precious dollars by being intentional in inventory management and collections.  As shown on Exhibit 2, the companies in our sample “found” $20.8 billion of cash by reducing working capital levels.  For perspective, that’s nearly 12% of the total lost revenue of $175 billion during 2009.Exhibit 2Cash (invested in) / Provided by Working CapitalWhat strategies are available to your family business to help harvest cash from working capital during this cycle?Companies become more disciplined investors. One of the first things companies did to conserve cash during the Great Recession was to curtail investment spending on M&A and capital expenditures.  Exhibit 3 depicts investment spending over the period.  Relative to the 2007 peak, total investment spending decreased nearly 80% to the 2007 trough.Exhibit 3Aggregate Investment SpendingThe data doesn’t reveal the answer to the most relevant question: what was the long-term impact of the dramatic reduction in investment spending in 2009?  Revenue growth accelerated in 2010 and 2011 to rates higher than those experienced in 2007 and 2008.  Part of that is likely attributable to pent-up demand from the weak results in 2009, but it does at least give us pause to wonder what portion of “ordinary” investment spending is effectively squandered by companies.How will your family business prioritize investment opportunities during the Coronavirus downturn?Borrowers reduced debt levels. Whether by choice or by lender demand, companies repaid debt during 2009, in contrast to other years in which incremental borrowing is the norm.  Exhibit 4 illustrates the net change in debt in each year over the period.  After effectively eliminating incremental borrowing in 2008, the companies used $29 billion of available cash flow to pay back debt during 2009.  For context, that represents about 83% of the $35 billion reduction in investment spending that year compared to 2008.Exhibit 4Net Incremental Borrowing (Repayment of Debt)What is the status of loan covenants, credit line availability, and other factors that can influence your decision (or need) to borrow or repay debt in a downturn?Dividends were much less affected than share buybacks. Of the 274 dividend payers in our sample, only 57 reduced per share dividends during 2009, reflecting the powerful signaling property of dividend payments.  Reducing the annual dividend is likely the last resort for public companies seeking to conserve cash.  However, as shown on Exhibit 5, public companies tend to use more cash in share repurchases than dividend payments.  From more than $28 billion in 2007, share repurchases fell to $19 billion in 2008, and bottomed out at $4 billion in 2009.  The irony, of course, is that due to the depressed share prices, 2009 is precisely when repurchasing shares would have had the highest prospective return for public companies.Exhibit 5Aggregate Shareholder DistributionsMost family businesses don’t redeem shares as aggressively as public companies.  As a result, suspending redemptions won’t conserve as much cash as it will for their public brethren.  How have you prepared your family shareholders for a potential reduction in dividends?  For shareholders deriving a significant portion of their annual income from family business dividends, any reduction can be unpleasant.  How will you prioritize dividend payments against investment spending and debt reduction?  Do your family shareholders know what your dividend policy is?ConclusionAs we said at the outset, we are not professional economic forecasters.  There are certainly many elements of our current situation that are far different than what we encountered over a decade ago.  That said, the Great Recession was no walk in the park, either.  Yet, companies of all shapes and sizes survived.  As we have noted in previous weeks, it is our firm conviction that family businesses are better-suited to handling the type of adversity we are currently facing than non-family businesses.

As family business leaders continue to make hard decisions in real-time against the ever-changing backdrop of the pandemic, their legal and tax advisors would do well to consider whether this is an opportune time for intra-family ownership transfers.  For many family businesses, the current economic uncertainty presents a unique, and perhaps fleeting, opportunity for more tax-efficient estate planning.Wall Street vs. Main StreetInvestors value the shares of public companies on a (nearly) continuous basis.  It should not be too surprising that these “real-time” valuations are subject to a good bit of volatility.Is the value of your family business that volatile?Unlike public companies, private family businesses are not subject to continuous public valuation.  Reliable valuation data points for family businesses exist only when a competent business valuation is prepared or when there is an arm’s-length transaction with a third party.  As a result, whatever day-to-day volatility exists in the value of your family business is not visible.  However, just because you can’t see it doesn’t mean it’s not there.  Instead, what is often assumed to be limited volatility in the value of a family business is more likely a function of the limited frequency with which value is observed.The same fundamental factors that influence public stock prices – risk assessments, growth expectations, and cash flow projections – also influence the value of private family businesses.We say all that to say this: unless you are a grocer or the like, the value of your family business is likely lower today than it was two months ago.The (Potential) Silver Lining In All of ThisAt this point, you may be thinking that, even if the value of your family business is currently depressed, you have no intention of selling today.  But even for families that have no intention of selling in the current environment, the fact that the value of your family business has declined should not be ignored.One of the cornerstones of estate planning is the concept of fair market value (“FMV”).  Fair market value is the price at which shares in family businesses can be gifted or otherwise transferred when executing estate planning.  In general, the lower FMV is, the more efficiently shares can be transferred in pursuit of estate planning goals.IRS regulations (Revenue Ruling 59-60) define fair market value as:“The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.  Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”Fair market value does not depend on whether you are willing to sell your family business today.  What does matter is the price that would be received, were a transaction to occur today.  And if a transaction were to occur today, the price would reflect the same uncertainty that we see manifest in public markets.  In case there was any doubt about this, Revenue Ruling 59-60 offers the following additional guidance, which seems almost prophetic with regard to where we find ourselves today:“The fair market value of specific shares of stock will vary as general economic conditions change form ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal.  Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.”As the number of confirmed coronavirus cases across the globe grows, we do not yet have a clear sense of what the long-term economic toll will be.  Large-scale restrictions on social gatherings are having an immediate effect on the dining, entertainment and other service industries.  The size of the economic ripples on other sectors is hard to forecast.  However, the real-time impact of the uncertainty on public securities market can be measured.Family business directors are currently facing many pressing issues.  Amid all of the chaos, however, directors should know that the estate planning opportunities triggered by lower valuations may not last.  Schedule a quick call with your estate planning advisors to see if there are steps you can take to help reduce the burden of future estate taxes on your family business.

While we respect the fundamental divide between Wall Street and Main Street, the official end of the bull market for public stocks signals that Coronavirus-induced disruptions to the global economy are real and are expected to persist.  As the pandemic unfolds, the economic effects will eventually reach Main Street, where most family businesses operate.  The stock market tends to be the best leading economic indicator, so family business directors would do well to think about how best to position their businesses to weather the slowdown.We are not predicting that there will, in fact, be an official recession, or even how long or significant the economic slowdown will be.  However, sluggish economic growth during at least a portion of 2020 seems inevitable at this point.  A little over a year ago, we asked our readers whether their family businesses were ready for the next recession.Times of stress like the current period highlight some of the principal benefits of being a family-owned business.  Unlike public company managers and directors, family business leaders can respond to current circumstances with a long view in perspective, not worrying about next quarter’s earnings release.  That long view includes a focus on operating efficiency, balance sheet strength, and competitive dynamics.Operating EfficiencyA great economy can obscure inefficiencies in your family business.  A slowing economy can reveal exactly where actions are needed.  From the perspective of a family business, this can be viewed as an opportunity rather than a necessity.  Improving operating efficiency is not about boosting next quarter’s earnings, but rather enhancing the long-term sustainability of the family business.  A slowdown can be an opportune time for making strategic investments in technology, systems, and processes that will pay dividends both during, and well after, the slowdown.Balance Sheet StrengthIt is more challenging to adapt the family business balance sheet on the fly.  Just as the best time to plant a tree is twenty years ago, the best time to secure favorable credit facilities is before everyone sees a slowdown coming.  Nonetheless, it is never too late to engage with your bankers to review covenant compliance and ensure that access to existing lines of credit will not be interrupted if and when needed.The best way to enhance financial flexibility in anticipation of an economic slowdown is to identify unnecessary or non-operating assets.  Capital is precious in a downturn, and you don’t want to “waste” capital by funding assets that don’t actually support the operations of the family business.Working capital: Have your cash collections been stretching out?  Do you have excess inventory?Fixed assets: Do you have idle productive assets or excess warehouse capacity?  Is your administrative office space consistent with how work actually gets done these days (telecommuting, etc.)?Other: Does the family business own assets that are really for the private enjoyment of select family members?  Now may be the right time for the business to sell those assets to the family members that actually use them.The best way to enhance financial flexibility in anticipation of an economic slowdown is to identify unnecessary or non-operating assets.Competitive DynamicsTaking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity.  You don’t have to outrun the bear as long as you can outrun the other hunters.  An economic slowdown can prove to be a prime opportunity to solidify your family businesses’ long-run competitive position.It’s not for the faint of heart, but strategic acquisitions during a downturn often provide better long-term returns than those made at the top.  If a buyer’s market develops, do you have a strategic plan for what businesses your family business would want to acquire at opportunistic prices?ConclusionWe hope that the economic slowdown triggered by COVID-19 is short and shallow.  Regardless of the duration and intensity, however, family business directors should view the challenge it presents as an opportunity to take the long view.  The reality of the coronavirus should cause all of us to change some of our ingrained personal habits not just to avoid infection in the near-term, but to live healthier lives in the long-run.  In the same way, family business directors should focus on taking prudent steps to manage not just the near-term economic slowdown, but to position their family businesses to thrive for future generations.

A presentation by Mercer Capitals’, Travis W. Harms, CFA, CPA/ABV, that provides an overview of the economic benefits of owning shares in a family business.

According to author Christopher Booker, all stories fit into one of seven basic plots. While details of character, narrative perspective, setting, and the like can make stories appear quite different from each other, any story can ultimately be reduced to one of a handful of basic plots.  With respect to literature, we have no idea whether Mr. Booker’s thesis is sound or not, but we have long suspected that something similar is true for family business.  Like stories, no two family businesses appear the same, as demonstrated by the old saw that if you have seen one family business, well, then you’ve seen one family business.  Yet, despite their many unique attributes, there are only a few basic underlying plot structures that family businesses follow.More than any other financial statement, the statement of cash flows reveals the basic plot of your family business.  The statement of cash flows is the least understood financial statement, so family leaders often ignore it when attempting to communicate financial results to their family shareholders.  But for those who know what they are looking for, the statement of cash flows reveals what a company is really up to.This week, we conclude our series of posts on communicating financial results to family shareholders.  Having focused on telling the story of the family business through the balance sheet and income statement, we turn our attention this week to the statement of cash flows.The Statement of Cash FlowsYou can discern the basic plot of your family business by answering two questions.  First, what time is it?  Second, how are we managing financial risk?What Time Is It?For farmers, the changing of the seasons dictates whether it is time to plant or time to harvest.  Family businesses are not tied to the cycle of seasons.  But at any given time, a family business is either planting or harvesting, and the statement of cash flows tells us what time it is.The statement of cash flows allocates the cash flows of your family business into three categories: operating, investing, and financing.  Comparing the operating and investing cash flows reveals what time it is for your family business.  The operating cash flows are those generated by the existing operations of the business.  The investing cash flows represent the amounts reinvested in the business (generally either through capital expenditures or business acquisitions).Exhibit 1 illustrates how the investing and operating cash flows interact to reveal the “time” for your family business. If the investing cash flows (the money being put into the business) exceed the operating cash flows (the money coming out of the business), it is planting time for your family business, as is the case in Exhibit 1.  For family businesses in harvest mode, the opposite is true, and operating cash flows are greater than investing cash flow. Since investing cash flows are often lumpy, we find it best to look at the statement of cash flows on a multi-year basis.  Examining cash flows on a rolling three or five year basis helps to eliminate the “noise” that may creep into the results for a single year in which a major capital expenditure of acquisition is completed. Your family shareholders should know what time it is for your family business, and why.  It is not unusual for companies to oscillate between planting and harvesting over time, so a format like that in Exhibit 1 can be used with either historical or prospective cash flows, depending on what message you need to convey to your family shareholders. How Are We Managing Financial Risk?Family businesses manage financial risk through capital structure, or deciding how much money to borrow.  Companies that are in planting mode need additional capital, and that capital can come from the bank or from shareholders.  In contrast, family businesses that are harvesting have “excess” capital to return to capital providers.Exhibit 2 illustrates how family businesses manage financial risk through capital structure. Our planting company from Exhibit 1 needs $17 million of outside capital (the excess of investing over operating cash flows).  That capital can come from lenders or in the form of new equity from shareholders.  Relying primarily on debt increases the financial risk of the company, all else equal.  It also potentially increases future returns to family shareholders. If it is harvest time, the family business will have “excess” capital that can be used either to repay debt or distribute to shareholders through dividends or redemptions.  Repaying outstanding indebtedness is the more cautious approach for harvesters, while making distributions to shareholders is the more aggressive path. Bringing It All Together: What Is the Plot for Your Family Business?Together, the two questions answered by the cash flow statement (What time is it? How are we managing financial risk?) reveal the basic underlying plot for your family business.  Exhibit 3 outlines the four basic plots. The black checkmarks in Exhibit 3 indicate the dominant story threads for each plot, while the grey checkmarks identify secondary themes that may or may not be present in a particular story. Plot #1 :: Aggressive Planting. When family businesses finance their capital needs during planting season with debt, they are following the aggressive planting script.  This is the most nail-biting plot of them all, with the uncertainty of future returns from current investment compounded by increasing financial leverage.  If the borrowing is accompanied by shareholder distributions, the risk profile is even more elevated.Plot #2 ::Cautious Planting. Occasionally family businesses in planting mode will opt to finance their capital needs with new equity rather than debt.  Family businesses often eschew seeking outside (non-family) equity capital, so this plot is less common.  However, with the number of investment funds seeking minority stakes in family businesses increasing and the growing use of joint ventures and other “synthetic” equity raises, this plot may become more prevalent.Plot #3 :: Aggressive Harvesting. Harvesters have “excess” capital to dispose of.  Aggressive harvesters prefer to leave existing debt outstanding and distribute to shareholders in the form of dividends or share repurchases.  The most aggressive harvesters actually continue to borrow more money to fund even more substantial shareholder distributions.Plot #4 :: Cautious Harvesting. More risk averse harvesters view the “excess” capital at their disposal as an opportunity to repay outstanding debt.  In other words, rather than provide an immediate return to family shareholders, the companies use the proceeds from harvest to reduce the risk profile of the family business and/or prepare the balance sheet for the next planting cycle. The narrative details for your family business will be as unique as your family.  Yet, the underlying story for your family business ultimately fits into one of these four basic plots.  What is yours?ConclusionOur objective in this series of posts has been to give our readers some examples of how to communicate financial results more effectively.  Financial statements include lots of financial data.  The first step in effective communication is identifying the key themes that really matter to family shareholders.  Exhibit 4 recaps the key themes we have identified from each financial statement.Focusing on these key themes will help you prune away unnecessary numbers and details, allowing you to communicate in a way that can actually promote positive engagement among your family shareholders.  And that is an investment with a high return.

Family Business Director recently started watching Christopher Nolan’s 2010 movie Inception.  While we are not really competent to comment on the artistic merits of the film, we were more than a bit confused by some of the dream-within-dream-within-dream sequences and the generally non-sequential plotline.  We took some comfort from the fact that at least one website devoted to this sort of thing ranked Inception as one of the most confusing movies ever made.If the balance sheet is a still photo, the income statement is a movie.If the balance sheet is a still photo, the income statement is a movie.  While the balance sheet records the assets and liabilities of your family business at a particular point in time, the income statement is a record of the revenue earned and expenses incurred by your family business over time. Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively?  In this series of posts, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful.  In the last post, we focused on the balance sheet; this week, we turn our attention to the income statement.The Income StatementWhen communicating results from the income statement, you don’t want your family shareholders to feel the way we did while watching Inception.  If the income statement is the movie that tells the story of your family business, the goal should be to make the plotline as transparent and easy to follow as possible.  The primary threads of the plotline for your family business as revealed in the income statement are growth, margin, and return on investment.GrowthGrowth is essential to family business success.  As pointed out recently by David Wells, the “average” family needs to earn anywhere from 8% to 10% annually to maintain real, after-tax, per capita family wealth over time.  Since growth is so important, family business managers should emphasize the trend in revenue over time when communicating results to family shareholders.However, revenue growth alone does not tell the full story for most family businesses.  After all, the business earns revenue by producing a good or providing a service, and revenue is the product of the volume of goods produced or services rendered and the effective price received per unit of activity.  For some businesses, a volume metric is obvious (i.e., cases sold); for others, a bit more creativity may be required.  Regardless of the specific volume measure, however, the underlying story is the same: revenue growth is a function of changes in the quantity of goods or services sold, and changes in the effective price received for such goods or services. Exhibit 1 illustrates how breaking revenue into activity and pricing measures can add texture to revenue growth discussions.  Exhibit 1 highlights for family shareholders that the growth attributable to selling more cases of product has been augmented by price increases to drive even faster revenue growth.  The same type of presentation can then be used to discuss plans for the future.  Telling shareholders that you expect revenue growth is pretty abstract; telling them that you anticipate selling 7% more cases at a 3% higher price is much more concrete and understandable. MarginRevenue is the source of everything good in business.  But your family shareholders benefit only to the degree that revenue outruns expenses.  Profit margin measures the efficiency with which you convert revenue into profits.  In other words, how many dollars of profit does your family business wring out of $100 of revenue?As with revenue, the challenge for communicating margins to family shareholders is to move from the abstract (our EBITDA margin was 20% last year) to the concrete (we spend these proportions of our revenue on these expenses).Exhibit 2 illustrates one way to depict the family business’s profit margin in a more concrete and understandable manner. One virtue of the presentation in Exhibit 2 is that it aligns the concept of profit margin with the functional areas of the business.  In other words, it clarifies how much of the company’s revenue goes to funding the various necessary functions of the business.  This helps to remove much of the mystery about how the family business actually makes money.  It also helps link profitability to business strategy by providing perspective on potential investments.  For example, if we spend 2% more to acquire higher quality raw materials, we will be able to save 4% on manufacturing costs. The presentation in Exhibit 2 relates to a single period.  By establishing that base, then you can easily benchmark those results against available peer data or the family business’s own performance over time.  Tracing where the company’s revenue goes is a great way for your family shareholders to better understand your current profit margin, along with the opportunities and challenges facing the business. Return on InvestmentInvestors are much more interested in how to earn more per dollar invested.One surefire way to double the interest you earn on your savings account is to double the amount on deposit.  While that strategy works, it’s not really what investors want to hear.  Investors are much more interested in how to earn more per dollar invested.  Yet, when companies report results to their shareholders, they often focus exclusively on the amount of income (profits increased 30%!) while ignoring the question of how much was invested.  Return on invested capital (ROIC) is our preferred measure of financial performance for family businesses because it takes into account both earnings and the capital invested to generate those earnings.In its simplest form, ROIC is the ratio of NOPAT (net operating profit after tax) to invested capital (the sum of equity and debt capital invested in the business).  So if the 30% increase in profits referenced above was achieved only after increasing the capital invested in the business by 40%, that’s really not such a good thing.  Exhibit 3 helps to emphasize that ROIC depends on both the income generated by the business and the amount of capital invested. ROIC is an especially effective tool for capital allocation decisions within multi-segment family businesses.  As shown in Exhibit 4, family shareholders can benefit from a clear presentation of how much capital is allocated to each segment of the family business, how returns compare among business segments, and how returns compare to a specified hurdle rate. Exhibit 4 helps family shareholders see both the relative capital allocation to each segment and how the returns for those segments relate to the target return of 12%.  This sort of presentation can help prepare family shareholders for important discussions about investment priorities going forward.ConclusionThe income statement is the story of your family business, and it is important to tell that story well for the benefit of your family shareholders.  Telling the story of the family business is probably not the best time to channel your inner auteur, however.  Instead, stick to the basics and focus on an easily-grasped narrative arc that emphasizes growth, margin, and return on investment.  Your family shareholders will thank you.

Suppose that your exposure to the French language consists of two years of high school classes twenty-five years ago.  Imagine how frustrating it would be if suddenly the only news outlet available to you was Le Monde.  With no small effort on your part, there’s a good chance you would be able to discern the broad outlines of the day’s events, but the odds of misunderstanding a key part of the story would be high, and any subtleties or nuance in the writing would be totally lost on you.Communication promotes shareholder engagement, but what does it look like to communicate financial results effectively?That is likely how many of your family shareholders feel when it comes to comprehending the financial results of your family business.  Perhaps they took an accounting course at some point in their lives.  Or simply by virtue of having grown up around the family business, they have developed a vague sense of the differences between revenue and equity, or assets and expenses.  As a result, when they read a financial report, they are generally able to discern the broad outlines of performance for the year or quarter, but the odds of misunderstanding a key part of the story are high, and any subtleties or nuance beyond the most rudimentary data are likely to pass them by.Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively?  In this series of posts, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful.  We start in this post with the balance sheet.The Balance SheetThe balance sheet is a snapshot of what the family business owns, and what it owes, at a single point in time.  The most important balance sheet concepts to communicate to family shareholders are scale, composition, and efficiency.ScaleIs $1 million a lot of money?  The answer to that question depends, of course, on your perspective.  For a family-owned restaurant, it may be everything; but for Ford Motor Company, it is a rounding error.  To have any meaning, balance sheet totals need context.  As a raw data point, the fact that your business has net fixed assets of $205 million is meaningless to your family shareholders.  To really communicate scale, you need a reference point, whether a prior date in your family business’s history, a contemporary peer, or some other benchmark.  Exhibit 1 is an example of contextualizing balance sheet scale. Exhibit 1 helps communicate scale more effectively in several ways. The icons help reinforce that financial statement balances aren’t just numbers, but correspond to actual stuff in the real world. The family business doesn’t exist to generate financial reports, but to produce real goods or provide real services.Comparing the balance today with that from a decade ago helps to give a sense for what $205 million really means. The meaning of a $205 million fixed asset balance today would be completely different if the balance in 2010 had been $300 million instead of $65 million.The average annual investment figure helps family shareholders to appreciate the cumulative nature of capital investment, and the fact that the need for capital spending is ongoing even though actual expenditures may occur only sporadically.The growth rate provides a benchmark for evaluating other parts of the company’s story, such as revenue growth or the growth rate in other asset categories.CompositionIt is also important for family shareholders to understand the relative proportions of the balance sheet.  With regard to the left side of the balance sheet, how are the total assets of the business allocated among the primary asset categories?  The most important takeaway from the right side of the balance sheet, which consists of liabilities and equity, is the relative mix of funding sources used to finance the business.It is hard to beat a pie chart or area model for demonstrating the composition of a whole.  Exhibit 2 illustrates one way to use area models to communicate the composition of the balance sheet.The balance sheet presentation in Exhibit 2 is effective for a several reasons.First, we have grouped individual line items together in order to reduce the “clutter” found on too many balance sheets. Detail that is appropriate for managers or even directors to consider just distracts from the overall message when the goal is communicating with shareholders.Second, we rearranged things a bit, netting non-debt liabilities against the left side of the balance sheet. This isolates the total invested capital entrusted to management, and helps prepare shareholders for an emphasis on return on invested capital as a primary performance measure.Finally, presenting the various balance sheet categories at scale conveys the relative composition of the balance sheet more intuitively than a series of numbers does. Occasionally, it will be important to demonstrate the composition of your balance sheet relative to some benchmark, whether a peer group or historical measures for your family business.  When comparing composition to differently-sized peers, it is helpful to express the components as a percentage of the whole rather than in dollar amounts, as illustrated in Exhibit 3. EfficiencyThe final balance sheet concept to communicate to family shareholders is efficiency.  Managers and directors are stewards of family capital, and balance sheet efficiency measures demonstrate how effective their stewardship has been.Tracing the elements of the operating cycle conveys how the business operates in a fresh perspective.Efficiency measures include turnover and return statistics.  Turnover measures compare a balance sheet item to a corresponding activity measure such as units sold, revenue, or cost of sales.  Return statistics have a measure of income as the numerator and a balance sheet measure such as assets, invested capital, or equity as the denominator.The cash conversion cycle measures the working capital efficiency of a business.  In other words, how much family capital is tied up in inventory and receivables?  Since the return on working capital is often relatively low, managers generally try to reduce their balance sheet allocation to working capital.  Exhibit 4 provides an example of how to communicate the cash conversion cycle to family shareholders.Exhibit 4 summarizes each component of the calculation, while also providing an intuitive basis for the calculation.  By tracing the elements of the family business’s operating cycle, it conveys how the business operates to family shareholders in a fresh perspective.ConclusionEffective communication unlocks the power of positive shareholder engagement.  When it comes to the financial performance of your family business, effective communication is more than simply providing audited financial statements when requested by family shareholders.  Doing so is like handing them a newspaper written in their second (or third) language.  They may get something out of it, but it will largely be a matter of chance.In this post, we have provided examples of how to communicate the key balance sheet concepts of scale, composition, and efficiency to your family shareholders.  The exhibits in the post are simply illustrations; the challenge is identifying the best way to communicate these balance sheet concepts to the shareholders of your family business.  In future posts, we will illustrate techniques for communicating the key financial concepts from the income statement and the statement of cash flows.

The new year provides a natural opportunity for family business directors to think about the current condition of their family business and ponder what the future might hold.  In this first post of 2020, we identify a handful of questions that family business directors would do well to think about.1. What is our Family Business Worth?In contrast to more liquid investments, like a portfolio of marketable securities, the value of a family business cannot be known with precision.  The good news is that a precise value isn’t nearly as important as an accurate estimate.  And reasonably accurate estimates can be developed.If the family has no intention of selling, why is it important to know what your family business is worth?  There are lots of reasons, but we’ll address three of the most important in this post.An accurate valuation helps shareholders better manage their own personal finances. No one would tolerate a financial advisor that refused to divulge the value of your investment portfolio because you’re not going to spend it all this year.  Knowing the value of all the assets that you own (liquid and illiquid) is essential to prudent personal financial planning and decision making.An accurate valuation helps facilitate intra-family transactions. Even if the family does not plan to sell the business, certain shareholders may desire to transfer (through gift or sale) shares to other family members.  An accurate, up-to-date valuation helps minimize the likelihood that intra-family transfers will unintentionally create economic winners and losers within the family.  Some family businesses opt to sponsor redemption programs as a mechanism for providing shareholder liquidity.  An accurate contemporaneous valuation is essential for such programs.An accurate valuation helps prepare the family for unsolicited acquisition offers. Capable and motivated buyers can offer to buy the family business even if it is not for sale.  Once such an offer hits the table, deciding how to respond often becomes emotionally-charged.  A third-party assessment of value that is performed outside the “heat of battle” can go a long way toward ensuring that the board formulates a rational and measured response to any unsolicited acquisition offers. These different applications highlight the importance of understanding the various “levels” of value.  The value of a controlling interest is likely higher than the value of a liquid minority interest, which is in turn likely higher than the value of an illiquid minority interest.  An experienced, qualified business appraiser will help directors understand the value of the family business at each “level” and the economic factors that contribute to the resulting discounts and premiums.2.  What Return Should our Family Shareholders Expect?Family shareholders are entitled to a future return on their investment in the family business.  While the actual returns achieved over a given period are influenced by a host of factors (some of which are within management’s control and some of which are not), what is a reasonable expectation for future returns?Return follows risk.  So determining what return family shareholders should expect ultimately comes down to identifying alternative investments of comparable risk.  Family business directors should carefully evaluate the risks facing family shareholders relative to a range of potential alternative investments.Establishing the expected return is important for both shareholders and the managers and directors of the family business.  For shareholders, the expected return provides an important benchmark for evaluating the performance of their investment over time.  For managers and directors, the expected return is a critical component of weighing shareholder distributions against potential available investments.  Family capital will eventually flow to its most productive use, whether that is inside or outside the family business, and the expected shareholder return is a key component of capital allocation for the family.3. What Form Should Shareholder Returns Take?Shareholder returns come in two – and only two – forms: distribution yield and capital appreciation.  Cash flow that is distributed to family shareholders cannot be reinvested in the business to fuel growth.  Alternatively, cash flow that is distributed to family shareholders is no longer at risk of being lost in the family business.  Given these tradeoffs, there is no single “right” dividend policy for a family business.As a director, can you clearly articulate what your family business’s dividend policy is (and why it is what it is)?  Nearly as important, have you and your fellow directors consistently communicated that policy to family shareholders such that they too understand it and can describe it?  Individual shareholders may not agree with it, but you will never be able to make everyone happy.  It is essential, however, that your family shareholders know that there is a guiding rationale rooted in thoughtful consideration of required shareholder returns, available investment opportunities, and shareholder preferences.  If your dividend policy is perceived to be based on nothing more than the caprice of the board, it will inevitably breed distrust and acrimony.4. What Investments Should our Family Business Make?The process of making corporate investment decisions, referred to as capital budgeting, is essentially the flipside of dividend policy.  Operating cash flow that is retained needs to be put to productive use lest it become “lazy.”  From your perspective as a director, what segments of your family business seem most attractive for current investment given your family business’s strategy?Capital budgeting should serve strategy.  When management presents a significant investment opportunity to the board, can you discern a genuine organic link between the company’s pre-existing strategy and the proposed investment?  Given what you, as a director, understand the family business’s strategy to be, what types of investments would make sense in 20202?Maintenance capital expenditures are investments in preserving (or, preferably enhancing the efficiency of) the business’s current productive capacity. Maintenance capital expenditures are not glamorous, but successful family businesses recognize their importance.Growth capital expenditures are investments in increasing the business’s productive capacity. These expenditures allow the family business to expand geographically, add complementary product or service offerings, or diversify away from the legacy business.Whereas growth capital expenditures add to overall industry capacity, mergers and acquisitions are investments that assimilate existing industry capacity to the family business. While a potential acquisition may be attractive on the basis of its own (standalone) investment merits, most M&A transactions are pursued in the belief that adding the acquired operations to the family business will result in enhanced cash flows beyond what either company could generate on its own.5. How Much Debt is Appropriate for our Family Business?Together with investment and dividend policy, financing policy is the third strategic financial decision facing family business directors. Family businesses are financed with some combination of family equity and debt capital.  Debt capital is attractive because lenders are generally content with a lower rate of return than equity holders.  As a result, the prudent use of debt can reduce the overall weighted average cost of capital for your family business (and increase returns on the family’s equity capital).  But the benefits of debt are not free: adding debt to the company’s capital structure increases the risk faced by the family shareholders.  As a director, you should be careful considering how much debt is appropriate for your family business on the basis of the company’s asset base, earnings stability, economic and industry outlook, available borrowing terms, and family shareholder risk tolerances. ConclusionAs 2020 begins, we encourage you to take the time to think about these five questions.  Regardless of the issues you are facing that are specific to your family business, these questions are perennial and common to all businesses.  Pondering these questions may simply confirm that the status quo in these areas remains appropriate, or it may trigger some needed new thinking in one or more of these areas.Whether it is providing valuation calculations to estimate the value of your family business or serving as a neutral, independent sounding board in your deliberations, our family business professionals look forward to helping you develop appropriate answers to these questions for your family business.  Give us a call today to discuss your needs in confidence.

Listing the best books one has read over the preceding twelve months is commonplace.  Family Business Director eschews the humble-bragging endemic to such lists.  Instead, we offer a list of four books that we plan to read in 2020.  We confess to reading far more book reviews than actual books, and we selected these books, in large measure, on the basis of generally glowing reviews.  Upon completing each book, we will report back in future posts with our own impressions and takeaways for family business directors.The Cartiers: The Untold Story of the Family Behind the Jewelry Empireby Francesca Cartier Brickell So the Cartier family business might seem a bit more glamorous than yours.  But, business is business, and the inside account of a well-known family business that started in 1847 is sure to have plenty of great lessons regardless of what industry your family business is in.  The author is a member of the Cartier family but never worked in the business herself, so her perspective on things should be interesting.Patient Capital: The Challenges and Promises of Long-Term Investingby Victoria Ivashina & Josh Lerner The authors are both professors at Harvard Business School.  Investing for the truly long-term brings its own unique set of risks and rewards, and enterprising families are natural long-term investors.  We look forward to reading about what the authors find to be essential for successful long-term investing.Clyde Fansby Seth Yes, apparently Seth gets by on just one name.  Family Business Director has never read a graphic novel before, but we are intrigued.  The book tells the story of a second-generation member who drove his father’s business – Clyde Fans – into the ground.  We are really not quite sure what to expect, but in general, we find that we learn more from good fiction than most non-fiction.Kochland: The Secret History of Koch Industries and Corporate Power in Americaby Christopher Leonard In order to become a polarizing political influencer, you first have to make a lot of money.  Whether you welcome or abhor the political machinations of the Koch brothers, it is undeniable that Koch Industries has been a wildly successful family business.  This book purports to be the corporate history of a very secretive family business.  We look forward to learning more about how Koch Industries grew, and how remaining a privately-owned family business contributed to (or hindered, as the case may be) the company’s success. As 2019 winds down, we want to extend best wishes to our clients and subscribers for continued success in 2020.  Happy reading!

While its status as a Christmas song is perhaps debatable, Merle Haggard’s “If We Make It Through December” is classic country music at its finest.  The song captures the pathos of economic distress, with the recently-downsized protagonist lamenting his inability to provide the Christmas he wants for his daughter.Although we suspect Mr. Haggard was not writing in this direction, the song has always made Family Business Director think about breakeven analysis.  As the year draws to a close, family business directors naturally evaluate the firm’s profitability over the course of the year.  For some, profitability was assured months ago.  For others, it remains uncertain whether they will make it through December without incurring a loss for the year.What is Breakeven Analysis?The purpose of breakeven analysis is to identify the volume of sales at which the company moves from an operating loss to operating income.  Breakeven analysis is a great tool for family business managers and directors to forecast profitability and evaluate business strategies.The fundamental insight behind breakeven analysis is that some costs of a business are variable with respect to revenue, while others are fixed.Variable costs are those incurred in rough proportion to revenue, such as raw material inputs, direct labor, revenue-based royalty payments, or incentive-based compensation.In contrast, fixed costs do not vary with revenue, but are incurred regardless of how much revenue the business generates in a given year. Typical fixed costs include corporate overhead personnel, insurance, rent, and depreciation. Of course, classifying expenses as either variable or fixed is a bit arbitrary, and depends on the time horizon considered.For example, rent is a fixed expense in the short-term, but when the lease expires, management can decide whether to continue incurring the expense. In the longest of long runs, all expenses are variable.Furthermore, some expense categories have attributes of both variable and fixed expenses. Often, rental agreements for retailers include two components: a base rent that is payable regardless of revenue, and an incentive component that is calculated with reference to sales. These ambiguities should not deter family businesses from using breakeven analysis.  Absolute precision is not necessary to yield valuable insights. The relationship of variable and fixed costs determines the breakeven level of revenue for a family business.  To illustrate, consider Play It Safe Enterprises.  Play It Safe incurs fixed costs of $2.5 million annually, and variable costs of $40 per unit, compared to a current selling price of $50 per unit.  Exhibit 1 illustrates the resulting breakeven analysis.Play It Safe’s breakeven sales volume is 250,000 units.Why Should Family Businesses Care About Breakeven Analysis?Make no mistake, Haggard – the Poet of the Common Man – is always on heavy rotation at Family Business Director headquarters.  Yet, what brought breakeven analysis to our mind was this quote from a Harvard Business Review article about what makes family businesses different from their publicly-traded peers: “Our results show that during good economic times, family-run companies don’t earn as much money as companies with a more dispersed ownership structure.  But when the economy slumps, family firms far outshine their peers.”  In other words, the family businesses in the study had lower breakeven sales volumes than their non-family peers.To illustrate, consider Play It Safe’s publicly-traded competitor Go For Broke, Inc.  Exhibit 2 summarizes the breakeven analysis of Go For Broke.Relative to Play It Safe, Go For Broke has invested more heavily in automated production equipment, resulting in higher annual fixed costs ($4.0 million compared to $2.5 million).  The payoff from the decision to automate production is a higher contribution margin per unit sold.Nevertheless, the breakeven sales volume at Go For Broke is 6.7% higher than at Play It Safe. In other words, if Go For Broke is going to “make it through December,” they will need to sell nearly 7% more units than Play It Safe does.In a good year (300,000 units) operating profit is $500,000 for both companies. But in a great year (350,000 units), Go For Broke earns 25% more operating income.  During hard times (200,000 units), in contrast, Go For Broke incurs a $1.0 million operating loss while Play It Safe loses only $500,000. So, operating leverage (the degree to which a business’s operating costs are fixed) is a key part of risk management.  Since risk management is ultimately the board’s responsibility, directors should give some thought to breakeven analysis this December.Managing Risk in the Family BusinessWe’ve written often about how family businesses can manage shareholder risk through capital structure decisions.  Most directors are well aware of how the decision to borrow money increases both the risk and potential return to family shareholders.  In our experience, directors are less likely to consider breakeven analysis in their risk management decisions.  Yet, the composition of the family business’s operating cost structure can influence the risks and returns to family shareholders just as much as, if not more than, the business’s capital structure.So which company has the better cost structure, Play It Safe or Go For Broke?  Of course, neither structure is inherently better than the other.  The right decision ultimately comes down to knowing the risk tolerances and return expectations of your family shareholders and assessing the outlook for industry demand and competitive dynamics.  All else equal, strong confidence in the economic and industry outlook suggests that more operating leverage will prove rewarding, while operating in the shadow of recession means shifting to a less leveraged cost structure will be prudent.Once he made it through December, Hag’s protagonist anticipated making a change, as he had “plans to be in another town come summertime.”  For family businesses, changing the company’s cost structure generally takes more time.  But even changes at the margin can affect results in a meaningful way.  As directors, there’s no time like December to think about whether any changes are needed in your family business.Merry Christmas from Family Business Director!  We will be off next week, but look forward to being back with more content for our subscribers after the holidays.

The intersection of family and business generates a unique set of questions for family business directors.  We’ve culled through our years of experience working with family businesses of every shape and size to identify the questions that are most likely to trigger sleepless nights for directors. Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, "Does our dividend policy fit?" Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability.Our multi-generation family business clients ask us about dividend policy more often than any other topic. This isn't surprising, since returns to family business shareholders come in only two forms: current income from dividends and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.In other words, dividends are the most transparent expression of what the family business means to the family economically. Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability. The business may “mean” different things to the family at different times (or, to different members of the family at the same time). In our experience, there are four broad “meanings” that a family business can have. These “meanings” are not mutually exclusive, but one will usually predominate at a given time. Importantly, the “meaning” of the business has implications for dividend policy.Meaning #1 - The family business is an economic growth engine for future generations. For some families, the business is perceived as a vehicle for increasing per capita family wealth over time. For these families, dividends are likely to take a backseat to reinvestment in the business needed to fuel the growth required to keep pace with the biological growth of the family.Meaning #2 - The family business is a store of value for the family. For other families, the business is perceived as a means of capital preservation. Amid the volatility of public equity markets, the family business serves as ballast for the family’s overall wealth. Dividends are generally modest for these families, with earnings retained, in part, to mitigate potential swings in value.Meaning #3 - The family business is a source of wealth accumulation. Alternatively, the family business may be perceived as a mechanism for accumulating family wealth outside the business. In these cases, individual family members are expected to use dividends from the business to accumulate wealth through investments in marketable securities, real estate, or other operating businesses. Dividends are emphasized for these families, along with the (potentially unspoken) expectation that distributions will be used by the recipients to diversify away from, and limit dependence on, the family business.Meaning #4 - The family business is a source of lifestyle. Finally, the business may be perceived as maintaining the family’s lifestyle. Dividends are not necessarily expected to fund a life of idle leisure, but are relied upon by family shareholders to supplement income from careers and other sources for home and auto purchases, education expenses, weddings, travel, philanthropy, etc. These businesses typically have moderate reinvestment needs, and predictability of the dividend stream is often more important to shareholders than real (i.e., net of inflation) growth in the dividend. Continuation of the dividend is the primary measure the family uses to evaluate management’s performance. From a textbook perspective, dividends are treated as a residual: once attractive reinvestment opportunities have been exhausted, the remaining cash flow should be distributed to the shareholders. However, at a practical level, the different potential “meanings” assigned to the business by the family will, to some degree, circumscribe the dividend policy alternatives available to the directors. For example, eliminating dividends in favor of increased reinvestment is not a practical alternative for family businesses in the third or fourth categories above, regardless of how abundant attractive investment opportunities may be. Figure 2 illustrates the relationship between “meaning” and dividend policy. The textbook perspective on dividend policy is valid, but can be adhered to only within the context of the “meaning” assigned to the family business. In contrast to public companies or those owned by private equity funds, “meaning” will generally trump dispassionate analysis of available investment opportunities. If family business leaders conclude that the “meaning” assigned to the business by the family does not align with the optimal dividend policy, the priority should be given to changing what the business “means” to the family. Once the change in “meaning” has been embraced by the family, the change in dividend policy will more naturally follow. Once the change in “meaning” has been embraced by the family, the change in dividend policy will more naturally follow.A dividend policy describes how the family business determines distributions on a year-to-year basis. A consistent dividend policy helps family shareholders understand, predict, and evaluate dividend decisions made by the board of directors. Potential family business dividend policies can be arrayed on a spectrum that ranges from maximum shareholder certainty to maximum board discretion.Family shareholders should know what the company’s current dividend policy is. As evident from Figure 3, knowing the dividend policy does not necessarily mean that one will know the dollar dividend for that year. However, a consistently-communicated and understandable dividend policy contributes greatly to developing positive shareholder engagement. So what should your family business’s dividend policy be? Answering that question requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce? Once the inward and outward perspectives are properly aligned, the dividend policy that is appropriate to the company can be determined by the board and communicated to shareholders. Potential Next StepsCalculate historical shareholder returns, distinguishing returns attributable to capital appreciation from those attributable to distributionsAssess what the business “means” to the family economicallyEvaluate how the prevailing “meaning” of the business corresponds to the challenges and opportunities facing the businessIdentify the target capital structure for the family businessArticulate a predictable dividend policy and communicate that policy to family shareholders

As recounted in the Harvard Business Review article entitled "What You Can Learn from Family Business," an academic study of family-controlled and non-family public companies found that debt constituted 37% of the capital of family-run businesses, compared 47% for the non-family companies.  This finding is generally consistent with our experience working with family businesses of all sizes.  In this post, we consider why family-run businesses might be a bit more debt-shy than their non-family peers.Debt and Family Business ValueGreater use of low-cost debt reduces the overall weighted average cost of capital.One of the principal textbook reasons for using financial leverage is to “maximize” the value of the business.  According to the theory, greater use of low-cost debt reduces the overall weighted average cost of capital.  If the value of a business is equal to the present value of expected future net cash flows of the enterprise, a lower discount rate will result in a higher present value.  Since the relevant discount rate for the value of the family business is the weighted average cost of capital, companies that borrow the “optimal” amount of debt will thereby “maximize” their value, or so the theory goes.This theory is unimpeachable as far as it goes, but in our view, a couple sizable grains of salt are in order.  First, the difference between the current and “optimal” weighted average cost of capital is often quite modest.  As shown in Figure 1 below, increasing financial leverage increases the costs of both debt and equity capital. Because the absolute cost of the capital components is dynamic with respect to the amount of leverage, the resulting weighted average cost of capital is less sensitive to leverage than one might expect.  As a result, borrowing money for the sole purpose of “maximizing” shareholder value has the potential to be a fools’ errand. Second, when family businesses are sold, buyers are focused on the value of the assets (tangible and intangible).  Most transactions are structured so that the seller receives a gross amount of consideration which they must then use to pay off any outstanding indebtedness, with the residual serving as the net proceeds to the family shareholders. The textbook theory assumes that the company’s shares are freely-traded so that there is a deep and liquid market for minority shares in the company. In that case, the capital structure is a given that will not be affected by trading activity in the shares, and investors are rightly concerned with just what that capital structure is.But the reality for most family businesses is that transactions of minority interests in shares are infrequent, and that the relevant market is that in which the company as a whole will transact; buyers in that market are indifferent to the existing capital structure of the seller. In this way, the market for family businesses is more like the housing market than the stock market.  The value of a house does not depend on the size of the mortgage on that house.  In the same way, the value of your family business to a potential buyer does not depend on the amount of debt outstanding.Debt and Returns on Family CapitalIf capital structure management doesn’t influence the value of your family business, why does the amount of debt matter?Why are family businesses willing to accept lower returns in exchange for less risk?Financial leverage may not change the value of your family business, but it absolutely will influence how the return on invested capital is allocated to lenders and family shareholders.  Shareholder returns for a given level of ROIC will be higher the more debt financing is used in the family business.  But these higher returns are available only in exchange for bearing greater risk.  If, as the authors of the Harvard Business Review study maintain, family businesses do, in fact, use less financial leverage than their non-family peers, why are family businesses willing to accept lower returns in exchange for less risk?We suspect there are at least two reasons for this preference on the part of family shareholders.First, the costs of failure for family businesses are much higher than the finance textbook would indicate.  In the event of bankruptcy, the shareholders of textbook theory blithely accept the financial loss and continue on their merry way.  In contrast, the failure of a family business comes with enormous costs in terms of the socioemotional wealth of the family.  The resulting job loss, negative economic impact to the local community, and damaged family reputation weigh heavily on family shareholders but are of no concern to the textbook investor.Second, family shareholder wealth (and, potentially, income) is often concentrated in the family business.  As a result, shareholders are naturally more averse to risk than the textbook investor.  If you’re going to have all of your eggs in one basket, you need to do everything in your power to protect that basket.  For many family businesses, that defensive posture includes borrowing less money than their non-family peers.The Financial Value of ResilienceIn our experience, successful family businesses use debt judiciously to take advantage of attractive capital investment opportunities, enhance family shareholder returns, and on occasion to promote diversification outside the family business.  The finding that, on balance, family businesses tend to use a bit less debt than their non-family peers is consistent with our observations over the years.  The authors of the Harvard Business Review conclude that family businesses prioritize resilience over performance.Even apart from the concept of socioemotional wealth, resilience pays dividends in the long run.  To illustrate, consider the long-term outcomes for two family businesses: Slow & Steady Corp. earns a 10% return each year, while the returns for Up & Down, Inc. alternate between 0% and 20% each year.  The average annual return is 10% for each business, yet, after ten years, Slow & Steady Corp. is worth more than Up & Down, Inc.If your family business has a long-term horizon, resilience will prove rewarding.  Indeed, the Harvard Business Review study found that – over the long-term – the family-run businesses generated superior returns.Since resilience is rewarded, how are you and your fellow directors enhancing the resilience of your family business through your capital structure decisions?

For most of us, Thanksgiving is a time to disregard normal dietary restraint in the company of extended family members that one rarely sees.  For some enterprising families, however, Thanksgiving quickly devolves from a Rockwellian family gathering to a Costanza-style airing of grievances.  So, in the holiday spirit, we offer this list of the top ten questions not to ask at Thanksgiving dinner.  If you have trouble distinguishing between the board room and the dining room, this list is for you.1. Why can’t I work in the family business? Nearly all family businesses welcome the contributions of qualified family members; however, having the right last name is not a sufficient condition of employment for successful family businesses.  As families grow into the third and subsequent generations, family employment policies can become especially contentious.  Crafting a workable family employment policy that specifies required qualifications and external work experience is often one of the first and most important tasks undertaken by a family council.2. Why does cousin Joe get such a big salary?This can be a great question, and it is quite possible that Joe is either under – or over – paid relative to his contribution as an employee.  As family businesses grow, the board should carefully evaluate how compensation practices for family members compare to those for non-family members.  Working in the family business should be neither indentured servanthood nor a sinecure.  It is a job, and successful families treat it as such.  Having one or more independent (non-family) board members can be a great way to ensure that compensation practices in the family business are fair.3. Why does cousin Sam get anything from the business?This question gets to the heart of many family business disputes we have witnessed: the belief that family members who don’t spend their lives working in the family business aren’t entitled to any distributions.  Successful families are able to separate the return on labor (wages and benefits) from the return on capital (distributions).  Just as the family members providing labor are entitled to market-based compensation, family shareholders are entitled to distributions if and when paid, even if they don’t work in the business.  That’s simply what ownership is.  It works that way for public company shareholders, and there’s really no reason to treat your family shareholders any differently.4. Why isn’t the shareholder redemption price higher?A shareholder liquidity program can be a great way to promote peace in the family.  Even when a shareholder liquidity program exists, however, shareholders often don’t understand that the family business has more than one value.  Which value is appropriate for a redemption program depends on the family dynamics and goals for the program.5. Why doesn’t the business pay a bigger dividend?Being wealthy is not the same thing as feeling wealthy.  Many family shareholders are wealthy but don’t necessarily feel that way because dividends either aren’t paid or are only a token amount.  Having a well-reasoned and easily-articulated dividend policy is an essential step in promoting family harmony and sustainability.  Occasionally, founders and second-generation leaders withhold distributions simply on principle, even if the business has limited reinvestment opportunities.  This rarely ends well.6. Why doesn’t the business invest more for the future?This is the flipside to the previous question.  Funds that are distributed are not available to reinvest in the family business.  A single dollar of earnings cannot be both distributed and reinvested – a choice is required.  Making that choice wisely requires knowing what time it is for your family business.  As the family grows biologically, it is natural to wonder if the family business will, or can, keep up.  You have to sow before you can harvest.7. Why doesn’t the business borrow more money?Growth requires capital, and since family businesses rarely have an appetite for admitting non-family shareholders, that means debt may be the only way to fund important growth investments.  Prudent amounts of leverage to help finance growth investments can actually help secure, rather than imperil, the family business’s future.  But before borrowing money, directors should ask a few key questions.8. Why does the business have so much debt?Some shareholders fret about using too little leverage, while others worry about the risk of having too much debt.  Over the long-run, the capital structure of your family business should reflect the risk tolerances and preferences of your family shareholders.  The idea that you can financially engineer your way to a lower cost of capital (and therefore, higher value) for your family business through fine-tuning capital structure is over-rated.  Capital structure determines how much risk and reward shareholders can anticipate, but does relatively little to influence the actual value of your family business.9. Why don’t we register for an IPO?There are examples of families that have taken their businesses public while retaining control over the board of directors.  It’s not always a lot of fun.  Despite retaining control, being public means inviting the SEC and other regulators to take a keen interest in your business.  Even if your family keeps its eye on the long-run, Wall Street can take you on a wild ride based on the short run.  Having publicly-traded shares may be what’s best for your family business, but it’s a big step and a really hard one to take back.10. Why don’t we sell the business?When is the right time to convert the illiquid wealth that is the family business into ready cash?  A buyer might approach your family business with an offer that you weren’t expecting, or your family might decide to put the business on the market and seek offers.  In either case, you only get to sell the business once, so you need to make sure you have experienced, trustworthy advisors in your corner.  Selling the family business will not remove all the stresses in your family; in fact, it may add some.Of course, all of these are really great questions to be asking – the Thanksgiving dinner table is just not the right venue.  This Thanksgiving, try setting business to the side for at least one day.  Our advice: instead of talking about the family business, stick to a safer topic like politics.  Above all, be thankful for the opportunity to be a family that works together.Happy Thanksgiving!

We were recently whiling away the hours scrolling through the archives of the Harvard Business Review when an article caught our eye.  “What You Can Learn from Family Business” was written by Nicolas Kachaner, George Stalk, Jr. and Alain Bloch, and appeared in the November 2012 issue.  It is well worth reading, and can be found here.  In the article, the authors describe an empirical study they undertook to discern the ways family businesses are different from their non-family owned peers.The authors examined data from 149 family-controlled public companies as the foundation for their study.  For what it’s worth, we suspect publicly-traded family businesses look at the world a bit differently than their private brethren, but you have to go where the data is available.  In any event, the reported findings were generally consistent with our experiences working with private family businesses.The authors identify seven attributes of family businesses that differentiate them from non-family owned peers.  The overall conclusion of the study is that family businesses focus more on long-term resilience than short-term performance.Family businesses are frugal in good times and bad.Family businesses keep the bar high for capital expenditures.Family businesses carry little debt.Family businesses acquire fewer (and smaller) companies.Many family businesses show a surprising level of diversification.Family businesses are more international.Family businesses retain talent better than their competitors do. In a series of posts over the next several weeks, we’ll take a closer look at some of the attributes identified by the authors, particularly from the perspective of privately-held family businesses.  This week, we’ll consider how family businesses make capital expenditure decisions.Family Businesses and Capital ExpendituresThe authors describe family businesses as “especially judicious” with regard to capital expenditures.  We suspect that this stems from the fact that spending family capital just plain hurts more than spending anonymous shareholder capital.  As family businesses mature, the tension between reinvesting in the business to support future growth and distributing earnings to the family for consumption and outside investment often becomes acute.  As a result, family business managers are keenly aware that dollars spent on capital expenditures are dollars that are not distributed to the family.Equity Capital ConstraintsSetting up a joint venture can allow the family business to act bigger than its balance sheet.Beyond the psychological hurdle noted above, an additional constraint on capital spending for privately-held family businesses is the common aversion to raising equity capital from outside (non-family) investors.  Family business directors know that even minority investments from outsiders come with strings attached in the form of governance and economic rights.  The institutional investor that becomes a 20% or 30% shareholder in your family business will not be shy about exerting influence over significance strategic decisions.  And it is quite unlikely that the investment horizon for the institutional investor mirrors that of the family.  That’s not to say that outside equity capital may not be the right solution for your family business, but accepting outside capital will most definitely change your family business.Some families balance the need for outside capital to fuel growth with the desire to protect family control of the business by using joint ventures or other similar structures.  When there is a discrete growth initiative that the family business wants to undertake, but doesn’t have the financial capacity to tackle by itself, setting up a joint venture with a strategic or financial partner can allow the family business to act bigger than its balance sheet.  Of course, shared investment means shared upside, but that can be preferable to sitting out on an otherwise attractive investment opportunity for a lack of funding.  While the joint venture partner will have significant say over the conduct of the joint venture, they can be effectively fenced off from the governance of the family business as a whole.Capital Rationing and StrategyIn the face of capital scarcity, family business directors must select a limited number of capital projects to approve.  The selection process is referred to as capital rationing.  Capital rationing is common to all businesses; even when capital is readily available, other constraints, like the availability of human capital, place limits on how much capital investment can be made in a given period.Family business directors and managers often give much attention to measures of financial feasibility like net present value, internal rate of return, and payback period.Net present value (NPV) is a comparison of the marginal cost of a capital project to the present value of the expected marginal benefits associated with the project. The expected benefits are discounted to the present at the weighted average cost of capital.Internal rate of return (IRR) is the discount rate at which the present value of expected marginal benefits is equal to the marginal cost of the project.The payback period measures the number of years it will take to recoup the marginal cost of the capital project. These measures are crucial, and directors should not approve capital projects that do not pass these tests.  However, passing the financial test is not enough.  NPV, IRR, and payback period are not substitutes for a coherent strategy.Prioritizing strategy will enhance the long-term sustainability of your family business.Since the number of projects with acceptable financial returns likely exceeds the amount of capital the family business has available to invest, a common approach is to simply increase the minimum hurdle rate until fewer projects pass.  While this is an effective way to address capital rationing, in our view, it gives short shrift to strategy.  We believe most family businesses are better off investing in a project that advances the company’s overall strategy and has an IRR of 13% than an alternate project with an expected IRR of 18% but only a tenuous relationship to the strategy of the family business.Assessing strategic fit of potential projects to address capital rationing is not as easy as simply inflating hurdle rates, but we are convinced that prioritizing strategy will enhance the long-term sustainability of your family business.ConclusionThe authors conclude that parsimony when it comes to capital expenditures may cost family business some short-term growth opportunities, but ultimately enhances the resilience of family businesses when recession comes.  And recession has always, eventually, come.So what about your family business?  Are you spending family capital wisely?  Have you explored alternative sources of equity capital?  Do you have a disciplined process for reviewing potential capital projects for both financial feasibility and strategic fit?  In short, are you managing for long-term resilience or short-term performance?

Software developers must regularly decide whether to purchase existing software for desired functionality or to write the software themselves. In fact, software developers make these decisions so often that there is an entire literature devoted to helping them make the best “build vs. buy” decision in any particular situation. Family business directors face a similar decision when it comes to making capital investments. There are essentially two options for capital investment:Capital expenditures (i.e., “build”)Acquisitions (i.e., “buy”) As shown on Exhibit 1, we classified each of the operating companies the S&P 1000 as either “Builders” or “Buyers” based on the relationship between aggregate cash flows for capital expenditures and acquisitions from 2013 through 2015. As groups, the Builders allocated 89% of total capital investment to capital expenditures, while acquisitions accounted for 81% of total capital investment for the Buyers. With regard to median size (measured by revenue) and operating margin, the two groups are virtually indistinguishable. The Buyers’ relative capital investment was greater, contributing to modestly faster revenue growth over the three years ending in 2018. Buyers are over-represented in the healthcare and IT sectors, while consumer sector (both discretionary and staples) is more hospitable to Builders. So how should you and your fellow family business directors decide whether to build or buy? What will be the most effective form of capital investment for your family business? Since software developers think more about the build vs. buy decision than most of us do, we thought it would be interesting to apply a software-related decision framework to family business investment decisions. For purposes of this blog post, we follow the six step decision framework advocated by Justin Baker. Step #1: Identify Functional RequirementsFor family businesses, all capital investment should begin with strategy. What strategic objectives require capital investment? What competitive advantage is the company seeking to extend, strengthen, or defend? Strategy should guide family businesses in selecting capital investments; too often, family businesses attempt to formulate a strategy out of available capital investments.Step #2: Define the Scope of Work and Reconcile Against ConstraintsFamily businesses face both financial and non-financial constraints when evaluating capital investments. Directors should be carefully attuned to both of these constraints. Since family businesses are often reluctant to raise equity capital from outside the family, the amount of capital available for investment is limited to operating cash flow and available debt financing. Non-financial constraints are most often either cultural (is there any precedent for making acquisitions?) or managerial (does our management team have the requisite capacity or skill set to execute the proposed capital project successfully?). If there is a managerial constraint, are there family members with the needed skills, or will it be necessary to bring in non-family managers? Regardless of the answers to these questions, a clear-eyed assessment of the relevant constraints will help ensure that directors are evaluating a feasible set of build or buy options.Step #3: Solution DivergenceSolution divergence simply means identifying the potential build and buy options. On the buy side, this might mean keeping a running list of competitors, suppliers, or customers that could provide a compelling strategic combination with the family business. On the build side, operating managers are often the best source of potential capital expenditures. In either case, is your family business’s corporate strategy have enough visibility throughout the organization so that operating managers have a good feel for what acquisition targets or capital projects are going to be worth pursuing? Has the board and senior management communicated a list of “must haves” for any capital investment? It can quickly become demoralizing for operating managers when there are no clear criteria against which proposed investments will be evaluated. Solution divergence is ultimately about nurturing a process for generating a sustainable pipeline of proposals (both “builds” and “buys”) for directors to evaluate.Step #4: Solution ConvergenceWhereas solution divergence describes the process of identifying potential capital investments, solution convergence refers to the process for selecting the capital investments to be made. In addition to strategic considerations, the selection process should also reference financial return metrics like internal rate of return (IRR) and net present value (NPV). Satisfactory financial metrics are a necessary, but not sufficient, condition for selecting a capital project. Capital investments should satisfy both financial and strategic objectivesShould financial hurdles be different for “build” projects than “buy” projects? Some families, concluding that acquisitions are inherently riskier than capital expenditures, assign higher hurdle rates to acquisitions. The risks traditionally ascribed to acquisitions include the tendency to overpay in competitive bidding situations and the difficulty of assuring a healthy cultural fit between buyer and seller. These risks are certainly real, but capital expenditures are not without their own unique risks. Specifically, capital expenditures create incremental industry capacity, and forecasting market demand and the impact of additional supply on pricing can be just as challenging as integrating acquisitions. The use of “premium” hurdle rates for acquisitions is ultimately neither right nor wrong, but simply a form of capital allocation by another name. Regardless of the hurdle rate selected, capital projects must satisfy both financial and strategic criteria to merit investment.Step #5 – Build or Buy or BothThis is the execution phase. Selecting the capital investments to be made is not the end of the process. Successful family businesses translate forecasts into operating results. Directors cannot just assume that the hand-off from the corporate development and finance teams to the operations team will be done well. In the case of an acquisition, integrating new employees and realizing planned synergies while minimizing negative surprises take top priority. For capital expenditures, avoiding cost overruns and delays that can eat away expected returns on projects is critical.Step #6 – Develop Guidelines for ReassessmentCapital investments are hard to reverse. Nonetheless, family businesses need feedback processes to ensure that the family doesn’t throw good money after bad, and to help improve forecasting techniques and improve accountability in the interest of making better capital investment decisions in the future.ConclusionIs your family business a builder or a buyer? Which factors contribute to your build vs. buy decisions? Do you employ a consistent framework for evaluating these decisions? Do you have a robust process for seeding a pipeline of potential future projects for consideration? Do you understand the cultural factors that make acquisitions or capital expenditures more palatable for your family shareholders? Simple answers elude each of these questions, but directors should assess what processes are in place or need to be developed to ensure that family capital flows toward the most productive uses in the family business, whether in the form of building or buying.

It is harvest time in rural America.  Farmers are working long hours gathering the crops that have been planted, fertilized, watered and worried over since springtime.  While the cycle of planting and harvesting is an annual one on the farm, for family businesses, the cycle can span decades or even generations.There are many different ways to classify family businesses, but one simple distinction that we find ourselves coming back to often is that between planters and harvesters.Planters are family businesses that are currently investing more cash flow in future growth than their existing operations generate. Since these companies are focused on sowing the seeds for future growth, family shareholders should expect near-term returns to come primarily in the form of capital appreciation.In contrast, harvesters generate more cash flow from current operations than they are investing for future growth. While there likely will still be some degree of expected capital appreciation for these firms, they offer their family shareholders the potential for greater current income. So what time is it for your family business?  Is it planting season or harvesting season?  You can easily tell by taking a look at the statement of cash flows.  This generally underappreciated financial statement has three sections.The operating section summarizes the sources of cash flow from existing operations (principally earnings, depreciation and other non-cash expenses, net of changes in working capital).The investing section details the cash flows allocated toward corporate investments, the most significant components of which are capital expenditures and business acquisitions.The financing section reveals whether the company is a net borrower or lender, has issued or repurchased equity shares, and whether or not it pays dividends to shareholders. We can classify family businesses as either planters or harvesters by simply comparing the first two sections of the statement of cash flows.  For planters, total investing outflows exceed operating inflows.  Harvesters, on the other hand, generate more operating inflows than investing outflows. Once you determine whether your family business has been a planter or harvester in the past, it is time as a director to determine whether a change is appropriate in the future.  To help us think about the characteristics of planters and harvesters, we examined statements of cash flow for companies in the S&P 600 (small-cap) and S&P 400 (mid-cap) indexes.  After screening out financial and real estate businesses, we were left with a sample of 741 companies having median revenue in 2018 of about $1.5 billion.  We classified each firm based on aggregate cash flows from 2013 through 2015; 40% of the companies were planters and 60% were harvesters.  Exhibit 1 summarizes some characteristics of each group. In the aggregate, planters invested $1.94 per $1.00 of operating cash flow, compared to $0.57 for harvesters.  Harvesters tended to be more profitable, with a median operating margin of 10.0%, compared to 6.9% for planters.  The net effect of more aggressive investing was a combination of faster revenue growth and improving profit margins for planters.  Of course, return is the ultimate test for shareholders, and over the following three years (2016 through 2018), harvesters generated higher returns than planters (7.8% compared to 3.5%). Peril and PromiseIt is easy to determine whether your family business has been a planter or harvester in the past.  The real question for directors is assessing whether it should be harvest time or planting time for your family business now.  Neither planting nor harvesting is inherently superior to the other.  Directors need to read the calendar for their family business, understanding the peril and promise of each time.Planting Time: PromiseThe promise of planting time is the opportunity for a greater future harvest.  As families grow over time, directors should evaluate the appropriate relationship between family and business growth.  Planting time offers the promise that the growth of the business can keep pace with, or potentially exceed, the growth of the family, fueling per capita growth in family capital.  What’s more, prudent planting can create opportunities for family members to assume roles of increasing responsibility in the business and promote shareholder engagement.Planting Time: PerilBusiness would be easy if planting decisions could be deferred until harvest outcomes are known.  Sadly, that is simply not the case.  You have to plant before you harvest.  As a result, the principal peril of planting time is the risk that the harvest will turn out to be less attractive than expected.  Referring back to Exhibit 1, the planters’ investments did contribute to faster revenue growth and improving margins.  However, it is not clear that the incremental benefits from investment were truly sufficient relative to the investment made.  The weaker observed stock returns for planters suggest that – for many of the companies – the harvest was not as robust as planned.  In other words, the market concluded that at least some of the companies in our sample misread what time it really was, planting when they should have been harvesting.Harvest Time: PromiseIt is nice to be rich, but it’s even better to have money.  The promise of harvest time is that the family will finally reap the benefits of the risks and investments of previous generations, turning the “paper” wealth of illiquid business value into liquid, readily diversifiable wealth.  Harvest time can facilitate the transition from being a business family to an enterprising family.  Harvest time can allow families to reduce their economic risk profile by moving at least some of their hard-won eggs into new baskets.  As families grow, diversifying family wealth can be a critical component of overall family harmony and sustainability.Harvest Time: PerilOne of the biggest perils of harvest time is complacency.  An over-emphasis on harvesting can starve the family business of needed investment.  If the family business does not keep up with the growth of the family, the resulting pressure on per capita wealth and earnings can add stress to family relationships and erode shareholder engagement.  Even from the perspective of the family business, the positive impact of investing for growth can be easily overlooked.  As shown on Exhibit 1, the harvesters experienced some margin decay over the following three year period, suggesting that at least some harvesters allowed their competitive advantages to wither during the harvest.  Directors need to take a balanced view of the long-term reinvestment needs of the business.ConclusionWhile there is some persistence in companies’ investing behavior over time, the companies in our sample did evolve.  We reclassified each of the companies in our sample based on cash flow data for the three years from 2016 and 2018.  Approximately half of the original planters became harvesters in the succeeding period.  Harvest time is not a final destination, however, as about 30% of harvesters turned into planters.  From this evidence, we conclude that your family business is never “stuck.”  Family business directors need to regularly check what time it is for their family business, and not assume that the characteristics of the past year or decade are appropriate today.  So, what time is it for your family business?

While public companies are planning for the next quarter, successful family businesses are planning for the next decade.  While private equity firms anticipate exit, successful family businesses anticipate transitioning to the leadership of the next generation.  A recent profile in the New York Times of Rumiano Cheese provides a great example of how family businesses persist and endure over generations.  Rumiano Cheese is celebrating its centenary this year, and the company’s story provides some great reminders for all family businesses that are in it for the long haul.Successful Family Businesses Adapt to Market DemandAt its founding in 1919, Rumiano was producing a dry parmesan cheese that was reminiscent – to the largely immigrant customer palate – of more scarce parmesan cheese.  When World War II created demand for a shelf-stable cheese product, Rumiano ramped up the production of so-called “American” cheese.  As consumer preferences have shifted to organic food, Rumiano has adapted in both its own branded cheeses and its ability to supply cheese ingredients to organic food manufacturers.What about your family business?  Are you meeting market demand, or hoping the market will accept what you want to produce?  How is market demand different today than it was five years ago?  What will customer preferences look like five years from now?Successful Family Businesses Match Investment with OpportunityRumiano expanded production to keep pace with the war-driven demand for “American” cheese.  When demand waned in the post-war years, Rumiano scaled back production capacity to meet demand.  Consistent with an ROIC mindset, the leaders at Rumiano were careful to match investment to available opportunities.  When consumer infatuation with whey protein presented a new opportunity, Rumiano committed $20 million in capital to meet the opportunity.What about your family business?  Does your balance sheet match your income statement, or are you holding on to assets that no longer serve a purpose?  Conversely, are you willing to commit the resources necessary to meet new opportunities in your markets?Successful Family Businesses Navigate External ChallengesFamily business observers sometimes talk as though all of the challenges associated with running a family business are internal (family dynamics, etc.).  They are not.  Before a family business can earn the “privilege” of addressing internal family-related challenges, it must successfully navigate a steady stream of external challenges that disrupt the status quo.  For Rumiano, those external challenges have included changing government regulations, unpredictable weather patterns, and the actions of competitors.What about your family business?  What external threats need immediate attention?  What emerging threats do you need to plan for?  What external challenges can be turned into opportunities by identifying and implementing creative solutions that actually strengthen your business?Successful Family Businesses Take Advantage of Local ResourcesWhile it is true that successful family businesses are those that adapt to changing market demand, it is also essential not to forget where you come from.  Amid all the change and evolution at Rumiano, one constant has been to take advantage of local resources – an abundant supply of high-quality milk from the many organic dairy farms located near the company.  You don’t have to own the resource to take advantage of it, but proximity is important.  The local dairy resources readily available to the company help forge Rumiano’s strategy of providing fresh, organic cheese.  This strategy frees the company from competing directly with the much larger industrial cheese producers based in the Midwest.What about your family business?  What local resources are available that can contribute to sustainable competitive advantage?  What partnership or joint venture opportunities are available to help you make the most of the local resources that have the potential to make your company unique?Successful Family Businesses Take Advantage of Global MarketsSuccessful family businesses may find their competitive advantage in their own backyards, but they may need to go across the globe to fully exploit that advantage.  The demand for whey protein is a global, not local, phenomenon, and Rumiano has followed that demand into protein-hungry Asian markets where growth opportunities for organic suppliers are abundant.What about your family business?  Is there global demand that you possess a competitive advantage in addressing?  What emerging markets can you establish leadership in today?  What resources are required to execute in global markets?  Are there potential partners having valuable experience in global markets with whom you can work and learn from?ConclusionWhether your family business’s planning horizon is five years or five decades, it is always instructive to hear the success stories of those who have been in it for the long haul.  Odds are that most of our readers are not in the cheese business; regardless, reading the 100-year story of Rumiano Cheese offers a great opportunity to reflect on where your family business has been, is, and is heading.

If the income statement is a movie that records how your family business performed during a particular period, the balance sheet is a snapshot that records what your family business looked like at a particular date.The balance sheet answers two core questions:What are the assets our family business owns? and,How has our family business paid for those assets? We’ll flesh out the first question in this week’s post, and turn our attention to the second question in a subsequent post.What is an asset?While we are generally dismissive of accountants on this blog, the bean-counters actually do an admirable job of defining what an asset is.  According to accountants,Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.The defining characteristic of an asset is that it represents a future economic benefit.  So, as you study your family business’s balance sheet, your focus should not be on how much the various assets cost, but instead on what future economic benefits those assets will generate.  As a family business director, you need to focus not just on what assets your business owns, but more importantly, why your family business owns those assets.Family businesses report many different assets, but it is generally helpful to classify them under four broad headings.Cash & equivalents. Cash is obviously an asset, but a rather peculiar one, as the probable future economic benefits generated by cash are quite limited.  While too little cash will lead to insolvency and failure, too much cash dilutes the returns generated for shareholders.Working capital. Working capital consists of accounts receivable, inventory, and prepaid expenses, net of accounts payable and accrued expenses.  Working capital is the “grease” that makes a family business run smoothly.  While an appropriate amount of working capital is essential, family businesses should be aware of the diminishing marginal utility of working capital.  As the amount of working capital exceeds the level necessary to operate the business, the incremental future economic benefits associated with working capital get smaller and smaller.Net fixed assets. Net fixed assets include real estate, production equipment, rolling stock, and other long-term productive assets of a business.  One of the most important tasks of a family business director is ensuring that the business has deployed the right assets in the right places to execute the company’s strategy and capitalize on the available market opportunity.Net other assets. Family businesses own sundry other long-term assets (minority investments in other businesses, goodwill & intangible assets from previous business combinations, and deferred tax items are common examples). Table 3.2 of The 2019 Benchmarking Guide for Family Business Directors summarizes balance sheet composition for the companies in our data set by industry.  Exhibit 1 below summarizes the data for the small cap (S&P 600) companies in our benchmarking universe.Examining the data for the public companies, we think there are four questions that family business directors should think about with regard to their company’s asset base.1. What is your family business’s cash strategy?We see cash fulfilling a number of different roles for our family business clients:Liquidity to meet current obligations as they come due.  This is the most fundamental (and necessary) use of cash in a family business.  Do you have a target level of cash to meet the operating needs of the business?Sinking fund for future capital expenditures or debt repayment. Accumulating cash balances to pay for anticipated investments or loan repayments can eliminate transaction costs for financing events, reduce interest expense, and reduce the risk that credit will not be available when needed.  These are worthwhile objectives for many family businesses, but there is a cost to these benefits in the form of depressed returns on family capital.Hedge against uncertainty. Some family businesses maintain additional cash balances to provide a margin of safety against the uncertainty inherent in their business model.  We can see some evidence for this in Exhibit 1, as utilities, which generally face the least near-term uncertainty regarding operations, also carry the smallest cash balances.Insurance against failure of corporate strategy. Eventually, prudent risk management morphs into unhealthy risk aversion as some family businesses hold such large cash balances that they are no longer hedging uncertainty, but attempting to insure against failure.  In addition to dragging down returns of family capital, this use of cash can promote management complacence (we never have to worry about making payroll, etc.) or encourage inefficient capital investment (all that money does eventually burn a hole in someone’s pocket).  Directors should carefully evaluate just whose risks are being managed in this case: the family shareholders, or management?The asset of last resort. Finally, for some family businesses, cash can become the asset of last resort.  This most often reflects some degree of family dysfunction, often expressed in the belief of family leaders that family shareholders can’t be trusted with dividends, so the money is safer in the company.  And if the company doesn’t have a productive use for the capital, it just sits there, weighing down returns on family capital.2. What opportunities do you have to optimize your cash conversion cycle?The most comprehensive measure of working capital management is the cash conversion cycle, which measures the time elapsed from when cash is paid for inventory to when cash is received from customers.  Different industries and business models have different cash conversion cycle expectations.  As noted in Exhibit 15, some sectors (industrials and materials) require significant inventory balances, while others that rely on subscription-based models (communication services) actually have negative cash conversion cycles.  Exhibit 2 illustrates the cash conversion cycle and identifies some key questions for family business directors with regard to each major component.  Less working capital is not always best; there may be potential strategic advantages to maintaining deep inventories or providing generous customer financing terms, but if such is the case, the rationale and corresponding benefits (superior pricing, etc.) need to be clearly noted.3. How effective is your capital budgeting process?The balance of net fixed assets is the cumulative result of all the capital budgeting decisions your family business makes.  How effective is that process?  Do managers have a clearly-articulated strategy that guides what sorts of capital investments are needed?  Has the board established hurdle rates for capital investment to define financial feasibility for proposed projects?  Does the company have a strategy for minimizing the impact of cognitive biases that lead to over-optimistic projections?  Is there a feedback mechanism in place to ensure that actual results are compared to projections for proposed capital projects?  As evident from Exhibit 1, net fixed assets account for a large portion of the total capital invested in businesses; as a family business director, you should be diligent to ensure that the capital budgeting process works to advance the company’s strategy.4. Do you know what makes your family business valuable?This is not the same thing as knowing what your family business is worth (although that is important, too).  Instead, the focus is on understanding what the core attributes of your family business make it valuable.  In one sense, your family business can be viewed as a portfolio of assets.  If those assets work together in executing an effective strategy that takes advantage of – and builds – the company’s sustainable competitive advantages, the value of the whole can be far greater than the sum of the individual assets.  Exhibit 3 summarizes data from the S&P 600 companies in our data set comparing the market value of each public company to the total invested capital (or sum of the asset values).  The overall median for the group is approximately 1.6x, meaning that for every $1.00 of capital invested in the business (whether debt or equity), the assets work together to generate $1.60 of market value. The dispersion of individual observations is quite wide, however.  Some of the companies actually experience a negative relationship between market value and invested capital (i.e., they turn $1.00 of investor money into assets valued by the market at less than $1.00).  The competitive advantages that drive higher market values become progressively more difficult to sustain.  The bottom line is that each of the companies with ratios well above 1.0x has a story and a strategy that support their market valuation.  What is your family business’s story and strategy?  What makes it valuable?  Without a clear answer to these questions, your family business is likely to get “stuck” and eventually experience slowing sales growth and shrinking returns, both of which have unpleasant side effects on the family. As a family business director, your role is akin to that of a portfolio manager.  As a good portfolio manager, you should care not just what assets your family business owns, but why it owns them.  In other words, what makes your family business valuable, and how does the current portfolio of assets contribute to enhancing and sustaining that value?

One of the first questions our family business clients ask us is how much debt they should have.  We refer to this as the capital structure question.  Capital structure is simply the relative proportion of debt and equity capital used to finance a business.  Figure 1, depicting a family business balance sheet, illustrates the capital structure decision. The operations of Capulet, Inc. and Montague Corp. are identical.  In other words, the two families have answered the capital budgeting question (“What investments are worthwhile uses of family capital?”) in the same way.  However, the Capulets and Montagues have reached very different conclusions regarding the capital structure question (“What mix of debt and equity financing should we use?”).  The Capulets have relied primarily on equity financing while the Montagues have favored debt. Answering the capital structure question well requires considering both business and family characteristics.  We find that discerning what the business means to the family is a critical first step.  We also find that referencing and interpreting relevant benchmarking data can help families reach consensus when answering the capital structure question.  We present benchmarking ratios relevant to the capital structure question in Chapter 6 of the 2019 Benchmarking Guide for Family Business Directors (“the Benchmarking Guide”).  In this post, we identify four questions that directors should ask about the use of debt in their family business. Question #1 – How Good Is Our Collateral?Rational lenders seek to minimize their risk of loss, and one way of doing that is by identifying the collateral that can be used to secure their position in the event of default.  So the first question to ask about debt in your family business relates to collateral – what assets does your family business own that will provide security to a lender?In the consumer context, home and auto loans are often described using the loan-to-value (“LTV”) ratio.  The LTV ratio describes the relationship between the amount of debt outstanding and the underlying collateral value.  In other words, if you borrowed $30,000 to finance the purchase of your $40,000 car, the LTV ratio on your loan is 75%.  In the business context, the analogue to the LTV ratio is the ratio of debt to net operating assets.  Figure 2 summarizes data from Table 6.1 of the Benchmarking Guide. Not all assets are equally useful as collateral.  For example, real estate and utility companies have a high proportion of fixed assets having alternative future uses in their asset bases, while health care and information technology company assets tend to be more concentrated in goodwill and intangible assets for which lenders have less enthusiasm. Smaller family businesses lacking sufficient collateral will sometimes rely on personal guarantees of certain family shareholders to provide security to lenders.  This is effectively a subsidy, and all shareholders (both guarantors and not) should be aware of the implications of such guarantees. Question #2 - Can We Service the Debt?Collateral value matters most in the event of default.  Of course, most family business borrowers would prefer not to enter default.  So, the second question to ask about the use of debt in your family business relates to the ability to make timely payments of principal and interest when they come due.The most common ratio used to evaluate the ability of family businesses to service their debt is the ratio of debt to EBITDA (earnings before interest taxes and depreciation).  For a more thorough discussion of the merits and shortcomings of EBITDA as a measure of financial performance, check out this post.  Table 6.4 in the Benchmarking Guide presents EBITDA leverage data for public companies.  As shown on Figure 3 below, EBITDA leverage varies by industry. Debt capacity as measured by the Debt / EBITDA ratio depends on the perceived riskiness, or volatility, of cash flow.  For example, companies in the consumer staples sector are less sensitive to economic conditions than those in the consumer discretionary sector; as seen in Figure 3, consumer staples companies borrow more per dollar of EBITDA that their counterparts in the consumer discretionary sector.  Larger companies are also often perceived to be less risky than smaller companies.  With a few exceptions, the large cap companies in Figure 3 have higher Debt / EBITDA ratios than their small cap brethren. Question #3 - How Much Will It Cost?The more debt a family uses to fund its operations, the more expensive the debt will be.  This is intuitive since the greater the debt balance, the greater the likelihood that lenders will not be repaid.  Table 6.6 of the Benchmarking Guide describes the effective interest cost for the public companies in our sample set.  Effective interest cost is the quotient of interest expense to the average debt balance for a period.In Figure 4, we pop the hood and look a little deeper at the data, comparing the effective interest cost for companies in the industrials sector.  We sorted the companies by Debt / EBITDA ratio, and then computed the median effective interest cost for those companies with leverage ratios less than, or greater than 2x. While we suspect this analysis would not pass muster statistically, it does confirm the reasonableness of our intuitive hunch that companies with more debt pay a higher effective interest rate, all else equal.  The data on Figure 4 also illustrates the effect of company size on risk, with larger companies having lower effective interest costs than their smaller peers. Question #4 - Will We Be Able to Sleep at Night?Increasing leverage not only increases the cost of borrowing, it also increases the risk – and therefore cost – of equity.  So the final question to ask with regard to the use of debt in your family business is this: Will we be able to sleep at night?  Unfortunately, there is no cut-and-dried academic answer to this question.  More than anything, the answer depends on the risk tolerances and preferences of your family shareholders.Observers often focus on the use of debt to minimize the overall cost of capital for a company and thereby maximize its value.  And while that may be, to some degree, possible, the increasing costs of debt and equity with leverage mean that the overall cost of capital is relatively flat across a wide span of potential capital structures, as shown in Figure 5. As shown in Figure 5, the weighted average cost of capital does not vary appreciably across a wide range of potential capital structures.  What this suggests is that, for family businesses, the capital structure decision has less to do with increasing the value of the family business and much more to do with financing growth and allocating risk and return among the debt and equity holders.  If family shareholders are willing to accept more financing risk, their available returns will be higher.  If, on the other hand, the preference of family shareholders is to minimize risk, then they should expect a lower return.  Going back to our example in Figure 1, the Capulets bear less risk, but the Montagues have the potential for greater returns.  Return always follows risk, and there are no shortcuts. ConclusionWhat’s the right capital structure for your family business?  We find that the best answer to that question can be found only after asking a series of other questions: How good is our collateral?  Can we service the debt?  How much will this cost?  And perhaps most importantly, will we be able to sleep at night?  Sadly, there are no shortcuts, but the long-term rewards for your family business of answering these questions well can be significant.  Capital structure decisions affect the long-term sustainability of your family business and can be costly to unwind.  Much better to measure twice and cut once than to arrive quickly at the wrong answer.

Family business leaders are well-acquainted with the tyranny of the urgent.  In this series of posts, we offer to-do lists for family business directors.  Each list relates to a particular family business topic.  The items offered for consideration won’t necessarily help your family business survive the next week, but instead, reflect priorities for the long-term sustainability of your family business.In last week’s post, we explored how family businesses can use periodic share redemptions or ongoing liquidity programs to promote shareholder engagement and satisfaction.  This week’s to-do list includes important tasks for family business directors to complete whether planning for a one-time share redemption or establishing a family shareholder liquidity program.Identify existing shareholder clienteles and determine the needs, objectives, and preferences of each.Identifying shareholder clienteles requires more than just refreshing the family tree.  Kinship ties may be a factor in defining shareholder clienteles, but may be secondary to other attributes that influence risk tolerances and liquidity preferences.  Ferreting out how shareholder clienteles are really defined may require administering a confidential shareholder survey.Assess the company’s financial capacity to support an ongoing shareholder liquidity program.An ongoing shareholder liquidity program is a use of capital that ultimately competes with other potential investment alternatives.  How does the expected return on share redemptions compare to returns expected on alternative capital investments?  What portion of projected operating cash flow are directors willing to allocate to a shareholder liquidity program?  Are there any covenants in the company’s credit facility that limit amounts used to fund share repurchases?  Does the company have unused borrowing capacity that can be used to support a more substantial one-time share redemption?Determine whether the company or other shareholders will be buyers.If the family business does not have the financial capacity to support an ongoing shareholder liquidity program, one or more of the family shareholders may have the interest and financial capacity to purchase additional shares.  Opening up the redemption program to shareholders as potential buyers allows the company to preserve capital for potentially more attractive investment opportunities and may allow the different shareholder clienteles to more closely achieve their liquidity and return preferences.Define the frequency, size/availability, and terms of a shareholder liquidity program that best meet the objectives of the shareholders and needs of the business.For an ongoing shareholder liquidity program, there are several key terms that family business directors need to weigh carefully before implementation.  First, is liquidity available to selling shareholders at any time, or will redemptions be restricted to periodic windows?  Second, will the opportunity to sell shares under the plan be subject to any volume limitations (whether in aggregate or per shareholder, expressed as a dollar amount, share count, or percentage of shares outstanding)?  Finally, what form will the liquidity take?  Will selling shareholders receive cash, a note, or some combination of the two?  If a note, what will the terms be?Define the level of value to be used for shareholder liquidity program purchases.The term “value” is susceptible to multiple interpretations.  When structuring a shareholder liquidity program, it is essential that you have a clear understanding of what the different “levels” of value are for your family business, and which one of those levels you will use to repurchase shares from family members.  Different levels will be appropriate for different family businesses, so family business directors need to choose carefully with an eye toward which level will be most likely to promote the objectives of the shareholder liquidity program.Obtain a qualified independent business valuation at the selected level of value.Once you have specified the relevant level of value, the next step is to select and retain a qualified independent business valuation professional (we have plenty to choose from here) to perform a valuation.  You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).The initial valuation is important to establish expectations.  The valuation report should demonstrate a thorough understanding of your business and its position within your industry, and contain clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support.  You should be able to recognize your family business as the one being valued, and when finished reading the report you should know both what the valuation conclusion is, and why it is reasonable.   Unless there have been significant changes to the business that warrant a change to the overall valuation framework, subsequent valuations should rely on the same valuation methods, with changes to the assumptions and conclusions reflecting new circumstances at the company, within the industry, or among relevant market data.  Subsequent valuations should not be mere copies of the original valuation, but should demonstrate a consistency of approach and perspective.  Having a consistent valuation process from period to period enhances the credibility of the liquidity program with your family shareholders.Design education and communication tools to ensure that shareholders are well-informed regarding the liquidity program.Finally, when it comes time to implement the liquidity plan, it is essential that your family shareholders understand what their options are under the plan, the level of value being used to establish price, and the consideration they will receive for their shares.  A shareholder liquidity program is ultimately a tool for promoting positive shareholder engagement.  By implementing the plan, you are moving your family shareholders from being passive recipients of occasional dividends to more active owners.  If you are going to grant family shareholders the right to sell a portion of their shares, you must also empower them to do so on an informed basis.  When a shareholder liquidity program is in place, family business directors must give renewed attention to shareholder communication and reporting.The professionals in our family business advisory services practice have decades of experience helping family businesses execute major share redemptions, provide independent valuation opinions, and design and implement shareholder liquidity programs.  Call us today to help you get started on knocking out your to-do list.

Family business directors must properly distinguish between capital structure and capital budgeting decisions to make the best decisions.  In this week’s post, we answer a frequently asked question that leads us into a discussion of what is known as the “separation principle.”  In short, what are the relevant cash flows for capital budgeting analysis?  And, when is it appropriate to combine investing and financing decisions?  If you have ever struggled with these questions, this week’s post has the answers you need.Q: Should we deduct interest expense when calculating the IRR on a project?A:  No.  For most capital budgeting applications, interest expense should not be deducted from forecast cash flows when calculating IRR.  When the hurdle rate reflects the weighted average cost of capital, the relevant measure of return should reflect cash flows available to both debt and equity holders (i.e., before deducting interest expense).As a general rule, family business directors should strive to keep investing decisions separate from financing decisions.  There are two primary rationales for this “separation principle”:The operating managers responsible for selecting and executing capital projects generally have no control over the family business’s financing decisions. Considering potential capital projects on a debt-free basis aligns the analysis with the perspective of the responsible manager.  The specific financing used to fund a given capital project is rarely the responsibility of an operating manger, but is ultimately the decision of corporate directors.The actual funding sources used to finance the specific project are not relevant to the decision to accept or reject the project. At first blush, this is counter-intuitive – surely the funding sources actually used are what matter the most.  The flaw with this reasoning is that family business capital structures can generally be modified independently of investment activity.Let’s consider a simple example to illustrate.  Assume a family business has a target capital structure of 75% equity and 25% debt.  Following a couple very profitable years, the company’s actual capital structure has drifted to approximately 80% equity and 20% debt.  As a convenient means of moving back toward the target, the company plans to finance 100% of a proposed $5 million capital project.  What is the appropriate hurdle return for this project?  The appropriate hurdle return is the weighted average cost of capital (75% equity / 25% debt) despite the fact that the actual financing will rely on 100% debt.  Failing to do so would inadvertently give this project credit for the fact that the company was under-leveraged at the time the project happened to be under consideration.  Undertaking this capital project is not the only means by which the company can re-lever its capital structure.  Through a refinancing transaction, the company can “fix” its capital structure problem without engaging in any capital investment.Are there any exceptions to the separation principle?  Yes, a couple.  First, occasionally projects include access to financing not otherwise available to the family business.  For example, if a proposed project would be eligible for uniquely advantageous bond financing through a municipality, it may be appropriate to evaluate that project on an equity basis.  Second, real estate investments are often evaluated net of the leverage that will be used to finance the project.  For many real estate investors, individual projects stand or fall on their own, in contrast to family businesses for which capital projects form an integrated portfolio of activities which are financed as a whole.  Furthermore, since many real estate investors are tax pass-through entities, it is customary to calculate returns on real estate on a pre-tax basis.Whether calculating the internal rate of return on a total capital or equity-only basis, it is essential to ensure consistency among the project cost, the relevant cash flows, and hurdle rates, as summarized in the following table.The following simple example illustrates proper alignment between the components of the internal rate of return analysis described in the preceding table. From a total capital perspective (the traditional and preferred viewpoint for capital budgeting), the total investment is the relevant cash outflow against which returns are measured.  The aggregate (pre-interest and debt service) cash flows result in a 12.4% internal rate of return.  From a financial point of view, the project is acceptable if the weighted average cost of capital for the family business is less than 12.4%. From an equity perspective (appropriate for the exceptional cases noted above), the relevant cash outflow is only the equity contributed by the family business to the project.  Annual project cash flows are reduced by both principal and (after-tax) interest payments on the assumed debt, yielding an internal rate of return of 17.6%.  While this IRR is higher than that under a total capital approach, the relevant hurdle rate for evaluating the acceptability of the project is the family business’s cost of equity (which will exceed the weighted average cost of capital). Why Does This Matter?Family business directors face three principal inter-related strategic financial questions:Capital Structure: How should is the appropriate mix of debt and equity financing for our family business?Capital Budgeting: What are the optimal reinvestment decisions for our family business?Dividend Policy: What form should returns to our family shareholders take? As depicted in the preceding chart, the answers to each of these three questions have consequences for the others, and family business directors should strive to answer these questions on an integrated, rather than piecemeal, basis.

Family Business Director calls Memphis, Tennessee home, and among other things, Memphis is a basketball town.  In the 2017 NBA playoffs, former Grizzlies coach David Fizdale launched a meme when he wrapped up his post-game press conference with an epic rant on the unbalanced officiating during the game by citing a litany of statistics, walking off exclaiming, “Take that for data!” Both the sports and business worlds are increasingly data-driven, and access to relevant data is essential to making good decisions.  Our goal in publishing the 2019 Benchmarking Guide for Family Business Directors was to make such data available for family business directors.  We have written often of our fondness for return on invested capital (ROIC) as the best comprehensive measure of financial performance for family business.  Table 4.3 of the Guide, reproduced below, summarizes ROIC measures for the population of public companies from which we drew observations. Hoping to make Coach Fizdale proud, we took a closer look at the data this week to see if could confirm our hunch that ROIC matters.  To do so, we divided our population of companies into two groups.  The first group includes those companies with ROIC greater than their respective industry and size group median, and the second group consists of the below median ROIC companies.  Dividing the population this way ensures that the groups are balanced with respect to size and industry composition. As shown in Exhibit 1, the median ROIC for the overall population is 8.7%, while the medians for the High ROIC and Low ROIC groups are 13.4% and 5.3%, respectively.  This week, we examine other attributes of the firms in each group to see whether ROIC is, in fact, a good predictor of positive outcomes for family shareholders.  Exhibit 2 summarizes the data. Having analyzed the data, we can identify five reasons family businesses should focus on ROIC.#1 – High ROIC Companies Grow FasterThe first thing we notice is that companies in the High ROIC group tend to have higher historical revenue growth rates than those in the Low ROIC group.  We measure historical revenue growth on a three-year compound annual basis.  This measure includes both organic and acquisition-fueled growth.  As summarized in Exhibit 2, the median compound annual growth rate for the High ROIC group is 7.0%, compared to 5.4% for the Low ROIC group.There is no necessary correlation between ROIC and revenue growth.  So why do the High ROIC companies grow faster than the Low ROIC companies?  We can hazard a couple of guesses:First, companies that are attentive to ROIC tend to have less lazy capital on their balance sheets. As a result, the assets that are held are more productive, and managers are more effective in finding revenue-relevant uses of corporate assets.Second, ROIC-mindful managers and directors tend to be more discriminating acquirers of other businesses. By focusing on the marginal ROIC impact of proposed acquisitions, these companies do a better job of weeding out poor acquisitions that dilute revenue growth.#2 – High ROIC Companies Distribute More CashThe good news does not end with revenue growth, however.  Perhaps the firms in the High ROIC group generate faster revenue growth simply by reinvesting earnings rather than distributing earnings to shareholders.  If so, the revenue growth differential would merely be a side effect of stinginess towards  shareholders.  Happily, however, this is not the case.  The companies in the High ROIC group actually distribute earnings to shareholders more liberally than their counterparts in the Low ROIC group.  Combining both dividends and share repurchases, the median aggregate payout ratio for the High ROIC group is 69% of earnings, compared to 54% for the Low ROIC group.ROIC is a natural deterrent to the empire-building tendencies which can be especially prevalent in family businesses.  Managers and directors who benchmark to ROIC would prefer to distribute earnings than reinvest those earnings in capital projects that do not provide adequate returns.  This is especially significant for family businesses, since many family disputes are rooted in reluctance or unwillingness to pay dividends.#3 – High ROIC Companies Are Less RiskyBut perhaps, the ROIC skeptic may claim, the High ROIC companies are merely accepting greater levels of risk – after all, return follows risk.  However, the data seems to rule out this possibility.  We considered two measure of risk: financial leverage and beta.Measured as a percentage of total invested capital, debt comprises 38.9% of the total for the High ROIC group compared to 42.5% for the Low ROIC Group.Beta is a measure of relative riskiness for equity holders: the higher the beta, the greater the risk. The median beta for the High ROIC group is 1.05x, compared to 1.13x for the Low ROIC group. These differences may not seem very large, but what is most important is what they tell us the High ROIC companies don’t do.  They don’t fund higher shareholder payouts by borrowing more money than their Low ROIC peers.  Nor do they chase returns by engaging in riskier projects.  As we noted above, we constructed our High ROIC and Low ROIC groups to be balanced with respect to both industry and company size, so those factors do not account for the observed differences in financial leverage and beta.#4 – High ROIC Companies Provide Better ReturnsIs ROIC simply a manipulation of accounting data with no traction in the real world, or does it actually translate into superior shareholder returns?  To answer this question, we calculated total shareholder returns (capital appreciation plus dividend yield) for each of the companies in our population for calendar year 2018.  As noted in Exhibit 2, the median shareholder return for the High ROIC group outperformed the median for the Low ROIC group by approximately 9.6% (negative 5.6%, compared to negative 15.2%).  Calculating ROIC is not merely an exercise for overly-excitable accountants, but is a tool for directing strategy and managerial attention to the behaviors that generate shareholder returns.Does your family business track shareholder returns over time?  If so, how do the shareholder returns compare to various benchmarks?  If not, is it because historical valuation data is not available, or because family leaders are reluctant to perform the calculation?  Paying attention to ROIC today is a reliable way to improve shareholder returns tomorrow.#5 – High ROIC Companies Are Worth MoreFinally, High ROIC companies are worth more than Low ROIC companies.  This will not come as a surprise to readers familiar with the work of consulting firm Stern Stewart in the mid-1990s.  The greater the sustainable return per dollar of invested capital, the more a given dollar of invested capital is worth.  The most straightforward way to measure this is by calculating the ratio of the market value of total capital (MVTC, the sum of debt plus the market value of equity) to total invested capital (TIC, the sum of debt plus the book value of equity).If the ratio is 1.00x, the capital entrusted to management by lenders and shareholders is neither enhanced nor diminished by the stewardship of management.If the ratio is greater than 1.00x, management’s efforts are increasing the value of the family’s capital; if the ratio is less than 1.00x, family capital is actually being squandered in the business. In the lexicon of Stern Stewart, MVTC/TIC is a proxy for Market Value Added.  The median MVTC/TIC ratio for our High ROIC group is 2.51x compared to 1.46x for the Low ROIC group, confirming our intuition that High ROIC companies are more valuable.ConclusionReturn on invested capital is not a silver bullet – it will not solve all of the challenges facing your family business.  It can even be misused.  However, when we let the data speak for itself, the benefits of ROIC are undeniable.

We have not been shy about our affection for return on invested capital (ROIC) as a comprehensive measure of financial performance for family businesses.  In fact, we think financial performance measurements are so important for family businesses that we recently published a compendium of potential benchmarking measures.  So the provocatively-titled cover article of the current issue of the Harvard Business Review – “Are Metrics Undermining Your Business?” – certainly made us do a double take.Metrics can have a distorting impact on corporate behaviors, and derail the very strategies the metrics were meant to advance.The authors of the article (Michael Harris and Bill Taylor) take as their starting point the well-publicized mess at Wells Fargo.  In an effort to give concrete form what was ostensibly a reasonable strategy of cross-selling services to existing customers, the bank established a metric based on the number of accounts opened.  In response to reportedly intense pressure to meet aggressive goals surrounding the metric and financial incentives tied to the metric, many Wells Fargo employees prioritized the metric – number of accounts – over the actual strategic objective – deepening and strengthening retail customer relationships.  The reputational and financial cost to the bank has proven to be enormous.The authors contend that an emphasis on metrics leads to surrogation, which they define as confusing what is being measured (deeper and stronger customer relationships) with the metric being used (number of accounts).  When employees and managers fall prey to surrogation, metrics can have a distorting impact on corporate behaviors, and actually derail the very strategies the metrics were meant to advance.Metrics and Family BusinessWells Fargo is an extremely large publicly traded financial institution, not a family business.  So are family businesses more or less likely to be burned by metrics?  The authors’ recommendations for reducing the odds of surrogation in an organization provide a great framework for answering this question.  The authors offer three steps to promote healthy use of metrics in business.#1 – Get the people responsible for implementing strategy to help formulate it.This really goes to corporate culture.  Is your family business marked by a top-down authoritarian management structure, or does strategy emerge from all levels of the organization?  Are non-family employees involved in strategy discussions, or is formulating strategy the exclusive preserve of family members?  Do selected metrics serve the broader corporate strategy, or are the selected metrics replacing the corporate strategy? Or, perhaps even subverting the corporate strategy?Capital budgeting is one area that we see a lot of family businesses struggle with.  One risk facing family businesses is that a capital budgeting metric like internal rate of return can change from being a necessary condition to a sufficient condition to approving a project.  In other words, instead of letting corporate strategy dictate which financially-feasible capital project should be pursued, family businesses may undertake what appears to be a financially-feasible capital project and then adapt the corporate strategy to fit the project.  It is critical that family business directors understand what questions a financial metric like net present value is designed to answer (“Are the expected returns from this project acceptable?”) and what questions it cannot answer (“Should we undertake this capital project?”).#2 – Loosen the link between metrics and incentives.Do your incentive structures promote metric-maximization at the expense of overall performance?The timeworn adage “You get what you pay for” is certainly true when it comes to employee performance.  Financial incentives are tricky because employees will give – or attempt to give – employers the behaviors that maximize their personal compensation packages.  The risk is that any metric that is concrete enough to influence actual day-to-day employee behavior will be so narrow that it may not – if pursued with single-minded intensity – always promote the overall health of the organization.Do your incentive structures promote metric-maximization at the expense of overall performance?  Are employees rewarded for identifying and acting on those situations in which blindly following the metric would actually be counterproductive?  For example, inventory turnover is a common financial metric used to improve working capital management and cash flow.  All else equal, faster inventory turnover contributes to greater capital efficiency and higher return on invested capital.  But all else is never, in fact, equal.  A purchasing manager with compensation incentives based on inventory turnover may resist taking advantage of discounted pricing for a special bulk purchase that would benefit the company because it would reduce inventory turnover.  Family business leaders need to take care that compensation incentives do not become so closely tied to isolated metrics that counterproductive business decisions are made.#3 – Use multiple metrics.Managers have long recognized that a “balanced scorecard” approach to metrics is healthier than obsession with a single number.  This can be challenging for family businesses where the prior success of the company is linked – in the corporate culture, if not in actual fact – to a single performance metric.  While a particular metric may have been a perfect proxy for the overall health of the business in the past, changes in the business or industry are likely to cause the relevance of particular metrics to change.  The scorecard for your family business needs periodic updating to ensure that you are tracking what drives success today rather than in the past.This is true for the value of family businesses as well.  We still occasionally see buy-sell agreements that attempt to enshrine a “valuation formula” to determine the value of the business at future dates.  No matter how appropriate the formula may be when adopted, it is almost certain to distort the value of the business when a triggering event actually occurs years or decades later.Family Businesses and Return on Invested CapitalSo what about ROIC?  Does the threat of surrogation cause us to re-think ROIC as the best comprehensive measure of family business performance?  In short, no.  While the article offers some appropriate warnings for family business directors, there is no reason to abandon ROIC.  As we discussed in a recent post on innovation, family business directors do well to consider broader notions of family wealth that encompass more than just dollars and cents.  But even in the context of broader definitions of family wealth and/or business purpose, return on invested capital is a great tool with which to coordinate the activities of your family business to support your strategy.

This week’s post is a part of a periodic series called “Family Business Industry Spotlights.”  In these posts, we will share conversations with our family business advisory professionals who have deep experience working with family businesses in a particular industry.  We think the conversations promise to be of interest to family business directors regardless of their industry.  This week, we talk with Scott A. Womack about the challenges and industry trends facing families in the Auto Dealer Industry.1. How have auto dealers performed over the past decade?As with most questions, this isn’t a quick and easy answer. Generally, I would say that the auto dealer industry has rebounded from two very poor years during the recession (2009 and 2010) and performed favorably since 2011. A seasonally adjusted annual rate (SAAR) for new lightweight vehicle sales is a leading indicator for the health of this industry. Since June 2011, the SAAR has been generally climbing and has maintained a figure above 14 million units since January 2012.The longer answer is more complicated. In addition to the national economic trends, the success of an auto dealer can be sensitive to more local economic conditions. Further, the auto dealer industry tends to be somewhat cyclical. For instance, it is very common for an auto dealer to have several good years, followed by a down year or two.Brands or manufacturers also have a big impact on the profitability and success of a particular auto dealer. Some brands have historically been more desirable than others, and the perceived values of other brands have fluctuated over the past decade for a variety of reasons.2. In your experience, how do families in the auto dealer industry deal with ownership and management transition?Like many other industries, many auto dealers are in to the second and third generation of family ownership at this point. We see many current owners facing the potential decision to sell because the next generation either doesn’t have the desire or ability to continue running the business. Another unique element of this industry is that each dealership has to have a factory-approved dealer principal. Approval of proposed new principals is not always a given, and we have seen many hiccups in this process at death of an owner, transition to other family members, or proposed sale to a third party.The other trend that we are seeing occurs when a family has several children and some are active in the business and some are not. Some families are choosing to transfer interests in the business only to those children that are active in the management/operations. For the non-active children, retaining an interest in the real estate may be an option to reach an equitable outcome. Most auto dealers are set up with the operations as an entity and the real estate held in a separate holding-company entity. It can become quite important to have both properly valued for any tax implications with these gifts/transfers, but also for the transparency to the children that the different gifts/transfers have been equitable.3. What are some important trends in this industry that families should be thinking about?As the SAAR begins to flatten out and show small signs of decline in the first two quarters of 2019, auto dealers are probably also experiencing similar trends with their new vehicle sales. Opportunities exist for auto dealers to capitalize on used vehicle sales during these times. Also, auto dealers should be able to focus on their Fixed Operations (parts & service). As the average age of vehicles in service continues to rise, more consumers are spending money to repair existing vehicles rather than purchase new vehicles. Finally, we are seeing more auto dealers practice expense controls to mitigate the current revenue trends.4. If you could add one agenda item to the next auto dealer’s board or management meeting what would it be?In the last few weeks, we have bid on two large projects in this space: one involving an IRS-challenged valuation impacting a taxable estate and another involving a family transition and buy-sell agreement stemming from the last family transition dispute. In both cases, a proper valuation from an industry-qualified appraiser would have greatly remedied the situation. The auto dealer industry is very specialized, from the way dealers report their financial statements (factory dealer statements) to the terminology used (Blue Sky value). Don’t be afraid to ask an appraiser for their specific industry experience and what specialized methodologies should be used for this industry. Be wary of general valuation appraisers that are not alert to factors such as LIFO adjustments and potential normalization adjustments for real estate, leasehold improvements and rent.5. If a family is considering or has made the decision that they want to sell their dealership, what things should they be thinking about?Even before a family reaches this point in the decision process, I would recommend having the business valued. While certain obvious events dictate the need for a formal valuation (death of owner, divorce, litigation, transaction), sometimes it can be too late. Not only would a valuation provide a current indication of value, but it can also manage expectations around what the family thinks the value should be. Additionally, the valuation should help identify many of the value drivers in this industry which would allow for the family to assess and monitor over time if they wished to try to increase the current value to be more in line with their expectations.Another item a family should consider is the potential timing of a sale during the calendar year, as the timing may impact the tax consequences. An earlier sale in the calendar year could limit the wages for that year’s tax return that could offset a large ordinary income event from LIFO and depreciation recapture and other ordinary income. Whenever possible, contact your accountant or tax planning consultants to discuss the timing of a proposed sale.

This post is the fourth and final installment from our Corporate Finance in 30 Minutes whitepaper. In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Three QuestionsCorporate finance is the search for rational answers to three fundamental questions.The Capital Structure Question: What is the most efficient mix of capital? In other words, is there such a thing as too little or too much debt?The Capital Budgeting Question: What capital projects merit investment? In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?The Distribution Policy Question: What mix of returns do shareholders desire? In other words, do shareholders prefer current income or capital appreciation? Do these shareholder preferences “fit” the company’s strategic position? Can these shareholder preferences be accommodated within the existing capital structure? These three questions do not stand alone, but the answer to each one influences the answers to the others.Question #3: Distribution PolicyCapital structure and capital budgeting intersect at the point of the cost of capital, which serves as the hurdle rate for evaluating potential capital projects.As shown in Exhibit 1, capital budgeting also shares an intersection point with distribution policy.If capital projects having expected returns in excess of the cost of capital are abundant, it may be appropriate to retain a greater proportion of earnings for reinvestment than if attractive capital projects are scarce.Ultimately, the total return available to shareholders is determined by the operating performance of the business.Beyond that, however, the board does have some measure of discretion with regard to the form of that return (yield vs. capital appreciation).Family shareholders are likely to have a unique set of preferences with regard to the composition of their total return.Those preferences may vary over time and, potentially, within the shareholder base at a particular point in time.In the public markets, shareholders can sell shares if the mix of return components does not correspond to their preferences.Family business shareholders do not have ready liquidity, so it is important for directors and managers to solicit input regarding shareholder preferences.The ability to configure the desired mix of return components is constrained by the availability of incremental debt and equity capital.For example, for a given level of operating cash flow and capital investment, higher dividends can be achieved through incremental borrowing, new share issuance, or asset sales.In each case, boosting dividend yield would come at the expense of capital appreciation.Incremental borrowing capacity may be limited if the company’s capital structure is already optimally leveraged.For family businesses, it may be infeasible to issue illiquid shares at a fair price.And asset sales are not a sustainable source of cash flow.If family shareholders have diverse preferences regarding the composition of total return, perhaps the best means of tailoring returns is to implement a share repurchase program.Shareholders desiring current income can sell a portion of their shares to the company, which fuels capital appreciation for those preferring future upside.In order to implement this strategy, however, there must be a mutually agreeable share price.If the price is too low, the selling shareholders will effectively be subsidizing the remaining shareholders, while a price that exceeds fair market value will benefit the selling shareholders. Topics for Board DiscussionDistribution policy is the most transparent board action for family shareholders.There may be many things shareholders are content not to know regarding the company, but the timing and amount of periodic dividends will not be one of them.Where is the company in its life cycle? Mature companies with more limited opportunities for attractive capital investment are more natural dividend payers.How does the company’s current capital structure compare to its target capital structure?Over time, the board can use dividend policy to migrate the company to its target capital structure while minimizing transaction costs.What are shareholder preferences?Do the shareholders have a consistent set of expectations regarding return composition or do different shareholder groups have conflicting preferences?What type of distribution policy best fits the company and its shareholder base: a set dollar amount, fixed payout ratio, fixed yield on value, or residual distributions after attractive capital investments have been funded? Dividend policies can provide much desired predictability to shareholders, but can also place artificial constraints on the board.How much financial flexibility does the company have to accommodate shareholder preferences?Can the company borrow additional funds?Is there a market for issuance of new shares?If so, at what price?Is a share redemption program feasible? Can the board formulate a market-clearing price that does not unduly reward or punish either group of shareholders? WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper

For bargain shoppers, the discounts at Nordstrom have been eye-catching lately.  And we don’t mean the clothes.  The shares of the fourth-generation family retailer, whose shares have been publicly traded since the early 1970s (ticker: JWN), have lost nearly 40% of their value during 2019.For bargain shoppers, the discounts at Nordstrom have been eye-catching lately.  And we don’t mean the clothes.According to a Wall Street Journal report, the Nordstrom family is preparing a bid to increase its ownership stake in the company from approximately one-third to over 50%.  Although the exact form of the proposed transaction has not yet been specified, it is almost certain that the family would need to offer a premium to the current share price to complete such a transaction. One interesting twist to this family drama is that at least some observers believe that the shares are depressed because of the inept management of the very family members who are proposing to increase their ownership stake.  The company is managed by two fourth generation brothers (three, until the oldest died unexpectedly in January), but a majority of board seats are held by non-family independent directors.  Amid stagnating operating performance, some on the board have been seeking to bring in an unrelated outsider to replace the family managers. These developments come after directors rejected a bid by the family to take the company private in 2017 for $50 per share (the shares closed on Friday at $29.30). Some stocks are underpriced; others are cheap for a reason.  Assuming the family’s proposal to increase its ownership stake goes forward, the independent directors will need to decide which is true of Nordstrom’s shares.  Reported earnings for 1Q19 fell 55% from the prior year as total revenue slid by 3.5%.  At Friday’s closing price, JWN shares imply a value of approximately 6.2x trailing EBITDA.  Department store peer Macy’s (ticker: M), whose shares have also languished during 2019, trades at a comparable 6.5x multiple.  As always, whether Nordstrom shares are undervalued or properly assessed by the market remains a matter of difficult judgment. Some stocks are underpriced; others are cheap for a reason.Since very few family businesses are publicly traded, their directors do not have to engage in these difficult deliberations under the public microscope.  The core issues however, are not uncommon to private family businesses.  The alternatives available to the Nordstrom investors likely include some combination of the following:Negotiate a transaction price at which the Nordstrom family could increase their ownership stake above 50% while remaining publicly-traded. If the directors accept a Nordstrom family proposal to increase their ownership, it would likely result in the family exerting more direct control over the company in the future.  If the current family managers are, in fact, a source of the company’s underperformance, allowing the family to gain control of the board could consign the remaining public shareholders to ongoing underperformance.Replace family management with non-family professionals. If the directors believe that recent performance does not reflect the company’s true operating potential, the best course of action may be to remove the current family managers and allow a new group of outside managers to steward the shareholders’ resources.  The principal risk with this decision is that Nordstrom’s recent poor performance is a function of inevitable industry trends that will not be eliminated by a new management team.  If that is the case, the shareholders (both family and public market investors) may see continued erosion in the value of their investment in future years.Solicit a financial partner to help take the company private. The past is the past, and allowing sunk costs to influence future courses of action is probably the most pervasive cognitive bias that afflicts family business decision-making.  That said, the fact that the board passed on an offer of $50 per share two years ago undoubtedly rankles for some shareholders while the share price now hovers around $30.  The price for a going private transaction today may not be as high as the former $50 per share offer, but is almost certain to exceed the current market price.  A financial partner may be allied with the Nordstrom family and allow the current management to remain, or a prospective partner may envision making substantial management and strategic changes following the going-private transaction.Sell the company to a strategic buyer. If the directors conclude that the current market price provides a realistic portrait of Nordstrom’s likely future within the new retail landscape, selling the company to a motivated strategic buyer may be the best financial outcome for the shareholders.  When motivated strategic buyers exist for a business, the potential synergies and strategic benefits available from the combination may increase the transaction price beyond what the selling shareholders could reasonably expect from any other outcome.Enterprising families should understand, however, that while selling the family business may eliminate some challenges, it creates new ones.  In an insightful article for the New York Times over the weekend, Paul Sullivan describes the new challenges faced by several families after selling the family business.Without the “glue” provided by the business, family ties may weaken.Ownership of the family business confers other forms of socioeconomic wealth. Following a sale, these benefits may evaporate.Stewarding an active business provides a greater sense of purpose than managing a portfolio of passive investments. Upon selling the business, family members previously active in the business may find they are somewhat adrift personally.The publicity around a sale of the family business can change perceptions of the family’s wealth, and create new claims on that wealth.Future returns from reinvestment of transaction proceeds may be less attractive than those earned from owning the family business. Most of the family business leaders we know are probably relieved they don’t have to make decisions under the burden of public and market scrutiny like the directors at Nordstrom do.  However, the types of decisions that they are called upon to make are often just as challenging.  Whether it is assessing the value of your family business, benchmarking the performance of your family business, or evaluating strategic alternatives, our experienced family business advisory professionals are here to help.  Call us today to discuss your needs in confidence.

The best performance metrics address not just “what” performance has been in the past, but reveal the “why” behind that performance and give direction for “how” to improve performance in the future.  In last week’s post, we introduced return on invested capital (ROIC) as a comprehensive performance measure for family businesses.  In this week’s post, we will dig a little deeper with ROIC, demonstrating how we can use ROIC to answer the “what,” “why,” and “how” questions for your family business.What Has Historical Performance Been?Return on invested capital correlates income statement performance (in the form of net operating profit, or NOPAT) with the balance sheet resources used to generate that performance (in the form of invested capital).  The basic calculation of ROIC describes how much NOPAT the business generates per dollar of invested capital: ROIC measures the efficiency with which management is using family resources to generate income for the family.  Because it is expressed in the form of a return, ROIC facilitates comparison to the performance of alternative investments that may be available to the family.  Because ROIC is scaled to the size of the company, it also facilitates comparisons with available peer benchmarks. Why Has Historical Performance Been What it Has Been?Return on invested capital is valuable enough as a free-standing metric.  But if we take a quick peek under the hood, we can learn a lot more about why ROIC is what it is.  As shown on Exhibit 2, by inserting revenue into our calculation of ROIC, we end up with two distinct components that each have a story to contribute to the overall ROIC narrative. When we look at it this way, we can see that ROIC is the product of turnover and profit margin. Turnover measures how much revenue each dollar of invested capital generates. In other words, how well have management and the directors allocated family resources to a portfolio of business assets that produce revenue?  All else equal, the more revenue generated per dollar of invested capital, the higher return on invested capital will be.Profit margin reveals how efficiently the family business converts revenue to profit. Revenue is essential, but only profits fuel family returns.  All else equal, higher profit margins result in a higher return on invested capital. Examining ROIC through the lens of turnover and profit margin begins to lay bare how the family business’ industry and strategy influences financial performance.  For example, Chapter 4 of Mercer Capital’s 2019 Benchmarking Guide for Family Business Directorspresents turnover and profitability data by industry for a group of publicly traded companies.  Exhibit 3 compares the various components for large companies in the health care and industrials sectors. Relative to industrial companies, health care providers are very asset-intensive (real estate and expensive medical diagnostic equipment).  However, health care providers tend to wring more profitability out of each dollar of revenue (medical care tends to be expensive).  As a result, the median ROICs for the two sectors are broadly comparable despite the sectors’ having very different individual return components. Breaking down the overall return into its component parts is helpful for discerning the “why” of performance within a particular industry.Breaking down the overall return into its component parts is helpful for discerning the “why” of performance within a particular industry as well.  Our example company, Blue Corp., earned a 10.0% return on invested capital on the basis of its turnover (2.0x) and profitability (5.0%).  Assume that Blue Corp.’s primary competitor, Red, Inc., also generated a 10.0% ROIC.  However, Red, Inc.’s higher turnover (2.5x) was offset by a lower profit margin (4.0%).Relative to Red, Inc., Blue Corp. has a less efficient mix of assets, but more profitable operations.  With this knowledge in hand, the directors of Blue Corp. can begin to formulate some probing questions for their next meeting:Do the performance differences revealed by ROIC correspond to our stated corporate strategy? In other words, given how our family business has elected to position itself in the market, do the components of ROIC make sense?Given our corporate strategy, is a 100 basis point premium in profit margin to Red, Inc. sufficient? Does the market perceive our family business to be a premium provider?  If so, are we pricing our services appropriately, or are we leaving money on the table?Or, does our corporate strategy really necessitate that we have lower turnover than Red, Inc.? How does our strategy influence the manner in which we allocate family resources to productive assets?How Can We Improve Performance in the Future?Assessing why our past performance looked the way it did naturally leads us to the final and most pressing question: how can we improve our return on invested capital in the future?  What operating changes or strategic adjustments will be required of our family business today if our goal is to enhance ROI tomorrow?The component analysis we introduced in the prior section is instructive here as well.  ROIC cannot improve unless one or both of the components of ROIC improve.  Exhibit 4 illustrates how we can “map” current performance and the available options for increasing ROIC. The dotted lines on Exhibit 4 represent different combinations of turnover and profitability that result in the same ROIC.  So, for example, both Blue Corp. (2.0x turnover and 5.0% margin) and Red, Inc. (2.5x turnover and 4.0% margin) generate the same ROIC.  Suppose that Blue Corp.’s goal is to improve ROIC to 15%.  If turnover remains unchanged, NOPAT margin will need to increase to 7.5%.  On the other hand, if profitability remains constant, turnover will need to increase to 3.0x.  Of course, there are limitless possibilities in between and on either side of the current parameters.  To take an extreme example, if Blue Corp. has a strategy to double profit margins to 10.0%, it can withstand a decrease to turnover to 1.5x and still meet the 15.0% ROIC goal. What operating changes or strategic adjustments will be required to enhance ROI tomorrow?Once the current set of components for your family business have been plotted on the map, along with available peer benchmarks, managers and directors can begin to evaluate what operational or strategic levers represent the best path to increasing ROIC (i.e., moving away from the origin in Exhibit 4).  The challenge is to drill down from a broad goal, such as “Improve ROIC to 15.0%”, to concrete objectives that will drive improvements in either turnover or profitability.  Here are some examples of concrete objectives that a family business may identify to boost ROIC:Reduce cash holdings to 2% of annual revenueIncrease inventory turns from 5x per year to 6x per yearImprove gross margin from 42% to 44%Reduce manufacturing overhead by 1% Directors and managers should set these concrete objectives in the context of relevant market dynamics, corporate strategy, and operating capabilities, and be informed when doing so by quality benchmarking data.ConclusionReturn on invested capital is a powerful tool for not just evaluating how your family business has performed in the past, but also for charting a course for future improvement.  Once your family shareholders and fellow directors get a feel for it, ROIC is likely to become a go-to tool for developing, refining and evaluating corporate strategy.

The management team at your family business has been hard at work growing revenue and profits by 50% over the past five years, so the value of your shares must have increased, right?  Not necessarily.Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story.  As a family business director, you need the whole story.  We’re not aware that Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital, because it tells you the rest of the story.What is Return on Invested Capital?Return on invested capital (ROIC) relates the operating performance of a business to the amount of capital used to support the operations of the business.  In other words, it measures the efficiency with which family capital is used in the family business.  In last week’s post on capital budgeting, we likened the directors and managers of a business to stewards responsible for selecting the capital projects in which to invest family resources. Return on invested capital measures how well directors and managers are handling their stewardship of family resources.  ROIC allows family shareholders to see how much income is being generated per dollar of investment. How is Return on Invested Capital Calculated?Exhibit 2 illustrates how to calculate ROIC for your family business. We need to unpack a couple of the terms in Exhibit 2 that may not be familiar. Net Operating Profit After Tax (NOPAT) is a measure of earnings that excludes interest expense. Analysts often segregate interest expense from the other expenses of the business for at least two reasons.  First, interest does not directly relate to the operations of the business.  In other words, interest expense does not fluctuate with revenue and does not compensate employees, pay vendors or suppliers, or otherwise contribute to the operations of the business.  Second, interest expense is a function of financing decisions that are often made by someone other than the person bearing operating responsibility.  As a result, it is not appropriate to evaluate performance with respect to that expense.Since interest expense is not deducted, NOPAT is like the more common measure of EBIT, or Earnings Before Interest and Taxes.  The difference is that NOPAT is reduced for taxes.  NOPAT is therefore equal to EBIT less taxes at the effective tax rate.  Sadly, Uncle Sam is the first one in line for returns, and NOPAT takes the tax burden into account.  Some analysts like to make additional adjustments to derive NOPAT, such as adding back research & development costs.  Such adjustments may have merit in certain circumstances, but they do add complexity to the calculations that aren’t essential to gaining the primary insights offered by ROIC.Invested Capital is the sum of all capital provided by shareholders (both common and preferred) and lenders. Since the purpose of ROIC is to measure the efficiency of management’s stewardship of family resources entrusted to the business, invested capital is traditionally measured with respect to book values rather than market values.  The average balance for the year in question is the preferred denominator since NOPAT is earned over the course of a year, and a point-in-time snapshot of invested capital may not fully capture the family’s true investment over the course of the year.  As with NOPAT, some analysts propose a laundry list of custom adjustments to invested capital.  These adjustments may have their place for some companies, but the basic calculation is generally a sufficiently reliable guide.Why is ROIC Important?Now we’re ready for the rest of the story.  Management has worked diligently to increase operating income by 50% over the past five years.  Yet, the value of your family shares has been stuck in neutral over that same period.  What gives?Focusing on profit alone will not reveal the answer.  But a quick calculation of ROIC shows us what has gone wrong.  Exhibit 3 presents the ROIC calculations for 2013 and 2018. As revealed in Exhibit 3, the 50% increase in profitability did not boost the share value because the amount of invested capital used in the business also increased by 50%.  In other words, the return on invested capital was unchanged.  Since the weighted average cost of capital for your family business is also 10.0%, the incremental earnings did not boost per share values.  Knowing that profitability has improved is not enough to know whether the value of the shares in your family business has increased.  Earnings are critical but are only half of the story when it comes to management performance and shareholder value.  As a director, it’s your responsibility to know the rest of the story when it comes to the financial performance of your family business, and ROIC is the perfect tool to do so. Stay tuned for a future post in which we will dig a bit deeper into the individual components of ROIC and learn about some additional insights that are available from this measure.

This post is the third of four installments from our Corporate Finance in 30 Minutes whitepaper. In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Three QuestionsCorporate finance is the search for rational answers to three fundamental questions.The Capital Structure Question: What is the most efficient mix of capital? In other words, is there such a thing as too little or too much debt?The Capital Budgeting Question: What capital projects merit investment? In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?The Distribution Policy Question: What mix of returns do shareholders desire? In other words, do shareholders prefer current income or capital appreciation? Do these shareholder preferences “fit” the company’s strategic position? Can these shareholder preferences be accommodated within the existing capital structure? These three questions do not stand alone, but the answer to each one influences the answers to the others.Question #2: Capital BudgetingExtending the image of the company as a portfolio of capital projects, senior management’s role can be conceived of as managing investments on behalf of the shareholders, allocating available capital to selected projects. As depicted in Exhibit 1, management discharges its stewardship role by selecting capital projects for which the expected return equals (or, ideally, exceeds) the cost of capital. On this view, management acts as an intermediary, matching investors with capital projects. There is a symbiotic relationship between the returns required by investors and the riskiness of the capital projects identified by management. Viewed from one side, management that has the responsibility of stewarding high- cost capital will rationally seek out risky projects with corresponding high returns. Viewed from the other side, a portfolio of risky, high-return projects will attract risk-seeking capital. This relationship underscores the importance of management and directors communicating realistic and transparent expectations to capital providers. For public companies, this occurs through quarterly earnings calls and SEC filings; for private companies, it is no less important, but is often ignored since the regulatory mandate is absent. While specific techniques of capital budgeting are beyond the scope of our discussion, the goal of the capital budgeting process is to identify potential capital projects and evaluate whether the expected return from such projects meets or exceeds the hurdle rate. When reviewing the results of a capital budgeting process, directors and shareholders should acknowledge the tension, or conflict, that may naturally emerge between management and shareholders. Recall that, from the perspective of shareholders, systematic risk (the contribution of a given project to the overall risk of a diversified portfolio) is more relevant than absolute risk (the dispersion of potential outcomes on a standalone basis). Careers are not readily diversifiable, however; as a result, it may be natural for managers to evaluate a project from the perspective of absolute risk. In a private company, shareholder portfolio diversification may be limited, so the absolute risk perspective may well accord with the shareholders’ risk preferences. In any event, directors and shareholders need to be aware of the different risk perspectives and be able to reconcile them. Topics for Board DiscussionDetailed capital budgeting is the responsibility of management; for significant projects, the board should evaluate management’s analysis and recommendations.What are the relevant cash inflows and outflows? The relevant cash flows for capital budgeting are those at the margin – what revenues will the company earn and costs will the company incur upon completion of this project that would not be earned/incurred in the absence of this project? For example, fixed operating costs that will be incurred whether or not the project is undertaken are not relevant to the capital budgeting decision.How are available capital projects ranked? Available capital for investment is always constrained at some level. Beyond a simple thumbs-up/thumbs-down evaluation of individual projects, how has management prioritized the available opportunities?What non-financial constraints does the company face? In addition to limited financial resources, companies have limited managerial, human capital, and other resources. Will undertaking the proposed capital project violate any of the non-financial constraints? If so, do the relevant cash flows include the financial cost of dealing with such constraints?What is the strategic rationale for the proposed project? With the “right” inputs, a capital budgeting spreadsheet can always generate a positive net present value. Going beyond the mere numbers, does management have a compelling strategic narrative for why the project “fits”? Is the project an extension of the company’s current strategy, or does it supplement or reverse the strategy in some way? How does the project contribute to efforts to differentiate the company from competitors?What returns have prior projects earned? In a strict sense, historical results are not relevant to the capital budgeting decision. However, a program for monitoring actual performance relative to projections on prior projects is a key element of a sustainable capital investment process, highlighting potential “blind spots” or biases with regard to the projected financial results for the project under consideration. Capital projects that increase the size of the company may be attractive to management without being beneficial to shareholders. A process of calculating realized returns on projects can help ward off capital project bloat. WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper

“The arrogance of success is to think that what you did yesterday will be sufficient for tomorrow.”We don’t know whether 19th century English clergyman William Pollard had family business in mind when he penned those words, but their application to successful family businesses is undeniable.If everyone recognizes that innovation is a desirable trait for family businesses, what family and business attributes are most conducive to fostering an innovative culture? Recently published academic research from Vasiliki Kosmidou and Manju K. Ahuja highlights the relationship between innovation and family wealth. Their article, “A Configurational Approach to Family Firm Innovation” appears in the June 2019 issue of the Family Business Review. Our goal in this post is to introduce some of the authors’ most relevant findings to family business directors, translating, as we do, into a less academic idiom.What is Innovation?In order to draw statistical conclusions regarding a concept as potentially nebulous as “innovation,” the researchers asked the following question of the family business owners in their sample: To what extent has your company placed emphasis on the following activities over the past 3 years? a - Developing radically new products b - Introducing radically new products c - Incrementally upgrading existing products d - Leading the industry in introducing breakthrough products to the market What about your family business? If you were responding to the authors' survey, how would they assess your family business’s innovation? As a director, what are you doing to foster an innovation culture at your family business?From a more quantitative perspective, many of our clients measure and track their vitality index. When measured over time, the vitality index, calculated as the ratio of new product revenue to total revenue, provides a gauge of how successful prior innovation efforts have been. Current innovation efforts can be measured by calculating research & development expense as a percentage of revenue.For all but the sleepiest industries, the question is not whether innovation will occur, but rather whether your family business will be leading – or reacting to – trends in innovation. Your family business’s overall strategy should determine its posture toward innovation. Do your family shareholders understand how innovation fits in with your corporate strategy? Do your innovation priorities align with what the business means to the family?What is Family Wealth?Not all forms of family wealth can be measured in dollar terms. Recognizing this reality, academic researchers emphasize the concept of socioemotional wealth (SEW). In this study, the authors evaluated SEW along three separate dimensions: family continuity, family enrichment, and family prominence. The diagnostic questions used to measure SEW are fascinating, and family business directors would do well to think about how they would respond along the various dimensions.Family Continuity Dimensiona - How important is it that the business gives the members of your family an opportunity to work as a unit? b - How important is it that the business gives the members of your family an opportunity to make decisions together? c - How important is it that the business gives the members of your family an opportunity to work toward agreement? d - How important is it that the firm remains in the hands of the family and that the business decisions are directed at developing and motivating future generations toward taking over control of the firm? e - How important is it that the company serves as a vessel through which your family values are maintained and promoted to younger generations of family members? Is your family business a unifying force for your family? For non-enterprising families, there is often very little connection to relatives beyond the range of first cousins. In contrast, multi-generation enterprising families often maintain robust connections at the level of second cousins and beyond. How much value does your family ascribe to continuity?Family Enrichment Dimensiona - How important is it that through operating a business enterprise, you can ensure the enhancement of happiness of your family not directly involved in the business? b - How important is improving the family life and the relationships among family members through operating your business? c - To what extent do the needs of your family, such as the need for employment, affect the business-related decisions? d - To what extent do the needs of your family, such as the need for financial stability, affect the business-related decisions? e - To what extent do the needs of your family, such as the need for belonging, affect the business-related decisions? f - To what extend do the needs of your family, such as the need for intimacy, affect the business-related decisions? What constitutes success for your family business? Do you and your fellow directors identify success in the same way as your family shareholders? If you are an independent director, to what extent do you consider the non-financial perspectives on success implied by the family enrichment questions? Or should you even attempt to do so?Family Prominence Dimensiona - If it is important that the family gain recognition and appreciation in your community, as a company you will engage in actions that have the greatest potential to benefit the family in this regard. b - How important is it that the family can benefit from social relationships developed through your business? c - How important is it that the business can benefit from your family relationships? d - If family reputation is important, as a family you will strive to conduct business in ways that do not jeopardize the family's reputation (i.e., ethically, honestly, respectfully) How closely is your family identified with your family business? Are family members visible in marketing and promotion efforts? Or, does your family prefer to remain “out of the spotlight?” Are your family members aware of/accept the potential link between personal behavior and business performance?The SEW factors are a great reminder to family business directors that family wealth is broader than simply the size of the family checkbook or investment account.Family Wealth as a Predictor of InnovationThe heart of the research paper is an attempt to correlate innovation in family businesses to family wealth and other potentially explanatory attributes (generational involvement, presence of non-family senior executives, and the operating and competitive environment).The researchers identified six “causal configurations,” or unique factor combinations, that characterized high innovation family businesses. We can summarize their results as follows:When SEW is not present in any of its forms, innovation is high only when the operating environment is adverse. In other words, in the absence of SEW, family businesses pursue innovation only when “forced to” by the external environment.When SEW is high, family businesses are innovative in favorable external environments. In other words, “wealthy” families appear to be motivated/willing to pursue innovation proactively, even when it does not appear that there is any immediate “need” to do so.For family businesses that score high on the family prominence dimension, innovation seems to follow even when the family continuity and family enrichment dimensions are weak and the environment is adverse. In other words, securing and maintaining reputation is a powerful motivator for corporate innovation.When the family prominence dimension is weak, but the family continuity and enrichment dimensions are strong, innovation can actually be impaired, especially if senior, non-family managers are not present. In other words, an emphasis on the internal dimensions of family wealth and a desire to keep management of the business in the family can actually inhibit innovation.ConclusionWell, so what? Why should family business directors care about the link between family wealth and innovation? We think the paper is noteworthy for a few reasons. First, it reminds directors of the importance of innovation in sustaining the family business. Second, the broader definition of family wealth, and the diagnostic questions regarding SEW provide thoughtful directors with plenty to chew on. Finally, the findings help directors critically evaluate how perceptions of family wealth and other factors may be influencing the innovation culture of the family business.

From time to time, Family Business Director will interview family business leaders or experienced advisors to get their perspective on important questions common to family businesses. In this second installment, we talk with Edward Jackson, a fourth-generation family member and director of H.G. Hill Realty Company.1. Give us a brief overview of your family and business.Our family business was started in 1895 by my great-grandfather, Horace G. Hill. The business was originally a one store cash and carry grocery operation. As the grocery operation grew, Mr. Hill started buying land on the right-hand side of the road on major thoroughfares going away from downtown Nashville. The belief was that people would not want to cross traffic to get to a store on the way home in the evening. All grocery stores were accompanied by a drug store and hardware store. Today, the grocery stores have all been sold and the remaining properties are being redeveloped with grocery-anchored retail, office, and multi-family opportunities.Senior management is composed of my first cousin, a G4 member as Chairman/CEO and an outside non-family President/CFO. There are also four other G4 members on the board.2. What roles in the family business have you fulfilled over your career?I am a G4 born-in family member and hold a seat on the board. Also, I am the Co-Chair of our company's strategic planning committee that is tasked with numerous objectives to include: capital needs, shareholder liquidity, dividend policy, and succession planning.3. Do you offer an ongoing share redemption program?  If so, how long has it been in place, and what do you perceive the primary benefits of the program to be?Within the past two years, we have developed a share redemption program. It is my belief that having a liquidity option in place for family shareholders is extremely important. Family members may not ever participate in the plan; however, just having the opportunity to redeem a few shares makes people more comfortable. Also, if you do not like the direction the company is going or how it is being run, you can opt out. In a way, if no one redeems their shares, then management knows they have buy-in from the family on how things are going. Our board approves a pool of funds to be used for redemption at our spring board meeting, and the pool is then presented at the shareholder meeting. Shareholders then have approximately ninety days to submit any shares for redemption.4. Does your family business have any independent (non-family) directors?  If so, when did you first add an independent director?  What are the challenges/benefits of having independent directors?Yes, we have had independent directors involved with our business since 2003. I think that outside directors, who understand your family culture and are experienced with some aspect of your business, are invaluable resources. In my opinion, their value depends on your board structure. Is the board advisory in nature or is it a true fiduciary board that can hold management accountable for the operations of the business? Advisory board members are usually not making strategic decisions for the business. They do, however, give the family comfort knowing that someone other than family members are watching over the organization. On the other hand, a fiduciary board needs to have independent members that can help the company achieve its overall vision. They are experts in the fields that can assist management in achieving the company and family vision.In our case, our current board is advisory in nature. Our independent directors are friends of the family that are in related business fields that complement our business model. These board members know our family, are in tune with what the family needs, and are good stewards of the business. They have been an invaluable resource and lend credibility to decisions being made at the board level.One of the toughest challenges to having independent board members is board compensation. It is not as big an issue for an advisory board; however, as you move to being more of a fiduciary it might become more of an issue. I think it is important for the directors to share in the benefits of decisions that they are making at the board level. Our company has begun to look at different scenarios to accomplish this goal. Another challenge for the independent director is to get away from the question of “what does the family want to do?” This is where having a clear vision for the company that the family buys into is so important. This vision allows decisions at the board to be made freely as long as the decision moves the company in a direction to achieve the stated vision. As you can tell, I am a true believer in a strong independent board in a family business.5. What is your best advice for other family business leaders?The best advice for family business leaders is to know all you can about your shareholder base and to communicate tirelessly with them. Through our family council and Mercer Capital, we have surveyed our shareholders on a number of topics over the years and have found the surveys to be a good tool. Knowing how the family feels about certain topics i.e. selling the business or being family owned vs family controlled can give leaders valuable insight. Also, twice a year we bring in experts in different fields that relate to our business to speak to the family. These experts help explain the various market influences that can impact us both in a positive and negative way. Educating your shareholders on the business goes a long way.

This post is the second of four installments from our Corporate Finance in 30 Minutes whitepaper.  In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Three QuestionsCorporate finance is the search for rational answers to three fundamental questions.The Capital Structure Question: What is the most efficient mix of capital? In other words, is there such a thing as too little or too much debt?The Capital Budgeting Question: What capital projects merit investment? In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?The Distribution Policy Question: What mix of returns do shareholders desire? In other words, do shareholders prefer current income or capital appreciation? Do these shareholder preferences “fit” the company’s strategic position? Can these shareholder preferences be accommodated within the existing capital structure? These three questions do not stand alone, but the answer to each one influences the answers to the others.Question #1: Capital StructureFrom a corporate finance perspective, a family business can be thought of as a portfolio of capital projects. The portfolio must be financed with a combination of debt and equity. The specific combination of debt and equity used is called the company’s capital structure. As noted in Exhibit 1, lenders are entitled to a contractual return and have a priority claim on the company’s assets. Shareholders, in contrast, benefit from the potential upside of growth opportunities, but have only a residual claim on the company’s assets. Since return follows risk, the expected return for debt holders is lower than that for equity holders. The analysis of capital structure is complicated by the iterative nature of the risks facing debt and equity holders. For any given proportion of debt and equity, the cost of debt will be lower than the cost of equity. However, increasing the proportion of debt in the capital structure increases the risk of both the debt and the equity, which in turn raises the cost of each. As illustrated in Exhibit 2, at some point the benefit of using a greater proportion of lower-cost debt is eventually offset by the escalating cost of both capital sources. The optimal capital structure minimizes the overall cost of capital. As shown in Exhibit 2, the optimal capital structure for a company is likely a range rather than a single point, since the underlying measurements are naturally imprecise. Topics for Board DiscussionWhile the optimal capital structure cannot be defined with precision, the deliberations of an informed family business board and shareholders will focus on the following:What is the company’s current capital structure? The first step is estimating the value of the business enterprise as a whole. What multiple of EBITDA (or some other performance measure) does management believe is appropriate for the Company? What is the basis for that multiple (public companies, transactions, or some rule of thumb)? How do the risk and growth characteristics of the company compare to the selected benchmark?How does the company’s capital structure compare to peers? Capital structure is often related to the nature and intensity of a company’s asset requirements, sensitivity to economic cycles and other industry attributes.What is the availability and cost of marginal sources of capital? If the company anticipates growth, the supporting capital can come through retention of earnings, issuance of new equity, and/or borrowing. Given the company’s current capital structure, what effect would the various marginal financing decisions have on the overall cost of capital?What is the company’s target capital structure? How, if at all, does it differ from the current capital structure? How does it compare to peers? What factors contribute to the differences from peers? Such factors could include differing strategic focus, unique elements of the company’s business model, or shareholder risk preferences. WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper

1. What is Section 409A?Section 409A is a provision of the Internal Revenue Code that applies to all companies offering nonqualified deferred compensation plans to employees. Generally speaking, a deferred compensation plan is an arrangement whereby an employee (“service provider” in 409A parlance) receives compensation in a later tax year than that in which the compensation was earned. “Nonqualified” plans exclude 401(k) and other “qualified” plans.What is interesting from a valuation perspective is that stock options and stock appreciation rights (SARs), two common forms of incentive compensation for private companies, are potentially within the scope of Section 409A. The IRS is concerned that stock options and SARs issued “in the money” are really just a form of deferred compensation, representing a shifting of current compensation to a future taxable year. So, in order to avoid being subject to 409A, employers (“service recipients”) need to demonstrate that all stock options and SARs are issued “at the money” (i.e., with the strike price equal to the fair market value of the underlying shares at the grant date). Stock options and SARs issued “out of the money” do not raise any particular problems with regard to Section 409A.2. What are the consequences of Section 409A?Stock options and SARs that fall under Section 409A create problems for both service recipients and service providers. Service recipients are responsible for normal withholding and reporting obligations with respect to amounts includible in the service provider’s gross income under Section 409A. Amounts includible in the service provider’s gross income are also subject to interest on prior underpayments and an additional income tax equal to 20% of the compensation required to be included in gross income. For the holder of a stock option, this can be particularly onerous as, absent exercise of the option and sale of the underlying stock, there has been no cash received with which to pay the taxes and interest.These consequences make it critical that stock options and SARs qualify for the exemption under 409A available when the fair market value of the underlying stock does not exceed the strike price of the stock option or SAR at the grant date.3. What constitutes “reasonable application of a reasonable valuation method”?For public companies, it is easy to determine the fair market value of the underlying stock on the grant date. For private companies, fair market value cannot be simply looked up on Bloomberg. Accordingly, for such companies, the IRS regulations provide that “fair market value may be determined through the reasonable application of a reasonable valuation method.” In an attempt to clarify this clarification, the regulations proceed to state that if a method is applied reasonably and consistently, such valuations will be presumed to represent fair market value, unless shown to be grossly unreasonable. Consistency in application is assessed by reference to the valuation methods used to determine fair market value for other forms of equity-based compensation. An independent appraisal will be presumed reasonable if “the appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.”A reasonable valuation method is to consider the following factors:The value of tangible and intangible assetsThe present value of future cash flowsThe market value of comparable businesses (both public and private)Other relevant factors such as control premiums or discounts for lack of marketabilityWhether the valuation method is used consistently for other corporate purposesIn other words, a reasonable valuation considers the cost, income, and market approaches, and considers the specific control and liquidity characteristics of the subject interest. For start-up companies, the valuation would also consider the company’s most recent financing round and the rights and preferences of any securities issued. The IRS is also concerned that the valuation of common stock for purposes of Section 409A be consistent with valuations performed for other purposes.4. How is fair market value defined?Fair market value is not specifically defined in Section 409A of the Code or the associated regulations. Accordingly, we look to IRS Revenue Ruling 59-60, which defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”5. Does fair market value incorporate a discount for lack of marketability?Among the general valuation factors to be considered under a reasonable valuation method are “control premiums or discounts for lack of marketability.” In other words, if the underlying stock is illiquid, the stock should presumably be valued on a non-marketable minority interest basis.This is not without potential confusion, however. In an Employee Stock Ownership Plan (ESOP), stock issued to participants is generally covered by a put right with respect to either the Company or the ESOP. Accordingly, valuation specialists often apply marketability discounts on the order of 0% to 10% to ESOP shares. Shares issued pursuant to a stock option plan may not have similar put rights attached, and therefore may warrant a larger marketability discount. In such cases, a company that has an annual ESOP appraisal may not have an appropriate indication of fair market value for purposes of Section 409A.6. Are formula prices reliable measures of fair market value?In addition to independent appraisals, formula prices may, under certain circumstances, be presumed to represent fair market value. Specifically, the formula cannot be unique to the subject stock option or SAR, but must be used for all transactions in which the issuing company buys or sells stock.7. What are the rules for start-ups?For purposes of Section 409A compliance, start-ups are defined as companies that have been in business for less than ten years, do not have publicly traded equity securities, and for which no change of control event or public offering is reasonably anticipated to occur in the next twelve months. For start-up companies, a valuation will be presumed reasonable if “made reasonably and in good faith and evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations.” Further, such a valuation must be performed by someone with “significant knowledge and experience or training in performing similar valuations.”This presumption, while presented as a separate alternative, strikes us a substantively and practically similar to the independent appraisal presumption described previously. Some commentators have suggested that the valuation of a start-up company may be performed by an employee or board member of the issuing company. We suspect that it is the rare employee or board member that is actually qualified to render the described valuation. The bottom line is that Section 409A applies to both start-ups and mature companies.8. Who is qualified to determine fair market value?The safe harbor presumptions of Section 409A apply only when the valuation is based upon an independent appraisal, and it is likely that a valuation prepared by an employee or board member would raise questions of independence and objectivity.The regulations also clarify that the experience of the individual performing the valuation generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates.In our reading of the rules, this means that the appraisal should be prepared by an individual or firm that has a thorough educational background in finance and valuation, has accrued significant professional experience preparing independent appraisals, and has received formal recognition of his or her expertise in the form of one or more professional credentials (ASA, ABV, CBA, or CFA). The valuation professionals at Mercer Capital have the depth of knowledge and breadth of experience necessary to help you navigate the potentially perilous path of Section 409A. Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

In last week’s post, we explored how the estate tax works and how family business shareholders are uniquely burdened by the prospect of having a substantial estate tax liability despite potentially having most of their wealth tied up in illiquid stock.  This week’s to-do list includes important tasks for family business directors seeking to help prevent, or at least minimize, unhappy surprises with regard to the estate tax.  While the estate tax is an obligation of the shareholders rather than the family business itself, if the shareholders are not adequately prepared to manage their emerging estate tax liabilities, there can be adverse consequences for the sustainability of the family business.Review the Current Shareholder List / Ownership Structure for the Family BusinessIn family businesses, the lines between family membership, influence, employment, economic benefit from the business, and actual ownership can be blurry.  Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?  Are there potential ownership transfers that would not only alleviate estate tax exposure, but also accomplish broader business continuity, shareholder engagement, and family harmony objectives?Obtain a Current Opinion of the Fair Market Value of the Business at the Relevant Levels of ValueA current valuation opinion is essential to quantifying existing exposures as well as facilitating the desired intra-family ownership transfers.  If you don’t have a satisfactory, ongoing relationship with a business appraiser, the first step is to retain a qualified independent business valuation professional (we have plenty to choose from here).  You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).When you are reading the valuation report, you should be able to recognize your family business as the one being valued.The valuation report should demonstrate a thorough understanding of your business and its position within your industry. It should contain a clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support.  You should be able to recognize your family business as the one being valued, and when finished reading the report, you should know both what the valuation conclusion is and why it is reasonable.The appraisal should clearly identify the appropriate level of value.  If one of your family shareholders owns a controlling interest in the business, the fair market value per share of that controlling interest will exceed the fair market value per share of otherwise identical shares that comprise a non-controlling, or minority, interest.  Having identified the appropriate level of value, the appraisal should clearly set forth the valuation discounts or premiums used to derive the final conclusion of value and the base to which those adjustments were applied.For example, many common valuation methods yield conclusions of value at the marketable minority level of value.  In other words, the concluded value is a proxy for what the shares of the family business would trade for if the company were public.  Some refer to this as the “as-if-freely-traded” level of value.If the subject interest is a minority ownership interest in your privately-held family business, however, an adjustment is required to reflect the lack of marketability inherent in the shares. All else equal, investors desire ready liquidity, and when faced with a potentially lengthy holding period of unknown duration, investors impose a discount on what would otherwise be the value of the interest on account of the incremental risks associated with holding a nonmarketable interest.  In such a case, the appraiser should apply a marketability discount to the base marketable minority indication of value.On the other hand, if the subject interest represents a controlling interest in the family business, a valuation premium may be appropriate. The “as-if-freely-traded” value assumes that the owner of the interest cannot unilaterally make strategic or financial decisions on behalf of the family business.  If the subject interest does have the ability to do so, a hypothetical investor may perceive incremental value in the interest.  Such premiums are not automatic, however, and a discussion of the facts and circumstances that can contribute to such premiums is beyond the scope of this post. We occasionally hear family shareholders express the sentiment that, since gift and estate taxes are based on fair market value, the lower the valuation the better.  This belief is short-sighted and potentially costly.  For one, gift and estate tax returns do get audited, and the “savings” from an artificially low business valuation can evaporate quickly in the form of incremental professional fees, interest, penalties, and sleepless nights when the valuation is exposed as unsupportable.  Perhaps even more importantly, an artificially low business valuation introduces unhealthy distortion into ownership transition, shareholder realignment, shareholder liquidity, distribution, capital structure, and capital budgeting decisions.  The distorting influence of an artificially low valuation can have negative consequences for your family business long after any tax “savings” become a distant memory.  While the valuation of family businesses is always a range concept, the estimate of fair market value should reasonably reflect the financial performance and condition of the family business, market conditions, and the outlook for the future.Identify Current Estate Tax Exposures and Develop a Funding Plan for Meeting Those Obligations when They AriseThe most advantageous time to secure financing commitments from lenders is before you need the money.With the appraisal in hand, you can begin to quantify current estate tax exposures and, perhaps more importantly, begin to forecast where such exposures might arise in the future if expected business growth is achieved.  Are shareholders prepared to fund their estate tax liability out of liquid assets, or will shareholders be looking to the family business to redeem shares or make special distributions to fund estate tax obligations?  If so, does the family business have the financial capacity to support such activities?  The most advantageous time to secure financing commitments from lenders is before you need the money.  What is the risk that an estate tax liability could force the sale of the business as a whole?  If so, what preliminary steps can directors take to help ensure that the business is, in fact, ready for sale and that such a sale could occur on terms that are favorable to the family?Identify Tax and Non-Tax Goals of the Estate Planning ProcessAs suggested throughout this post, while prudent tax planning is important, it can be foolish to let the desire to minimize tax payments completely overwhelm the other long-term strategic objectives of the family business.  If there was no estate tax, what evolution in share ownership would be most desirable for your family and business?  The overall goal of estate planning should be to accomplish those transfers in the most tax-efficient manner possible, not to subordinate the broader business goals to saving tax dollars in the present.The professionals in our family business advisory services practice have decades of experience helping family businesses execute estate planning programs by providing independent valuation opinions.  Give one of our professionals a call to help you get started on knocking out your to-do list today.

Family business owners cite different motives for investing their time, energy, and savings into building successful businesses.  Some have entrepreneurial zeal, while others are creators who see problems in the world that they can solve.  Others are natural leaders who are inspired by the job opportunities and other “positive externalities” that successful enterprises generate for employees and the communities in which they operate.  But common to nearly all family business owners is the desire to provide financially for their heirs.  As a result, one of the most common concerns such owners cite is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.The estate tax is a tax on your right to transfer property at your death.The Internal Revenue Service defines the estate tax as follows: “The estate tax is a tax on your right to transfer property at your death.”  The amount of tax is calculated with reference to the decedent’s gross estate, which is the sum of the fair market value of the decedent’s assets less certain deductions for mortgages/debts, the value of property passing to a spouse or charity, and the costs of administering the estate.As with all taxes, things are not as simple as they seem.  Before calculating the estate tax due, two adjustments are made.  First, all taxable gifts previously made by the decedent (and therefore no longer in the estate) are added to the gross estate.  Second, the sum of the gross estate and prior taxable gifts is reduced by the available unified credit.  The unified credit for 2019 is $11.4 million.  The following table illustrates the calculations for the taxable estate of an unmarried individual. To complicate things a bit further, estates have benefited from the introduction of “portability” to the estate tax regime in 2011.  Portability refers to the ability of an individual to transfer the unused portion of their available unified credit to a surviving spouse.  The ultimate effect of portability is that for married family business owners, the total available unified credit is slightly more than $22 million. Taxes are never fun, but what proves to be especially vexing about the estate tax for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock.  Going back for a moment to our prior example, if the decedent’s assets consist primarily of a portfolio of marketable securities, it is relatively easy to liquidate a portion of the portfolio to fund payment of the tax.  If, on the other hand, the decedent’s assets are primarily in the form of shares in the family business, liquidating assets to pay the estate tax may prove more difficult (estate taxes are payable in cash and may not be paid in-kind with family business shares).  As a result, family businesses may be sold or be forced to borrow money to fund payment of a decedent’s estate tax liability. Attorneys who specialize in estate taxes have devised numerous strategies for helping families manage estate tax obligations.  Strategies range from relatively simple, such as a program of regular gifts to family members, to complex, such as the use of specialized trusts.  While the finer points of various potential strategies is beyond the scope of this post, the concept of fair market value is essential to understanding and evaluating any estate planning strategy. What is Fair Market Value?As noted above, fair market value is the standard of value for measuring the decedent’s estate, and therefore, the estate tax due.  The IRS’s estate tax regulations define fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”So far, so good.The fair market value of family business shares depends not just on the fundamentals of the business but also on the relevant level of value.But how does all this work for a family business?  To understand the underlying rationale for much estate planning, we need to explore how the standard of value intersects with what is referred to as the level of value.  In other words, the fair market value of family business shares in an estate depends not just on the fundamentals of the business (expected future revenues, profits, investment needs, risk, etc.), but also on the relevant level of value.If an estate owns a controlling interest in a family business (in most cases, more than 50% of the stock), the fair market value of those shares will reflect the estate’s ability to sell the business to a competitor, supplier, customer, or financially-motivated buyer, such as a private equity fund.  In contrast, the owner of a small minority block of the outstanding shares of a family business has no ability to force the business to change strategy, seek a sale of the business, or otherwise unilaterally compel any action.  As a result, the owner of the shares is limited to waiting until the shareholders that do have control decide to sell the business or redeem the minority investor’s shares.  In the meantime, they wait (and, potentially, collect dividends).  If there is a willing buyer for the shares, they may elect to sell, but that buyer will be subject to the same illiquidity, holding period risks, and uncertainties, so the price is unlikely to be attractive.Business appraisers often describe the levels of value with reference to a chart like the following: The levels of value chart captures two essentially common-sense notions regarding value.  First, investors prefer to have control rather than not.  The degree to which control is valuable will depend on a whole host of case-specific facts and circumstances, but in general, having control is preferred.  Second, investors prefer liquidity to illiquidity.  Again, the magnitude of the appropriate marketability discount will depend on specific factors, but not surprisingly, investors prefer to have a ready market for their shares.  Fair market value is measured with respect to both of these common-sense notions. Estate Planning ObjectivesMinimizing taxes is only one possible objective of an estate planning process.As a result, one objective of most estate planning techniques is to ensure – through whatever particular mechanism – that no individual owns a controlling interest in the family business at his or her death.  Of course, minimizing taxes is only one possible objective of an estate planning process, which might include asset protection, business continuity, and providing for loved ones.Therefore, family businesses should carefully consider whether an estate planning strategy designed to minimize estate taxes will have any unintended negative consequences for the business or the family.For example, an aggressive gifting program that causes the founder to relinquish control prematurely may increase the likelihood of intra-family strife, or jeopardize the family’s ability to make timely strategic decisions on behalf of the business.Or, adoption of an unusually restrictive redemption policy in an effort to minimize the fair market value of minority shares in the company may lead to inequitable outcomes for family members having a legitimate need to sell shares. In short, families should be careful not to let the tax tail wag the business dog.  Families should consult legal, accounting, and valuation advisors who understand their business needs, family dynamics, and objectives to ensure that their estate plan accomplishes the desired goals.

It is understandably frustrating for family business directors when the simple question – what is our family business worth? – elicits a complicated answer.  While we would certainly prefer to give a simple answer, the reality a valuation is attempting to describe is not simple.The answer depends on why the question is being asked.  We know that sounds suspect, but in this post, we will demonstrate why it’s not.  Let’s consider three potential scenarios that require three different answers.What Is Our Family Business Worth to Our Family?This is the most basic question about value, and the answer revolves around the expected cash flows, growth prospects, and risk of the family business on a stand-alone basis.  This does not mean that the status quo is assumed to prevail indefinitely, only that a combination with a strategic buyer's business is not anticipated.  The family business may have plans for significant changes to operations or strategy, and if it does, the value should reflect such changes.The value of the family business to the family depends on three principal factors: expected cash flows, growth prospects, and risk.This perspective on value is especially important to family business directors weighing long-term decisions regarding dividend policy, capital structure, and capital budgeting.  The value of the family business to the family depends on three principal factors:Expected Cash FlowsIdentifying the expected cash flows of the business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business.  Revenue and earnings are important, but future cash flows also depend on how much the business will need to spend on capital expenditures and working capital to execute on the business plan.Growth ProspectsAll else equal, the faster a business is expected to grow, the more valuable it is.  Cash flows can grow because of increasing market share, a growing market, or improving profitability.  The assessment of growth prospects should take into account each of these potential factors and the sustainability of each.RiskThe value of a business is inversely related to the risk.  Investors crave certainty, and risk is just another word for not knowing what the future holds.  The wider the range of potential outcomes for your family business, the riskier it is, and the less enthusiastic investors will be about committing capital to the business.  When investing in riskier businesses, investors pay less.  Risk is evaluated relative to comparable investments or businesses.Whether using a discounted cash flow method or using methods under the income approach, the value of the family business to the family is a function of these three attributes of the business itself.  This measure of value is often likened to the perspective of stock market investors or private equity buyers that look to the operations of the business to drive return apart from a strategic combination with another business.If this first question deals with the value of the family business assuming it continues being a family business, the second question addresses the value of the business once it stops being a family business.  In other words, what is the value of the family business to a strategic buyer?What Is Our Family Business Worth to a Strategic Buyer?Families occasionally decide they don’t want to own the family business anymore.  Families can reach this decision for different reasons.  Sometimes, the family friction associated with managing the family business has reached an unsustainable level.  In other cases, the family may be approached by a buyer of capacity with what appears to be a very enticing offer.  Or, perhaps, an enterprising family decides that a “fresh start” with proceeds from the sale of the legacy business could unlock new opportunities for the family.  In any event, when the decision to sell, or at least consider selling, has been made, directors naturally turn their attention to maximizing the sales price.A strategic buyer is one that will combine the operations of the target company with their existing operations.A strategic buyer is one that will combine the operations of the target company with their existing operations in a bid to increase the earnings and cash flow of the target and/or the newly combined entity as a whole.  Strategic buyers are most commonly competitors of the target, but they could also be suppliers or customers.  The essential attribute is that a strategic buyer has the ability to change how the target operates, resulting in either higher earnings, better growth prospects, or reduced risk (or some combination thereof).Exhibit 1 illustrates potential earnings enhancements available to a strategic buyer (in this case a competitor). By combining the target with their existing operations, the larger strategic buyer will be able to achieve purchasing efficiencies, which will contribute to a higher gross margin.  In addition, there are redundant general and administrative expenses, which can be eliminated by the buyer.  As a result, the strategic buyer anticipates generating an EBITDA margin of 22%, compared to the 16% EBITDA margin available to the target company on a stand-alone basis.  Stated alternatively, the strategic buyer anticipates EBITDA that is 38% higher. Does that mean that the target company is worth 38% more to the strategic buyer?  Not necessarily.  The amount that a strategic buyer will, in fact, pay for the target company depends on how many other strategic buyers they are likely bidding against and how unique the target company opportunity is. The magnitude of strategic benefits available and the likely negotiating dynamics for a family business tend to be very fact-specific.  So, assessing the value of your family business to a strategic buyer will require that you and your fellow directors consider the following questions: Who are the competitors, suppliers, or customers with whom our family business would provide the most compelling strategic “fit”?What opportunities would such buyers have for increasing earnings and cash flow, improving growth prospects, or reducing the risk of the family business?How unique is our family business? Are there other similarly situated businesses that can provide comparable strategic benefits to buyers? A potential strategic sale is not the only context in which family business directors need to think about the value of the family business.  We’ll consider the final variation on the question of value in the next section.What Is a Share of Stock in Our Family Business Worth to an Investor?The final question relates to the value of an interest in the family business, rather than the family business itself.  Minority shares in a family business are often considered unattractive from an investment perspective for a number of reasons.  As a minority shareholder, one has no direct influence or control over business strategy or other long-term business and financial decisions: one is simply along for the ride and subject to decisions made by others.  Furthermore, since it is a family business, there is likely no ready market for the shares.  As a result, one is effectively stuck, and, potentially, for a long time.So, from this perspective we need to think about all the things that influence what the family business is worth to the family plus some additional considerations that relate to the unique position of being a minority shareholder in a private company.  This perspective is critical for gift and estate tax planning.Are There Any Dividends?Regular cash flow dulls the pain of illiquidity.  If there is a reasonable expectation that investors will receive dividends while owning the shares, that helps to mitigate the burden of being unable to sell the shares.  Since many family businesses are set up as S corporations, it is important to clarify that the dividends that matter are those in excess of any tax liabilities that are passed through to shareholders.What are the Prospects for Liquidity?Even though there is no ready market in which to sell minority shares in a family business, there are still opportunities to sell the shares from time to time.  For example, the family business could be sold, the company may repurchase shares from select shareholders, or other family members may be willing to acquire the shares at a favorable price.  While future liquidity opportunities cannot be predicted with precision, it is possible to establish a range of likely holding periods by analyzing relevant factors.  The longer the period until a liquidity event can be anticipated, the less attractive the investment.What are the Growth Prospects for the Investment?When liquidity does come, what proceeds can be reasonably expected?  In other words, at what rate would one anticipate the value of the business to the family to grow from the current level?  If the family business has a track record of reinvesting earnings in attractive capital projects, investors will view the growth prospects more favorably than if management has a propensity to accumulate large unproductive stockpiles of cash or other assets in the business.What are the Relevant Risks?As with the business itself, the value of a minority share is inversely related to the attendant risks.As with the business itself, the value of a minority share is inversely related to the attendant risks.  The risks of a minority share include all the risks associated with the family business plus those associated with the illiquidity of a minority interest.  In other words, the focus is on identifying those risks (including, potentially, lack of access to financial statements, uncertainty as to the ultimate duration of illiquidity, uncertainty regarding future distribution decisions, and the like) that are incremental to the risks of the family business itself.The combination of expected dividends, holding period, expected growth, and risk factors determine the value of a share in the family business relative to the corresponding pro rata portion of the value of the business as a whole to the family.ConclusionThere is no simple answer to “What’s our family business worth?” because the question is never quite as simple as that.  The answer depends on exactly how and why the question is being asked.  From transaction advisory services to gift and estate tax compliance to corporate finance decisions, our valuation professionals have the experience and expertise to help you ask the right questions about the value of your family business and get the right answers.  Call us today.

This post is the first of four installments from our Corporate Finance in 30 Minutes whitepaper.  In this series of posts, we walk through the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make. In our experience, an informed and engaged shareholder base is the most important ingredient for preserving family harmony. The purpose of this short review of basic finance principles is to promote productive engagement by equipping family business shareholders with a conceptual framework and vocabulary for communicating their financial needs and preferences to the board. While family businesses face many important questions, the scope of this guide is limited to the three inter-connected financial decisions of capital budgeting, capital structure, and distribution policy. Our goal is to enable family business directors and shareholders to understand the manner in which these decisions are linked together and how they interact with corporate strategy to generate shareholder returns and value. In this series, we start with a brief overview of return and risk, the two basic building blocks of corporate finance. Having laid that foundation, we proceed in future posts to address the three big financial questions facing corporate directors. Following a quick overview of the key finance concepts relating to each decision, we will offer a list of related discussion topics for boards and shareholders. We will conclude by reviewing how each of the three questions relates to, and depends upon, each other.Finance FundamentalsThe first fundamental axiom of corporate finance is the time value of money: a dollar today is worth more than a dollar tomorrow. In other words, the passage of time has a corrosive effect on wealth. The essence of investing is deferral; one elects to defer consumption today in hopes of having more tomorrow. Corporate managers are engaged in a race against the clock, knowing that their stewardship of family resources will be evaluated by the degree to which they offset and overcome the corrosive effect of passing time on the family’s wealth.Investment returns have two components. Yield measures the current income (interest or distributions) generated by an investment. Capital appreciation measures the increase in value during the period. As shown in Exhibit 1, total return is the sum of yield and capital appreciation. There are no other sources of financial return to investors. There is an inherent tradeoff between these two components – higher current income limits future upside, and faster growth usually comes at the expense of current income. Families must select their investments from a large, but limited, menu of potential alternatives. Investors uniformly desire higher returns. However, in the process of competing with one another, investors bid up the price on less risky investments. For a given financial outcome in the future, a higher price today results in a lower return over the holding period. As a result, the more desirable investments offer lower expected returns. The second fundamental axiom of corporate finance, the risk-return relationship, follows from this. As shown in Exhibit 2, return follows risk. The diagonal line illustrates some of the more common risk-return combinations available to investors. In order to achieve a higher expected return, investors must be willing to accept greater risk. Peter Bernstein defined risk succinctly: “Risk doesn’t mean danger – it just means not knowing what the future holds.” As depicted in Exhibit 3, the most common basis for measuring financial risk is the dispersion, or variability, of potential financial outcomes. The charts in Exhibit 3 plot an equal number of outcomes for two investments. The one on the left has a tighter range of potential outcomes and is, therefore – on an absolute basis – the less risky of the two. However, the absolute riskiness of an investment is less important than the contribution of that investment to the overall risk of a diversified portfolio. The rational response to risk is to diversify. Diversification is effective to the extent that the components of a diversified portfolio respond differently to common economic factors. Dividing one’s investment portfolio among multiple assets is a waste of time if those assets all behave in the same way. Correlation is a measure of the “co-movement” of returns. The more similar two investments are, the higher the correlation between them; highly correlated investments do not contribute much to diversification. Exhibit 4 illustrates the risk-reduction benefit of less-than-perfect correlation among assets in a portfolio. The two investments in Exhibit 4 (the blue and orange bars) have equal risk on an absolute basis. However, the returns are not perfectly correlated with one another, making them well-suited diversification partners. As a result, an equal-weighted portfolio of these two assets exhibits is less risky than either investment by itself. Since diversification is relatively easy, most people do it. As a result, the relevant measure of risk that corresponds to return (Exhibit 2) is the asset’s contribution to the overall riskiness of a well-diversified portfolio. This is called systematic risk. So, we can supplement our risk axiom as follows: return follows systematic risk. Quick ReviewBecause a dollar today is worth more than a dollar tomorrow, investors evaluate investment performance by calculating returns. Investment returns are the sum of yield (current income) and capital appreciation (future upside). Higher expected returns can be achieved only by accepting higher risk. From a financial perspective, risk is simply the dispersion of the variability of future outcomes. Since diversification reduces risk, the most relevant measure of risk to investors is systematic risk, or an asset’s contribution to the risk of a well-diversified portfolio. WHITEPAPERCorporate Finance in 30 Minutes: A Guide for Family Business Directors and ShareholdersDownload Whitepaper

In a previous post, we identified the four basic economic meanings that a family business can have.  For some families, the business is an economic growth engine for future generations.  For others, the family business is a store of value.  Alternatively, the family business can be a source of wealth accumulation or a source of lifestyle for family members. As noted in our prior post, there are certain family and business characteristics that can help family members discern what meaning “fits” their circumstances best.  The meaning of the family business, in turn, has implications for the dividend policy, reinvestment, and financing decisions for the family business. In this post, we examine how the meaning of the family business influences these corporate finance decisions. Family Business as an Economic Growth EngineFor some families, the purpose of the business is to grow the family’s wealth for the benefit of future generations.  Sustaining or growing per capita business value as the family grows biologically often requires deferring current returns.  The following table summarizes how this first meaning influences major corporate finance decisions. For this meaning to “stick,” family shareholders need to be willing to fund their household expenses and lifestyle choices with other sources of income, whether in the form of wages (inside or outside the family business) or returns on other investments. The principal risk of adopting this meaning is that, since truly attractive investment opportunities are scarce, the pressure to reinvest may result in the business making increasingly risky investments.  Such investments may offer returns high enough to meet growth objectives, but only at the expense of an unattractive risk level. Family Business as a Store of ValueFor other families, the business may serve as a store of value.  By store of value, we mean that the role of the family business is to mitigate the volatility that may be present in other elements of the family’s wealth.  In contrast to the public equity markets, which can experience dramatic short-term swings in value, the family business functions as a steadying force on the family’s collective balance sheet.  In other words, the emphasis for these families is on preserving rather than increase the value of the family business over time. When the business serves as a store of value for the family, the different generations of the family need to understand that the emphasis on capital preservation may result in an erosion of per capita business value over time (especially on an inflation-adjusted basis).  Investing is about tradeoffs: families can’t expect to have both safety and enviable growth.  There’s nothing inherently wrong with pursuing safety, but family members need to understand the (opportunity) cost of doing so. The principal risk of this meaning is the increased likelihood that the family business may accumulate low-yielding non-operating assets that create a drag on future shareholder returns. Family Business as a Source of Wealth AccumulationOthers, wary of putting all of the family eggs in a single bucket, view the family business as a source of wealth accumulation for the family.  Rather than the family business itself being the direct engine of economic growth through reinvestment and capital appreciation, the family business instead provides the “seed capital” for family shareholders to accumulate wealth outside the family business.  These families seek to foster an entrepreneurial culture in which the most substantial reinvestment activities occur outside the legacy family business. When families adopt this meaning, there is a chance that the business will no longer provide a unifying center to family life.  If individual family shareholders are reinvesting dividends from the legacy family business, differing investment outcomes can lead to significant wealth disparities among the various branches of the family tree over time.  In an effort to counteract this potential outcome, some families elect to pursue reinvestment through a common family fund.  This helps ensure that family wealth remains balanced, but also limits the ability of family members to tailor a wealth accumulation plan to their unique needs, preferences, and risk tolerances. From the perspective of the family business, a risk of this meaning is that the business may lose existing competitive advantages if profitable reinvestment opportunities are foregone in favor of distributions. Family Business as a Source of LifestyleProlonged capital appreciation may be what makes a family wealthy, but predictable dividend checks are often what make family members feel wealthy.  In accord with this reality, the final meaning that a family business can have is that of an ongoing source of lifestyle for family shareholders.  This does not require that dividends be sufficient to fund a source of idle leisure, but does require that dividends be regular and predictable.  With predictability, family shareholders have assurance that other sources of income will be supplemented by dividends from the family business.  Depending on the size of the business, these dividends may be sufficient to fund automobile, vacation, housing, or education choices that would not otherwise be attainable by family members. Families adopting this meaning need to understand the inherent tradeoff between realizing the lifestyle benefits of the family business in the present and preserving that benefit for future generations.  If the biological growth of the family is above average, it may be difficult for the family to maintain the lifestyle to which it has grown accustomed on a real per capita basis in the next generation. Since reinvestment takes a backseat to the predictability of dividend payments, the family business faces two mirror-image risks.  When the business performs well, low-yielding assets may accumulate if retained earnings exceed attractive investment opportunities.  On the other hand, in lean years, the dividend may crowd out needed capital investment in the business. ConclusionA clear understanding of what the business means to the family is essential if decisions about dividend policy, capital budgeting, and capital structure are to be made in a coordinated, rather than disjointed, manner.  Consensus regarding these critical long-term decisions will be fleeting and unpredictable without prior consensus about what the family business means to the family.  Our professionals are eager to help your family discern what your family business currently means and assess whether that meaning will provide a proper “fit” going forward.

A recent federal court decision in a tax dispute represented a significant victory for family business shareholders.  The case (Kress v. U.S.) revolved around the value of a multi-generation family business, Green Bay Packaging (“GBP”).  Our colleague Chris Mercer wrote an extended review of the technical appraisal issues in the case which can be found here.The plaintiffs, family shareholders in GBP, had made a series of gifts of minority shares of GBP based on contemporaneous appraisals from 2006 to 2008.In August 2014, the IRS assessed additional tax and interest on the gifts, claiming that the fair market value of the gifted shares was approximately over twice the amount claimed by family shareholders.In response to the IRS deficiency notice, the taxpayers paid the assessed tax and interest and filed suit in federal court for a refund.In its ruling, the federal district court sided with the taxpayers, concluding that the fair market value of the gifted shares was nearly identical to the amounts originally claimed. While we generally think family business directors have more important things to think about than tax-related judicial decisions, the Kress decision is one with which family business directors should be familiar.  In this post, we identify five important takeaways for family business directors from Kress.1. Contemporaneous Appraisals Are More PersuasiveThe business valuation reports that were ultimately vindicated by the Court were those prepared in real-time in the ordinary course of business.  GBP had a legacy of regular appraisals that were apparently used for a variety of purposes.  In the Court’s eyes, the contemporaneous appraisals prepared by a qualified professional having a long history of familiarity with the company were more reliable than the valuations prepared long after the fact and rendered in the context of an already existing dispute.Does your family business have a program of regular appraisals performed by a reputable and qualified business appraiser? Do the appraisals reflect a consistent valuation methodology, adapted to the unique circumstances and economic conditions at each valuation date?  Are the conclusions of these appraisals used in contexts other than tax compliance (i.e., corporate planning, shareholder redemptions, etc.)?2. S Corporations Are Not Worth More Than C CorporationsFor decades now, the IRS has maintained that S corporations – since they do not pay corporate income tax –are inherently worth more than otherwise comparable C corporations.  Observers have long noted that this position defies common sense as S corporations have to make distributions to shareholders each year in amounts sufficient for the shareholders to pay their personal tax liabilities on S corporation earnings.  In other words, S corporations are burdened by taxes on income the same way as C corporations; the only difference is that S corporation income tax payments flow through the hands of shareholders before reaching the IRS coffers.If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporation?The IRS’ stubbornness on this issue has been a nuisance to family shareholders more than anything.  Most experienced business appraisers, understanding the economic rationale summarized above, have ignored the preferred IRS position in measuring fair market value.  However, in so doing, all parties understood that they were inviting a potential challenge from the IRS.GBP is organized as an S corporation, but the company’s appraiser opted to follow economic logic and treat the company as if it were a C corporation for purposes of the valuation.  In accepting the resulting valuation conclusion, the Kress Court effectively acknowledged the propriety of that treatment.  While the appraiser retained by the IRS applied corporate taxes as if GBP were a C corporation, he then increased the conclusion of value by adding an S corporation.  The Kress Court rejected that premium.How is your family business structured for tax purposes?  If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporationThe Tax Cuts and Jobs Act of 2017 has shifted the calculus on whether the S election is beneficial – have your tax advisors helped you assess whether S corporation treatment remains optimal for your family business?3. Economic Conditions MatterThe gifts that were at the heart of the tax dispute were made in the years leading up to and at the start of the Great Recession.  The Kress Court criticized the report of the appraiser retained by the IRS for failing to give adequate consideration to the impact of the Great Recession on the fair market value of family businesses.By preparing contemporaneous valuations, GBP’s appraiser was necessarily attuned to the economic dislocations of the time and how the value of the business was affected.  In particular, the contemporaneous appraisals assigned significant weight to indications of value derived under the market approach, which examined the observable pricing behavior for a representative group of comparable public companies.  Developing indications of value under the market approach for consideration in the overall conclusion helps to ensure that the valuation effect of current economic conditions is not overlooked or minimized.Does your family business operate in a cyclical or counter-cyclical industry?  How does your valuation take into account signals from the market?  Is your family business ready for the next recession?4. Know Your Appraiser, and Make Sure Your Appraiser Knows YouGBP’s appraiser, John Emory, has had a long and distinguished career in the valuation profession.  Perhaps more important, it is evident from the Court’s decision that Mr. Emory had a thorough understanding of GBP’s business based on years of interviews with management.In contrast, the Kress Court noted that the appraiser retained by the IRS had not spoken with GBP management beyond attendance at a deposition.  While much can be learned about a company from careful study of its financial statements, some aspects of the business are much easier to understand by being on-site and speaking with management.Does your family business have an ongoing relationship with an experienced and qualified business appraiser?  Has your business appraiser developed a thorough understanding of how your family business operates and the factors that make your family business valuable?5. Don’t Get GreedyToo often, family business shareholders think about valuation only from the perspective of minimizing gift and estate taxes.  While the Kress decision does not provide sufficient financial data from GBP to make relative value assessments, the Court’s adoption of the taxpayer’s appraisal suggests that the valuation was a valid determination of fair market value rather than a “low-ball” estimate intended to minimize tax payments.Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity?This is particularly evident in the marketability discounts applied in the taxpayer appraisals.  The taxpayer’s appraiser applied marketability discounts between 28% and 30%.  While the appropriate marketability discount depends on the specific facts and circumstances pertaining to the subject interest, the marketability discounts applied often correspond to the underlying economics of minority shares in the family business.  The marketability discount is not a tool for reducing taxes, but is instead a reflection of the economic reality of owning illiquid shares in a family business.In short, while gift and estate tax compliance may be an important application of the valuation of your family business, it is not the only application.  As noted above, valuation conclusions will generally be more persuasive if they are used in multiple contexts beyond just tax compliance.  An aggressive valuation for tax compliance may carry unintended negative consequences elsewhere in your family business.As directors, how do you use appraisals of your family business?  Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity?  Does your family business have a redemption policy or buy-sell agreement?  If so, does it specify the “level of value” to be used?ConclusionThe Kress decision is a welcome one for family businesses.  Our valuation professionals are eager to talk with you about how the lessons from Kress noted above affect your family business.  Call us today.

From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.What are the most important qualitative factors to consider when evaluating a proposed capital project?Net present value analysis, internal rate of return, and other quantitative analyses are important tools for evaluating capital projects.  While family business directors should be acquainted with these tools and generally understand how they work, it is just as important that directors understand the limitations of these tools.Quantitative capital budgeting tools cannot answer this question: should we undertake the proposed capital project?Specifically, these capital budgeting tools are ideal for answering this question: Is the proposed capital project financially feasible?  Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project?  The first question opens the door to the second, but the tools of capital budgeting – no matter how sophisticated or quantitatively precise – cannot answer the second.  To answer the second question, you and your fellow directors need to consider three qualitative factors, each of which can be framed in the form of a corresponding question.1. Market OpportunityThe market opportunity question is simply this:  Why does the proposed capital project make sense?  Management must be able to provide a simple, straightforward, and compelling answer to this question.  The components of an acceptable answer to this question should focus on the customer need being addressed by the project and how the project is an improvement over how the market is currently meeting the identified customer need.  Under no circumstances should the answer to this question reference a net present value or internal rate of return.  If the minimum conditions of financial feasibility have not been met, the proposed project should not be in front of the board.2. Strategic FitOnce the market opportunity has been demonstrated and vetted by the board, the next question is this:  Why does the proposed capital project make sense for us?  In other words, how does the proposed capital project relate to the family business’s existing strategy?  Does the proposed project represent an extension of the existing strategy, or does it deviate from the strategy?One temptation that family businesses can succumb to is modifying an existing strategy for the express purpose of justifying a proposed capital project that a key constituency really wants to do, which is inadvisable.  Instead, the board should understand why a change in the company’s existing strategy is warranted and why the proposed change to the strategy is an improvement given current market and regulatory conditions, competitive dynamics, and opportunities.  If the board determines that the proposed change in strategy is appropriate, then the discussion can move to whether the proposed capital project should be approved.  If strategy is the driving factor, the proposed capital project may not necessarily be the best way to execute on the new strategy.Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess. This discussion presupposes, of course, that the family business has a strategy that has been clearly communicated to management, employees, and shareholders.  Absent a guiding strategy, capital budgeting can devolve into what one of our clients sagely referred to as “a race to the table.”  If there’s no guiding strategy, the first manager to arrive at the board meeting with a financially feasible project is likely to receive approval, even if the project does not promote the long-term health and sustainability of the family business. Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.3. ConstraintsThe final question is this:  Can the proposed capital project be done by us?  Management's time and attention, infrastructure and systems, and human resources are limited.  Will undertaking the proposed capital project divert scarce resources away from other areas of the business?  In our experience, managers proposing capital projects tend to underestimate the impact a project will have on the rest of the business.  While it is certainly true that some expenses are fixed in the short term, all expenses are variable in the long-run.  Resource constraints can be overcome, but directors should be certain that the full cost of doing so has been contemplated and reflected in the capital budgeting analysis.Does your family business have a robust capital budgeting process that determines whether a proposed capital project is financially feasible?  If it does, that’s great.  But the approval process cannot end with a green light on the financial side.  Family business directors need to be diligent to answer the qualitative questions identified in this post.

This post is the fourth and final installment from our Basics of Financial Statement Analysis whitepaper.  In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company.Telling the Company’s StoryHaving reviewed the primary financial statements individually, we review in this section how the statements relate to one another.  A comprehensive view of how items on one financial statement relate to items on another financial statement is necessary to discern the underlying story or narrative of the company.Exhibit 1 below summarizes the principal components of the three financial statements.  We address the most important relationships in the following numbered sections corresponding to Exhibit 1.#1: Balance Sheet and Income StatementThe balance sheet and income statement link up with each other at a few key points that are important for analysis.Total assets and revenue. Assets are valuable to the extent that they generate (profitable) revenue.  Measuring the efficiency with which the company’s assets generate revenue can be a helpful way to evaluate the success of a company’s strategy over time and to compare its performance to that of peer firms.  Decreasing asset efficiency may be a sign that the company is accumulating excess, or non-productive, assets when distributing a greater proportion of earnings would be more optimal.Revenue and accounts receivable.  For companies that sell on credit, correlating the balance of accounts receivable to revenue over time can reveal changes in normal credit terms, and/or provide a proxy for the financial health of the company’s customers.  As the average time receivables are outstanding increases, collectability becomes more difficult, and the wedge between reported earnings and operating cash flow widens.Cost of goods sold and inventory.  The relationship between cost of goods sold and inventory is akin to that between revenue and accounts receivable.  If inventory balances are growing disproportionately to cost of goods sold, there may be concerns regarding production inefficiencies, market demand for the company’s products, and an increasing likelihood of inventory obsolescence.Depreciation and net fixed assets. As noted previously, the amount of depreciation expense incurred on the income statement is determined by the net fixed assets on the balance sheet.Amortization and intangible assets.  As with depreciation, amortization charges are a function of intangible assets recognized on the balance sheet.  The presence of intangible assets and the resulting amortization expenses indicate that the company has grown – in part, at least – through acquisition rather than organically.Interest expense and debt.  The interest expense reported on the balance sheet is a function of the average amount of debt outstanding during the period and the effective interest rate on the debt.  Interest expense on the income statement will prompt an experienced financial statement reader to consult the notes to learn about the relevant terms of the debt.#2: Income Statement and Statement of Cash FlowsIn addition to reconciling reported earnings to operating cash flow, the statement of cash flows can provide leading indicators for the income statement.Net income and operating cash flow.  Two of the three primary components of the reconciliation of net income and operating cash flow are found on the income statement.  While non-cash charges to earnings do not consume cash in the current period, they do correspond to cash outflows in prior (depreciation and amortization) or future (equity-based compensation) periods.Capital expenditures and depreciation expense. Acknowledging that capital expenditures can be lumpy, the relationship between capital expenditures and depreciation expense is worth examining.  Capital expenditures in excess of depreciation should correspond to revenue and profit growth.  If capital expenditures consistently lag depreciation, that may be a signal that some expenditures have been deferred and will need to be made in the future to maintain productive capacity.Acquisitions and operating income.  Acquisitions on the statement of cash flows should be a leading indicator of operating income growth.  A history of acquisitions without corresponding increases in operating income may suggest that the company’s capital budgeting process is not functioning well.Transactions with lenders and interest expense. If the company is a net borrower, interest expense will be expected to grow in future periods.  If so, is operating income sufficient to sustain a higher degree of financial leverage?  If the company is repaying debt, interest expense will decrease, although potentially at the cost of slowing earnings growth on a per share basis.Transactions with shareholders and earnings per share. One motivation for companies to repurchase shares is to stimulate growth in earnings per share.  If attractive investment opportunities are scarce, repurchasing shares at an appropriate valuation may be an effective tool to augment growth in earnings per share.#3: Balance Sheet and Statement of Cash FlowsThe statement of cash flows analyzes cash flows by tracing changes in balance sheet accounts.Working capital and operating cash flow.  Changes in accounts receivable, inventory, and accounts payable are key elements of reconciling reported net income to operating cash flow.  While often not accompanied by the same degree of intentional deliberation, investment in working capital is no different than investment in fixed assets or business combinations.Capital expenditures and net fixed assets.  To the extent capital expenditures exceed depreciation charges, the balance of net fixed assets will increase.  If the incremental assets are not productive, investment returns will suffer.Acquisitions and intangible assets.  Devoting capital resources to acquisition activity will increase the balance of intangible assets.  The degree to which an acquisition is accretive to returns depends, in large part, on the negotiated pricing of the deal.Transactions with lenders and interest-bearing debt.  Net borrowing or repayment of debt will reconcile to changes in the balance of interest-bearing debt.  As noted previously, financial leverage increases both potential returns and risk.  Changes in debt should be evaluated relative to the overall market value-weighted capital structure of the company.Transactions with shareholders and shareholders’ equity. The decision to issue new shares or return cash to shareholders through dividends and share repurchases should be evaluated with regard to the availability of attractive investment opportunities and the marginal costs of debt and equity capital.DuPont Analysis – Dissecting the Plot The classic example of cross-financial statement analysis is DuPont analysis.  As illustrated in Exhibit 2, this technique breaks return on equity into its component parts using elements from the balance sheet and income statement.  DuPont analysis is a simple tool for helping to uncover the narrative underlying the company’s operating performance. Return on equity is a measure of the efficiency with which the shareholders’ investment in the business generates net income.  All else equal, shareholders prefer more net income per dollar of investment.  Using DuPont analysis, this aggregate measure of financial performance is disaggregated into three components, each of which can be correlated to the company’s overall strategy and compared to other firms. Profit margin. Profit margin measures the profitability of the company per dollar of revenue.  Profit margin reflects the relative competitive strengths of the company and the degree to which barriers to entry exist to limit competition.Asset turnover.  Asset turnover measures the efficiency with which the company employs its assets to generate revenue.  Asset turnover can reflect strategic decisions such as whether to lease or purchase facilities.  Non-operating or excess assets reduce asset turnover.Financial leverage. Financial leverage measures the degree to which the company uses OPM (“other peoples’ money”) to fund operations.  Financial leverage can have a multiplicative effect on return on equity, although it also increases risk. DuPont analysis can be used both to evaluate the company’s performance over time and to compare the company’s performance to peers.  The underlying conceptual framework can also be helpful in evaluating the effect of potential changes to the company’s strategy.Assessing Projected Financial StatementsUnderstanding historical financial performance is important, but the ultimate objective of financial statement analysis is to develop expectations regarding the amount and timing of future cash flows.  In this section, we review the key elements of a financial forecast.Revenue growth. Revenue is the starting point for nearly any financial projection model.  For most companies, a revenue forecast will be more credible if the analyst can distinguish between unit volume growth and anticipated changes in pricing.  Unit volume growth can then be compared to expectations for the broader industry, and pricing assumptions can be evaluated for reasonableness in light of inflation expectations and the competitive dynamics in the industry.Gross margin.  Gross margin projections should be supportable with reference to key commodity inputs and other elements of the production process (direct labor, fixed overhead).  Deviations from historical performance or available peer data should be reconciled to differences in strategy or projected market conditions.Profitability. Forecasts of profitability are best evaluated by calculating the implied margins.  EBITDA is often an appropriate measure of profitability for forecasting, since a discrete depreciation and amortization forecast can be calculated separately.  Comparison of fixed and variable costs can add texture and credibility to the forecast, particularly if margins are projected to change.  The concept of reversion to the mean is important to keep in mind when reviewing projected profitability; competitive and market forces can have a corrosive effect on above-peer margins over time.Capital expenditures.  The forecast of capital expenditures should be evaluated relative to the projected revenue stream and existing capacity utilization.  Since capital expenditures are often lumpy, the year-to-year relationship to depreciation will not necessarily be predictable.  However, over the long-run the two amounts should be comparable in the aggregate.Working capital. Working capital can be the “silent killer” of cash flow forecasts.  The reasonableness of projected working capital balances can be assessed either in the aggregate (generally as a percentage of revenue) or at the level of the individual components.  In either case, working capital assumptions should be compared to historical trends for the company, peer averages, and anticipated strategy shifts.Interest-bearing debt. When projecting cash flow to shareholders, anticipated borrowings are cash inflows, while the repayment of debt is a cash outflow.  Interest expense should be forecast with reference to average projected debt balances and assumed interest rates.  For companies that rely on floating rate debt, it may be appropriate to examine forward LIBOR curves to estimate future interest expenses. The critical touchstones for evaluating projected financial performance are the historical results of the company itself and relevant peer data, when available.  For the forecast as a whole (and each of the primary components), the projected inputs and results should be consistent with the company’s overall story, as revealed in the analysis of the historical financial statements.The Notes to the Financial StatementsAudited financial statements contain detailed notes.  Reading and understanding these notes is an integral part of reading the financial statements.  The notes relate valuable information that cannot be presented on the face of the actual financial statements.  While the content of the notes will vary, general categories of interest will generally include the following:Accounting policies. Management often chooses between multiple potential accounting treatments for a given transaction.  Understanding when revenue is recognized, what depreciation pattern/life is used, and how inventory is accounted for is important when comparing financial statements for different companies.Asset detail.  The composition of inventory (raw materials, work in process, and finished goods), net fixed assets (land, buildings, rolling stock, leasehold improvements), and intangible assets (customer relationships, tradenames, goodwill) helps to reveal the company’s strategy.Debt terms. For companies with financial leverage, the notes to the financial statements will provide important information regarding the rates and maturities of the company’s outstanding debt, all of which are critical to assessing the company’s financial flexibility.Remaining lease payments. Although multi-year lease agreements do not currently appear on the balance sheet as financial obligations, such agreements are in many ways similar to debt in that they represent fixed obligations that are payable regardless of the future operating results of the business.  The notes to the financial statements detail the annual lease payments the company is obligated to make in coming years.Pension and benefit liabilities.  The accounting for defined benefit pensions and other post-retirement benefits is complex.  The notes to the financial statements summarize the most important assumptions management has made regarding the amount of benefits to be paid and the expected return on plan assets.Acquisitions. The notes to the financial statements generally include discussion of significant business combinations, including pricing, allocation of purchase price to assets acquired, and occasionally, pro forma financial results for the acquired business.Equity-based compensation. Many companies use equity-based compensation plans to incentivize management.  While the accounting treatment of such plans can be somewhat arcane, the notes to the financial statements include informative schedules that help to quantify the potential dilution from such plans.Material subsequent events. There is a lag between the issuance date and the as-of date for the financial statements.  If a significant corporate event (acquisition, divestiture, refinancing, lawsuit, etc.) has occurred during that interim period, it will be disclosed in the notes to the financial statements. Astute readers of financial statements know how essential the notes are.  There is no shortcut to a careful reading of the notes.ConclusionReading financial statements is an essential part of evaluating the performance of management, corporate strategy, and plans for the future.  The balance sheet, income statement, and statement of cash flows each provide an indispensable vantage point on the company’s performance.  Understanding what the different statements do and how they fit together enables the reader to uncover the company’s narrative or story, with a view to developing expectations for future performance and evaluating how different strategy options will affect future cash flows.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper

This week’s post is the first in a periodic series of “Family Business Industry Spotlights.”  In these posts, we will share conversations with our family business advisory professionals who have deep experience working with family businesses in a particular industry.  We think the conversations promise to be of interest to family business directors regardless of their industry.  This week, we talk with Tim Lee about the challenges and industry trends facing families in the beverage wholesaling industry.1. How have beverage wholesalers performed over the past decade?This is a good-news-bad-news answer.  For context, we need to describe the structure of the industry.  Beverage wholesalers occupy the middle tier of a three-tier regulatory system in the alcoholic beverage industry.  With very few exceptions, virtually all alcoholic beverages must be delivered through the wholesaler channel which connects beverage producers and suppliers with the various retail licensees that sell goods to consumers.Let’s tackle the bad news for malt beverage wholesalers – the major domestic brands, while still commanding considerable market share, are experiencing decreasing volume as consumers clamor for new choices.  Ironically, despite the ongoing search for something new, prime consumer demographics have become saturated with an overabundance of beverage categories and choice, as attested by the peaking or shrinking volumes of some well-known craft brewers.  Boomer consumption patterns, particularly in high-density markets, no longer provide a safe haven for the major domestic brands.  Low-density markets still survive on the fading market share glory of legacy brands, but small territories with costly windshield times are exhibiting declining volumes due to an aging consumer base lacking/lagging in new product adoption.  Additionally, in gentrified high-density markets, wine & spirits and alternative choices abound, eroding brewers’ share of mouth.The short answer is – many wholesalers are doing fine, some better than ever.Despite the challenges on the malt side of the beverage world, innovation in craft, imports, and new categories, coupled with premium pricing across the spectrum have generally kept malt wholesalers cash flowing and profitable, albeit middle-tier consolidation has left fewer family wholesalers banking the dividends.  Wine & spirit wholesalers are doing quite well as many states liberalize previously restrictive retail licensing laws and an aging demographic pushes consumption patterns toward presumably less filling, higher alcohol-content beverage choices.  As with the malt side of the industry, the increasing dominance of large wine & spirit wholesalers has thinned the ranks of independent operators.So, the short answer is – many wholesalers are doing fine, some better than ever.  Others are facing certain absorption as the middle tier of the industry consolidates and hybridizes with other beverage categories.2. In your experience, how do families in the beverage wholesaling industry deal with ownership and management transition?Suppliers in the alcoholic beverage industry generally require their wholesalers to demonstrate ownership stability and commitment through direct business involvement.  In general, owners are required to be active participants in their businesses and to have approved succession and contingency plans.  As with other closely held businesses, familial continuity plans often evolve, promoting or mandating mergers or outright sales in order to facilitate the liquidity needs of departing owners whose wealth is often concentrated in their family businesses.  In cases where continuing family ownership is desired and feasible, we see varying approaches for transitioning ownership that range from conventional trust and estate strategies to thoughtfully designed and funded buy-sell agreements.  Regardless of the strategy employed, an acute understanding of how “fair market value” reconciles to strategic market value is vital to buyers and sellers in the transaction process.3. What are the biggest risks facing families in the beverage wholesaling industry today?The elephant in the room for family transition planning is consolidation and the ever-encroaching specter of professionalized capital upon the industry.  Families with the talent, capital, and risk tolerance to mimic the deep-pocketed players in the industry should fare well.  Those without the resources may be forced to bid farewell sooner than later.The elephant in the room for family transition planning is consolidation and the ever-encroaching specter of professionalized capital upon the industry.Risk for families in this industry is a very situational and subject to personal perspective.  The industry is, in my view, relatively low in execution risk under the prevailing regulatory platform.  It seems a virtual certainty that consumers will consume a certain amount of alcohol in one variety or another for the foreseeable future just as they have over the course of human history.  However, middle-tier operators are getting squeezed from both sides of their industry.  Disruption by way of regulatory change and the commercial interests that compel such changes seem a risk to the wholesaler industry as a whole.  In the interim, the risk is that smaller wholesalers will continue to get pushed out.On the bright side, unlike virtually all other industries where going out of business is economically punitive, laws in most states oblige suppliers and consolidators to compensate exiting wholesalers for the value of their brand rights.  Wholesalers who lack a fundamental understanding of transaction finance and brand rights valuation run the risk of leaving money on the table in those transactions.  Likewise, families electing to prune their shareholder base need a proper understanding of the options and challenges that accompany inter-family transactions.4. What is the most important industry trend that will affect families in the coming decade?At the risk of oversimplifying: consolidation, consolidation, consolidation.  Apologies – that was three most important trends.  The trends that affect consolidation are varied and complex, and the characteristics of transaction participants can have a direct bearing on deal values.  Families must get informed or risk being on the wrong side of a zero-sum equation.If your distributorship is healthy but stagnant, the industry is serving notice to either grow or exit.  Simply put, growth means deploying capital and/or deferring liquidity in an evolving market with emerging risks - selling out means harvesting business value and reallocating family wealth to other assets.  Big consolidators appear convinced that the legacy system will eventually experience a meaningful shake-up.  Mergers among global producers and the downstream consolidation of wholesalers suggest that, with the stroke of a regulatory pen, the historically distinct tiers of the U.S. alcoholic beverage system could be dramatically re-ordered.5. If you could add one agenda item to a beverage wholesaler’s next board meeting, what would it be?As a valuation and litigation practitioner and a transaction intermediary, I’d be remiss if I didn’t advise directors and major shareholders to get familiar with the myriad of value drivers in the industry.  There’s only one way to do that, which involves retaining an expert.  Also lacking for many wholesalers is a proper understanding of how tax reform has altered longstanding rules of thumb that many use to gauge their brand and distributorship valuations.  Get informed or risk getting out maneuvered by the deeper pocketed and growing oligarchy of beverage operators.

Family Business Director was in sunny Tampa last week at the spring edition of the Transitions Conference produced by Family Business Magazine.  It was a great event, with about 275 attendees representing nearly 100 enterprising families.  The perspectives offered from the stage and through intensive workshops highlighted some of the most pressing concerns family business directors have to address, and informal conversations with participants over meals and during breaks confirmed the reality of these issues in day-to-day family and business life.For family shareholders who are not employed in the business, the family business can be a bit of a mystery.The sessions offered fresh insights on perennial challenges around succession planning, conflict management, and communication.  But the recurring – if not underlying – theme that impressed us was the challenge of shareholder engagement.  For family shareholders who are not employed in the business, the family business can be a bit of a mystery.  Despite knowing that the family business is important to them economically, many “outside” shareholders are in the dark about how the company works and how the economic benefits of ownership accrue to them.The advantages of family-owned businesses are well-documented.  But consider for a minute the perspective of a minority family shareholder that doesn’t work in the business relative to a minority shareholder in a public company.In view of these comparisons, is it any wonder that “outside” family shareholders are occasionally frustrated?  Over time, lack of transparency triggers speculation on the part of shareholders as to what the “real story” must be.Public companies understand that well-informed shareholders contribute to a lower cost of capital.  A company’s cost of capital is the economic hurdle rate for a company, or the minimum return needed to satisfy its lenders and shareholders.  The cost of capital is a primary driver of business value and stock price.  As a result, most public companies are rather obsessive about keeping shareholders informed about the company’s performance, management, and strategy.  Yes, many of the disclosures are mandated by the Securities and Exchange Commission, but public companies often go beyond the bare minimum regulatory disclosures, believing that an informed and engaged shareholder base is a strategic advantage.  Public companies refer to this management function as “investor relations.”We have long found it a bit ironic that many family businesses do not assign the same importance to investor relations that public companies do.  After all, the leaders of family businesses are literally related to their shareholders.  We suspect the reluctance of many family businesses to take investor relations seriously stems from some combination of three potential beliefs.First, the family members working in the business may feel that the “outside” family members should simply trust them to do what is best for the business and the family. From this viewpoint, working in the business grants the family managers a measure of “sweat equity” entitling them to a measure of respect and implicit trust from the rest of the family.Second, in contrast to public company shareholders that can take their capital elsewhere, family capital is “captive” capital that cannot easily be reallocated by owners. In other words, some family businesses ignore investor relations because of a perception that they don’t have to.Third, the family members working in the business may believe that the “outside” family members are not capable of understanding detailed financial information regarding the performance of the family business.Family shareholders are most likely to grow suspicious when they perceive that relevant information is being unreasonably withheld from them.In our view, each of these perspectives is short-sighted.  The desire of family shareholders to be informed about their investment is not necessarily attributable to some unhealthy mistrust of the family members managing the business.  Rather, family shareholders are most likely to grow suspicious when they perceive that relevant information is being unreasonably withheld from them (i.e., “they must be hiding something”).  While family capital may indeed by “captive” to the family business, if the family relations become toxic enough, family shareholders may resort to litigation in an effort to liberate their capital.  Defending such litigation is not a good use of management time or business resources.  Finally, a robust shareholder education program, coupled with tailored disclosures carefully designed to communicate relevant information rather than merely overwhelm recipients with data can overcome nearly any communication barrier.In short, we came away from last week’s conference with a renewed appreciation for the value – and challenge – of investor relations for family businesses.  We know that many family businesses are very intentional about maintaining positive shareholder engagement, but we also know that many others are mired in perpetual conflict with one or more disengaged shareholders.  Forward-thinking family business directors will want to make investor relations a priority in 2019.

Mission statements, vision statements, corporate responsibility statements and lists of corporate values abound as managers and corporate directors seek to provide consistent direction for business decisions.  While such statements doubtless have their place, they often ignore what we see as a more fundamental question for family businesses: What does the business mean to the family?In our experience, families tend to assign one of four basic meanings to their family business.  Identifying what the business means to the family provides managers and directors with a roadmap for long-term strategic decisions regarding the family business.Failing to achieve consensus around what the business means to the family can lead managers and directors to make decisions regarding long-term strategic decisions on an inconsistent, piecemeal, or even contradictory manner.  Corporate finance and strategy textbooks tell directors how to make these types of decisions if their shareholders are economically rational robots that evaluate investment decisions from a strictly quantitative perspective.  In other words, the long-term strategic decisions are easy unless family shareholders are people who view their investments through a mix of economic, emotional, and practical considerations.  And they are.  Add family dynamics to that mix, and the easy textbook answers fade to irrelevance.The Four MeaningsThe meaning of a family business is a function of both family and business characteristics.  As shown below, the meaning of the family business, in turn, influences the dividend policy, investing, and financing decisions of the company.  In this week’s post, we will identify the four potential meanings and correlate family & business characteristics with those meanings.  We will explore how the meaning of the family business informs dividend policy, investing, and financing decisions in a subsequent post. Based on our observations over decades of working with family businesses, we have identified the following four potential meanings for a family business. 1. Economic Growth EngineFor some families, the business exists to drive economic growth for future generations.  For these families, the emphasis is not on generating distributable income for the current generation of shareholders, but rather on pursuing growth opportunities so that the business grows along with the family.Family Characteristics: Growing family with each subsequent generation larger than the preceding generation by a factor of two or three (or more).  The family has multiple members with entrepreneurial instincts and experience.Business Characteristics: The family business operates in an industry with ample attractive investment opportunities that can be used to spur growth.  The management team has experience growing businesses organically or through acquisition.  The business has access to financing to make investments when advantageous opportunities arise.Example: A new restaurant concept that is pursuing a rapid geographic expansion strategy to meet consumer demand for its unique combination of flavors, atmosphere, and experience. When the family business is an economic growth engine for the family, shareholders know that the emphasis is on the future, and make personal financial decisions accordingly.2. Store of ValueOther family businesses serve as a mechanism by which to preserve the family’s capital.  In contrast to the often dramatic swings experienced in the public equity markets, the family business is a stabilizing component of the family’s overall balance sheet.Family Characteristics: Family has relatively few shareholders or is growing slowly.  The family business makes up a significant portion of the family’s overall wealth.Business Characteristics: The family business operates in a mature or counter-cyclical industry with few attractive reinvestment opportunities.  The business owns tangible assets (real estate, manufacturing facilities) with alternative future uses.Example: A manufacturer of generic over-the-counter medications with a mature product portfolio for which sales growth largely tracks population growth. If the family business functions as a store of value, family shareholders take comfort in the durability of the business, and can make long-term personal financial plans with relative certainty that the family business represents a stable foundation for their overall investment portfolio.3. Source of Wealth AccumulationA family business can also be a source of wealth accumulation.  Families that adopt this meaning focus on diversification as a means of managing financial risk.  The business is managed to provide significant current distributions that family shareholders are expected to allocate to unrelated investments.  The objective is for the legacy family business to constitute a decreasing portion of total family wealth over time.Family Characteristics: Family exhibits diversity with regard to interests, geography, and risk tolerance.  The family business may represent a significant portion of the family’s overall wealth at present, but the family’s express desire is for that relative allocation to go down.Business Characteristics: The family business operates in a mature industry and has limited investment requirements.  While growth opportunities are limited, the business earns attractive margins attributable to an entrenched strategic advantage.Example: A producer of branded snack foods with a strong regional following that can operate with well-maintained, but old, production equipment. When the family business acts as a source of wealth accumulation, family shareholders adopt an outward focus, allocating time and resources to evaluating potential investment opportunities.4. Source of LifestyleFinally, a family business can also be a source of lifestyle for family shareholders.  These families value the stability of dividend payments as a supplement to wages and other sources of household income.  The business is managed to protect the company’s dividend capacity.  The objective is for the family business to predictably augment the family’s aggregate income from other sources to help facilitate travel, philanthropy, education, or other pursuits important to the family.Family Characteristics: While the senior generation may be able to rely on dividends as the primary source of income, family members in younger generations rely on wages or other sources of primary income.Business Characteristics: The family business operates in a maturing industry with modest investment opportunities.  A primary goal of capital investment activity is to generate some measure of real growth in distributions over time.Example: A developer of a niche enterprise software platform for veterinary practice management. If the family business is a source of lifestyle, family shareholders may appreciate the financial backstop provided by the value of the business, but ultimately gauge the success and health of the business by the stability, predictability, and growth of the dividend.  The predictable dividend may free some family members to pursue meaningful careers that are not especially rewarding financially.So What?Every family business plays a unique variation on one of these themes.  The meaning of a family business may shift over time as the family and business evolve.  What is the meaning of your family business today?  Do your family shareholders agree on the meaning of the family business?In family businesses, alignment and consensus regarding the meaning of the family business can prevent most of the disputes that breed resentment, open conflict, and litigation.  Give one of our family business professionals a call today for help with discerning the meaning of your family business.

This post is the third of four installments from our Basics of Financial Statement Analysis whitepaper.  In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company. An accounting professor of mine referred to the statement of cash flows as the “desert island” financial statement because if he were stranded on a desert island and could have only one financial statement with which to analyze a company, he would want it to be the statement of cash flows.  While sincerely hoping never to find myself in such a position, I do believe there is merit to the sentiment. The statement of cash flows reconciles the change in cash balance during the period by reference to reported earnings, non-cash charges, changes in balance sheet accounts, capital expenditures and other investments, and transactions with lenders and shareholders.  While often overlooked, the experienced financial statement reader knows that the statement of cash flows reveals the company’s fundamental underlying narrative more clearly than either the balance sheet or income statement do in isolation.Key Components of the Statement of Cash FlowsThe statement of cash flows is divided into three sections, with all sources of cash flow and uses of cash classified as operating, investing, or financing activities.Operating ActivitiesNet income is not synonymous with operating cash flow.  The purpose of the operating activities section of the statement of cash flows is to reconcile the two figures.  While the operating activities section often includes a dizzying number of reconciling entries, they generally fall into three categories:Non-cash charges.  Some expenses do not correspond to cash outflows in the current year.  Depreciation is an allocation of amounts spent in prior years on long-lived assets.  Amortization assigns the cost of acquired identifiable intangible assets to the years following the acquisition.  Equity-based compensation expense recognizes promised payments to employees in future periods for services rendered in the current period.  Since the purpose of the operating activities section is to reconcile reported net income to cash flow, these non-cash charges are added to reported net income.Realized gains and losses.  When the company disposes of an asset, the difference between the proceeds received and the net book value of the asset sold is recognized as a component of net income.  If the proceeds exceed the net book value, the sale will result in a gain, and if the proceeds are less than net book value, the company will record a loss.  While the resulting gain or loss influences reported net income, it does not represent a source of operating cash flow.  As a result, gains are deducted from (and losses are added to) reported net income in the reconciliation of operating cash flow.Changes in working capital.  When the company sells goods or services on credit, it recognizes revenue despite the fact that no cash has been collected yet.  The same potential timing differences apply to the relationship between cost of goods sold, operating expenses, and other components of working capital (principally inventory, accounts payable and various accruals).  The accumulation of working capital assets reduces operating cash flow, while growing working capital liabilities increase operating cash flow. Differences between reported net income and cash flow from operating activities are to be expected.  However, persistent accumulations of working capital (beyond that reasonably necessary to support sales growth) may be a signal that the quality and/or sustainability of reported earnings is doubtful.  For example, excessive accumulation of accounts receivable or inventory may result in future writedowns if accounts are ultimately uncollectible or if inventory becomes stale or obsolete.Investing ActivitiesOne of the most important tasks of corporate managers and directors is identifying suitable investments that merit allocation of available capital resources.  This process, known as capital budgeting, involves comparing the returns expected from potential projects to the firm’s cost of capital and selecting those projects that are financially feasible and consistent with the company’s broader strategy and competitive advantages.  The investing activities section of the statement of cash flows summarizes the results of the capital budgeting process.  As noted in Exhibit 1, cash flows from investing activities generally fall into one of three buckets.Capital expenditures.  Capital expenditures represent amounts paid to maintain or expand the productive capacity of the business.  Whereas depreciation expense represents a systematic allocation of the cost of long-lived assets to the accounting periods during the useful life of those assets, capital expenditures represent the cash paid for those assets in the period acquired.  The level of capital expenditures should be positively correlated with the availability of attractive investments to support growth.Acquisitions.  Business acquisitions are akin to capital expenditures.  Rather than investing in new production capacity, acquisitions allow the company to consolidate production capacity that already exists in the industry.  Most business combinations are rooted in a belief that there are economic benefits available to the combined business that are not otherwise available to either company on a standalone basis.  Capital expenditures may be wise or unwise, but the price of the acquired assets is generally well-known.  The amount paid for a business combination, on the other hand, is a matter of negotiation, and often involves competitive bidding among multiple potential acquirers.  As a result, there is a risk of overpaying for what would otherwise be a “good” acquisition.  The portion of the purchase price paid through issuance of the acquiring company’s shares will not appear on the statement of cash flows, but the attentive financial statement reader will note the corresponding increase in the number of shares outstanding. Since both capital expenditures and acquisitions represent uses of corporate cash, they appear on the statement of cash flows as negative figures (i.e., cash outflows).Proceeds from sales of assets.  The capital budgeting process can also work in reverse, identifying assets that do not promise attractive future returns, no longer align with the company’s strategy, or can be sold for an attractive price.  The cash proceeds from the sale or disposition of the asset appear as a positive figure in the investing activities section. Capital expenditures, acquisitions, and asset dispositions tend to be “lumpy”.  In other words, a significant capital expenditure that doubles productive capacity may not need to be repeated for a number of years.  As a result, it is often helpful to analyze the statement of cash flows on a cumulative basis (i.e., aggregate cash flows over a multi-year period).  This can provide a broader view of the company’s investing strategy and capital budgeting process and reduce undue focus on a single quarter or year.Financing ActivitiesThe final category is cash flow from financing activities.  As illustrated on Exhibit 2 below, cash flow from financing activities summarizes the company’s transactions with capital providers during the period. Transactions with lenders include borrowing and repaying debt.  If debt on the balance sheet increases during the period, positive cash flows from borrowing will exceed negative cash flows from repaying debt.  Borrowing appears as a positive figure on the statement because the proceeds from borrowing money increase the company’s cash balance.  One shortcoming of the statement of cash flows is that interest paid to lenders is not classified as a financing cash flow, but rather is a component of cash flow from operations. A company has two mechanisms for returning cash to shareholders: share repurchases and dividends.When the company issues new shares to investors, the proceeds from the issuance increase the company’s cash balance and therefore appear as a positive figure on the statement of cash flows.  A company has two mechanisms for returning cash to shareholders.  The first is to repurchase shares.  Share repurchases return cash on a non-pro rata basis to the shareholders electing to sell.  If the price paid for the shares differs from the value of the shares, a share repurchase will be either dilutive or accretive to the remaining shareholders.  In contrast, dividends provide a pro rata return to all shareholders without the risk of mispricing associated with share repurchases.  Among public companies, share repurchases are very common due to advantages under current tax law and the fact that share repurchases do not carry the burden of sustainability that dividends do (failing to repurchase shares is rarely perceived negatively, whereas reducing or suspending dividend payments is a very bearish signal).  For private companies, share repurchases are less common, due in large part to the difficulty in identifying a price that is not unduly accretive or dilutive to the remaining shareholders.Analyzing the Statement of Cash FlowsFor an experienced reader of financial statements, the relationships among the primary components of the statement of cash flows reveal the broad contours of the company’s financial strategy, particularly with respect to capital budgeting, capital structure, and distribution policy.  As noted previously, investing and financing cash flows are, by their nature, lumpy, so it can be helpful to analyze the statement of cash flows on an aggregate multi-year basis.  There are two basic relationships to evaluate.The first is the relationship of operating and investing cash flows.  If (the absolute value of) investing cash flow exceeds operating cash flows, management and the directors believe that attractive investment opportunities are readily available.  With the allocation of more capital resources to the company’s investment portfolio comes the expectation that future earnings and cash flows will be sufficient to justify the commitment by providing an attractive return on investment.Investing and financing cash flows are, by their nature, lumpy, so it can be helpful to analyze the statement of cash flows on an aggregate multi-year basis.If investing cash flows exceed operating cash flows, financing cash flows must be positive (i.e., net cash inflows from either borrowing money or issuing new shares). If, instead, operating cash flows exceed (the absolute value of) investing cash flows, management and the directors believe that attractive investment opportunities are relatively scarce.  Limiting the capital resources allocated to the company’s investment portfolio mitigates the pressure for growth in future earnings and cash flows but exposes the company to the potential opportunity cost of foregone investments that would have provided an attractive return.  When operating cash flows exceed investing cash flows, financing cash flows will be negative, as the company will have “excess” funds to return to capital providers.Second is the relationship between transactions with lenders and transactions with shareholders within cash flow from financing activities.  This relationship correlates to changes in capital structure at the margin.When aggregate financing cash flows are positive, borrowings will predominate over share issuance when management and the board assess the marginal cost of debt to be less than the marginal cost of equity.  While beyond the scope of this whitepaper, note that the marginal cost of debt is not the same thing as the interest rate on newly-issued debt.  If the marginal cost of debt is perceived to be higher than the marginal cost of equity, companies will issue new shares to fund investment.When aggregate financing cash flows are negative, management and the board must balance de-leveraging and returning cash to shareholders.  If they perceive the marginal cost of debt is less than the marginal cost of equity, they will forego the opportunity to de-leverage the balance sheet, and opt instead to return cash to shareholders through share repurchases or dividends.  If, instead, the marginal cost of debt is greater than the marginal cost of equity, the board should emphasize repayment of debt over returning cash to shareholders. These relationships are summarized in Exhibit 3 below.ConclusionThe statement of cash flows should not be ignored.  It provides important perspective regarding the company’s strategy and narrative that cannot be easily gleaned from the income statement or balance sheet in isolation.  The reconciliation of reported net income to operating cash flow provides additional insight regarding the nature and quality of reported earnings.  Cash flow from investing activities reveals the net results of the company’s capital budgeting process.  Transactions with lenders and shareholders summarized in the financing activities section reflect the board’s assessment of the marginal costs of capital.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper

This post is the second of four installments from our Basics of Financial Statement Analysis whitepaper.  In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company. If the balance sheet is a photograph, the income statement is a movie. It summarizes the activity of a business over a period of time. Whereas the balance sheet caption is “as of” a particular date, the caption for the income statement reads “for the period ending” on a particular date. As its name suggests, the income statement summarizes the revenues, expenses, and resulting income for the company during a particular period.Principal Income Statement ComponentsExhibit 1 summarizes the basic flow of the income statement. We will walk through each of the principal components in turn.RevenueThe concept of revenue is intuitive. It is the amount received from customers in exchange for the goods or services provided by the company. Analysis of revenue should focus on change over time. For many businesses, it may be possible to analyze revenue as the product of some measure of volume sold and effective pricing. Doing so allows the analyst to more clearly evaluate the underlying changes in revenue (i.e., is revenue increasing due to volume growth or higher prices). When looking at revenue over time, the goal should be to identify why revenue has been stable, grown, or decreased. These factors will not be enumerated on the face of the income statement, but the overall trends should prompt further investigation to fill out the narrative more clearly. Ultimately, revenue growth (or decreases) can be traced back to some combination of a few potential factors.Increasing volume with existing retained customers. Does the company have a base of recurring customers that generate revenue each year? If so, the company may piggyback on the growth of its existing customers. If the market for the company’s goods and services is growing, is the company gaining or losing share in relevant markets? If so, why?Volume from new customers is greater than lost volume from customer attrition. Some amount of customer churn is to be expected. Even satisfied, enthusiastic customers are occasionally acquired by non-customers or go out of business. If some degree of churn is inevitable, the company will need to identify and cultivate new customers to take the place of lost customers. What are the trends in customer attrition? Why do existing customers leave, and why do new customers start doing business with the company?Sales of new products/services in excess of sales from obsolete products/services. Whether because of technological advances or other factors, the company’s existing portfolio of products and services may eventually become obsolete. Is the company developing new products or services to take the place of such products? If so, do the new offerings appeal primarily to existing customers or to those who have not historically been prospects?Price increases. Regular price increases are an often-overlooked source of potential revenue growth. Does the competitive environment permit the company to increase pricing on a regular and predictable basis? If price increases are not feasible, is the company’s production efficiency increasing?Cost of Goods Sold & Gross ProfitCost of goods sold (“COGS” for short) is easiest to understand for a retailer or wholesaler, for whom the cost of goods sold is simply the amount paid for the inventory that is then sold to the company’s customers. For a manufacturer, COGS is the sum of the raw materials, direct labor, and production overhead incurred to manufacture the company’s products. Many service companies do not report a distinct cost of goods sold on the income statement.The excess of revenue over cost of goods sold is gross profit. For the purpose of reading and understanding financial statements, gross profit is generally a more enlightening point of analysis than cost of goods sold. Gross profit represents the amount available to pay for the company’s operating expenses and generate operating income. Analysts will generally compute a company’s gross margin by dividing gross profit into revenue. Gross margin is therefore a measure of gross profit per dollar of revenue. Calculating gross margin facilitates comparisons of the subject company’s performance over time and relative to peers.Calculating gross margin facilitates comparisons of the subject company’s performance over time and relative to peers.When analyzing gross margin for the subject company over time, the reader of the income statement should attempt to reconcile observed changes to competitive factors facing the business. If the company’s production inputs include raw materials subject to price volatility, can it adjust prices in response to the changing input prices, or does gross margin fluctuate? Does the company engage in hedging activities to reduce volatility? If gross margins are contracting over time, it may be a result of pricing pressure from low-cost competitors. Conversely, if gross margins are expanding, that may suggest that the company has pricing power due to some competitive advantage relative to competitors or suppliers.Comparing gross margins to those of peers can reveal differences in strategy among firms. A company focused on product differentiation would generally expect to report gross margins in excess of their peers, while one focused on cost advantages may be willing to accept a lower gross margin in the expectation that operating expenses will be lower.Operating Expenses & Operating IncomeOperating expenses include those costs incurred to support the sales & marketing, administration, and research & development activities of the company. These overhead activities are incurred to both service existing customers and to promote the company’s growth through acquiring new customers and developing new products. Deducting operating expenses from gross profit yields operating income. As with gross profit, operating income is best analyzed relative to revenue (i.e., operating margin).Operating income (also referred to as EBIT, or earnings before interest and taxes) is an important point of comparison to other firms because it is the lowest level of earnings that is unaffected by sources of financing. In other words, a company’s operating margin reflects the efficiency with which it converts revenue to profits before taking interest expense into account.Income statements presented in accordance with generally accepted accounting principles (GAAP) do not classify expenses as fixed or variable, even though doing so can be very helpful. Broadly speaking, variable expenses fluctuate with revenue, while fixed expenses remain unchanged over a fairly wide range of revenue levels. Companies with a greater proportion of fixed expenses are said to have operating leverage, meaning that a given change in revenue will have a greater impact on operating income. Exhibit 2 illustrates the concept of operating leverage.Both companies in Exhibit 2 generate the same base revenue and operating profit. However, most of the expenses for the company on the left are variable, while those for the company on the right are predominately fixed. While revenue for both companies increased by 10%, the company on the right experienced a more substantial increase in profitability. A few observations are in order:First, all companies have some degree of operating leverage. To the extent the company has any fixed costs, changes in revenue will trigger disproportionate changes in profitability. So the real question is not whether a company has operating leverage, but rather the degree to which it has operating leverage.Second, an emphasis on scenarios in which revenue is increasing might suggest that operating leverage is inherently good. Yet, that perspective needs to be balanced by the very real possibility that revenue could decline, in which case the company with a greater degree of operating leverage will experience a disproportionate decrease in profitability. Stated alternatively, the company with less operating leverage also has a lower breakeven point. For example, the company on the left in Exhibit 2 breaks even with revenue of $625, while the company on the right would lose $113 at that level of revenue.Finally, the distinction between variable and fixed expenses is imprecise and fluid. The longer the planning horizon, the more variable a company’s cost structure is. Even over a specified time period, whether a given cost is truly variable or fixed is a matter of some interpretation. Yet, the ultimate purpose of such analysis is not absolute precision, but rather a conceptual framework for evaluating strategy and a broad measure of the effect of changing revenue on profitability.Interest Expense & Pre-tax IncomeShareholders receive current returns in the form of dividends, and lenders receive current returns in the form of interest payments. Although conceptually equivalent (both are returns to capital providers), interest payments are recorded as expense on the income statement, while dividends paid to shareholders are not.The amount of interest expense incurred during the period is the product of the average interest-bearing debt balance outstanding during the period and the effective interest rate on the debt. The rate on debt can be either fixed at a set rate for the duration of the instrument, or it may float with reference to a market rate, like LIBOR. In either case, the amount of interest expense is not correlated with the amount of revenue or operating income generated by the company during the period. In other words, even floating-rate interest constitutes a “fixed” cost. Whereas operating leverage describes the change in operating income relative to a given change in revenue, financial leverage describes the change in pre-tax income relative to a given change in operating income. As with operating leverage, financial leverage magnifies both upside and downside returns.Experienced readers of financial statements will correlate interest expense on the income statement to the balance of interest-bearing debt on the balance sheet. This check helps confirm the emerging narrative the financial statements are telling about the company and illustrates how the financial statements are related to one another.Income Taxes & Net IncomeThe final deduction in calculating net income is income tax expense. The first consideration in analyzing income tax expense is the tax structure of the company. Many privately-held family businesses are organized as S corporations or limited liability companies, both of which “pass-through” taxable income to the shareholders. As a result, such companies neither pay income taxes nor report income tax expense. From a cash flow standpoint, however, these companies almost always distribute cash in an amount that would otherwise be reported as income tax expense to fund the income tax liability that accrues to shareholders personally.For taxable entities, income tax expense will ordinarily be proportionate to the reported pre-tax income. In other words, income taxes are perfectly variable with respect to pre-tax income – if the effective tax rate in the relevant jurisdiction is 40%, income tax expense will be equal to 40% of pre-tax income.From a somewhat broader conceptual perspective, net income is the change in shareholders’ equity during the period resulting from the operations of the business.One complicating factor that need not detain us too long here is that the IRS does not use GAAP to calculate taxable income. As a result, the amount of income that the company actually pays tax on during a given year may not match the amount of pre-tax income reported on the company’s financial statements. These differences often relate to different timing assumptions regarding when certain items of revenue or expense are recognized. Eventually, such differences will reverse themselves. If GAAP income exceeds taxable income, income tax expense will be based on the higher GAAP earnings, and the difference between income tax expense and taxes actually due is recorded as a deferred tax liability on the balance sheet. If GAAP income is less than taxable income, income tax expense will still be based on the lower GAAP earnings, but the excess of taxes actually due over income tax expense is recorded as a deferred tax asset on the balance sheet.Net income is the difference between revenue and all expenses. From a somewhat broader conceptual perspective, net income is the change in shareholders’ equity during the period resulting from the operations of the business. This conceptual definition of net income is consistent with the reconciliation of shareholders’ equity summarized in Exhibit 5 in a previous post.Earnings per ShareFor public companies, earnings are expressed on a per share basis. While per share earnings are a less common expression for private companies, the underlying concept remains valid. If the reported earnings are not scaled to the number of shares outstanding, it can be difficult to assess whether earnings growth generated by investments funded through the issuance of new shares has been economically accretive or dilutive. Expressing earnings on a per share basis is also important when evaluating the effect of potentially-dilutive equity-based compensation on shareholders.Normalizing AdjustmentsOur discussion thus far has assumed a very “clean” income statement. Income statements for real companies are often a bit messier and include items such as gains and losses on the sale of assets, currency gains and losses, the results of discontinued operations, extraordinary charges due to changes in accounting principles, and other non-operating sources of income and expense. Consistent with the broad conceptual definition of net income noted in the previous section, the inclusion of such items is entirely appropriate, as these items do have a very real effect on shareholders’ equity. On the other hand, one common purpose of income statement analysis is to discern the earning potential of the company on a prospective basis. For this purpose, it is entirely appropriate to make “normalizing” adjustments to the reported income statement. Such adjustments are used to convert the income statement from one that is backward-looking to one that is forward-looking. Normalizing adjustments will fall into one of the following three broad categories: Clean up unusual or non-recurring events. The most obvious adjustments are those that remove the effect of unusual or non-recurring events, such as losses due to unusual weather events, large recoveries in litigation, or unusual transaction costs that obscure the true earning power of the business. One should be wary, however, if management labels every roadbump that the company encounters as “non-recurring” while assuming that every bit of good fortune represents ongoing earning power. A series of annual, non-recurring losses begins to look like a recurring feature of the business. The goal is to normalize earnings, not sanitize them.Remove the effect of discontinued lines of business. Business lines come, and business lines go. To get a clean view of the future prospects of the business, the results of discarded business lines should be excised from the reported income statement. If the discontinued business was profitable, removal will reduce normalized earnings, and vice versa. While sales and cost of goods sold can generally be readily identified, associated operating expenses may be more difficult to estimate. If too much of the expense base is allocated to the discontinued business, earning power will be overstated.Add the impact of recently acquired businesses. For an acquisition made during the fiscal year, the reported earnings of the acquirer will not reflect the full impact of the acquisition on earning power. For example, if the legacy business generates earnings of $10 million, and the business acquired mid-year earns $5 million annually, reported earnings for the year will be $12.5 million. Adjusting reported earnings to reflect a full year of operations for the acquired business will result in a more accurate view of “run rate” earnings. For acquisitive businesses, these adjustments can be significant. Ultimately, such adjustments are appropriate to the degree they accurately reflect the earnings contribution of the acquired business. In short, earnings adjustments are an appropriate element of financial statement analysis, but the proposed adjustments should be carefully scrutinized to ensure that they do not distort the true earning power of the company.Excursus: EBITDAThe most commonly cited measure of earnings for private companies is EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is an example of a non-GAAP measure of financial performance since it does not appear on the face of most income statements. It is, however, readily calculated by simply following the components of its perfectly descriptive name. When management teams and others focus on adjusted EBITDA, it is important to have a clear reconciliation identifying the normalizing adjustments that were included in the calculation.Why do investors and managers focus on EBITDA? There are essentially two reasons. First, EBITDA is the broadest measure of earnings and cash flow for the firm. As depicted in Exhibit 4, EBITDA is a proxy for the cash flow that is available for a variety of purposes. It is therefore, in one sense, a measure of the discretionary cash flow available to a potential acquirer of the business as a whole, which explains why it is the performance metric of choice for describing and assessing merger and acquisition activity.Second, referencing EBITDA promotes comparability across firms. Working up from the bottom of the income statement, EBITDA provides the most consistent measure of relative operating performance of different companies by “normalizing” for structural features of how different companies are organized, financed, and assembled.Income Taxes. As discussed previously, many private companies are organized as tax pass-through entities and therefore report no income tax expense on the income statement. Since EBITDA is calculated without regard to income taxes, C corporations and S corporations are on equal footing.Interest Expense. The decision to finance operations with debt rather than equity does not directly affect the operating performance of the business. Since EBITDA is calculated without regard to interest expense, the operating performance of highly leveraged companies can be readily compared to that of companies with no debt.Depreciation. Depreciation is a non-cash charge. Annual depreciation charges are influenced by the amount of depreciable assets (some companies own real estate while others rent) and accounting assumptions (depreciable lives and methods). Calculating earnings prior to depreciation charges normalizes for these differences. A note of caution is in order here, however—the comparability benefits break down a bit at this point. If Company A rents facilities while Company B owns facilities, EBITDA will be lower for Company A (rent expense is deducted in computing EBITDA) than for Company B (depreciation is not). However, Company B will presumably have higher capital expenditure needs to maintain the properties that it owns than Company A will as a lessee. All of which is another way of saying that, while it is true that depreciation does not represent a cash outflow in the period recognized, it does represent a real cash outflow in a prior period, and one that will need to be repeated as the asset wears out.Amortization. Companies that grow through acquisition recognize intangible assets on their balance sheets that are subsequently written off through amortization charges on the income statement. Companies that grow organically do not incur amortization charges. Since EBITDA is calculated prior to amortization deductions, the performance of companies that have grown through acquisition is presented on a comparable basis with those that have grown organically. Unlike depreciable fixed assets, amortizable intangible assets generally do not need to be replaced through subsequent cash outflows.ConclusionThe income statement records the revenues earned and expenses incurred by the company during a period of time. Experienced financial statement readers focus on revenue growth and margins (on an absolute basis, with respect to change over time, and relative to peers). Breaking revenue down into its constituent parts (volume and price) can yield insights into the narrative behind changes in revenue over time. Analysis of fixed and variable operating expenses can help form judgments regarding breakeven revenues and the sensitivity of changes in operating income to changes in revenue. Interest and income tax expenses reveal the company’s financing and organizational decisions. Expressing earnings on a per share basis helps assess whether investments in growth have been accretive or dilutive. Normalizing adjustments may be appropriate to develop an estimate of ongoing earnings. EBITDA is a commonly-cited measure because it enhances comparability across firms and serves as a proxy for cash flow available to owners for a variety of discretionary ends.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper

From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.Why do our operating and capital budgeting forecasts always seem to turn out to be too optimistic?Excessive optimism is a common problem in corporate forecasting exercises.  The good news – or maybe it’s the bad news, depending on your perspective – is that overly optimistic projections are not necessarily the result of intentional errors on the part of your family business managers.  Rather, behavioral economists tell us that humans are prone to overconfidence as a result of what they refer to as cognitive biases.  One of the best non-fiction books of the past decade explores how these cognitive biases function and their ubiquity in everyday life, including business forecasting.  All family business directors would benefit from reading Daniel Kahneman’s Thinking, Fast and Slow.  In this post, we present a thumbnail sketch of the most common cognitive biases contributing to overly optimistic forecasts.1. Illusion of ControlWe tend to ascribe far too much of the outcome (whether good or bad) to our interventions, and far too little to events outside our control.Simply put, we humans fail to appreciate just how little control we have over the events that go on around us.  This tendency may well have some beneficial side effects in our everyday living, but it quickly becomes a liability when family business managers begin to forecast future results for a new project.  In looking back at prior events for guidance, we tend to ascribe far too much of the outcome (whether good or bad) to our interventions, and far too little to events outside our control.  As a result, we assume that – based on what we have learned from the past – we will do better this time.  However, our control over future outcomes – even if we have truly learned some valuable lessons, and will therefore execute better – is much smaller than we assume.  The result is a tendency to formulate overly optimistic forecasts, since we operate under the illusion that we exert far more control over the outcome than we actually do.2. Availability BiasThe availability bias describes the fact that we tend to assign too much weight to observations that are easy to recall from our memory.  For example, someone contemplating a visit to the beach is likely to overestimate the likelihood of a shark attack relative to other perils because – although exceedingly rare – when sharks attack, it is news.For family business managers, the availability bias manifests itself when scenarios that have either happened before or are easily imagined get assigned too much weight in a probability distribution.  We construct mental probability distributions not on the basis of statistical likelihood, but relative to the ease with which we can quickly generate examples of particular outcomes.  Successful family businesses have a history of good outcomes which managers unconsciously draw upon when assessing the likelihood of future outcomes.  This can contribute to overly optimistic forecasts.3. Desirability BiasThe desirability bias names the tendency to accept things as true that we want to be true.  Since family business managers naturally want their proposed project to have a good outcome, the desirability bias suggests that they will actually screen out evidence or data that does not support the desired outcome (project success), while emphasizing and highlighting evidence and data that does support the desired outcome.  It is not hard to see how the desirability bias contributes to unrealistic projections.4. Anchoring EffectBehavioral economists use the term anchoring to describe the tendency for our estimates to get “stuck” on the first number we see or impression we receive, even when there is no logical basis for doing so.  Kahneman provides the following example of the anchoring effect: when asked to estimate Ghandi’s age at death, individuals who are initially asked if he was older or younger than 114 will estimate a much older age than individuals preliminarily asked if he was older or younger than 35.  The preliminary question has no bearing on the estimate of Ghandi’s age, but respondents invariably get anchored to that initial number.Since the initial expectation for any capital project is that it will be successful (otherwise it wouldn’t be seriously considered), it is natural for family business managers to become anchored to the initial expectations, even in the face of evidence to the contrary.5. Extrapolation BiasWe fall prey to the extrapolation bias when we assign too much weight to recent events.  A classic example is that after seeing a coin-flip land on heads five times in a row, people will begin to extrapolate that trend into their expectations for future outcomes of the coin-flip even though the results of previous coin flips have no effect on the outcome of the next flip.For family business managers, the extrapolation bias comes into play when the 15% revenue growth experienced last year is assumed to persist even in the face of no, or contradictory, evidence.Organizations, like family businesses, are better equipped to counteract the baleful effects of cognitive biases than individuals are.Apologies if this list seems a bit depressing.  If these biases are really a part of human nature, must family business directors be resigned to receiving overly optimistic project forecasts?  The good news, as summarized by Kahneman in Thinking Fast, Thinking Slow, is that organizations like family businesses are better equipped to counteract the baleful effects of cognitive biases than individuals are.  The two most important steps that family businesses can take are to (1) promote awareness among managers of what the cognitive biases are and how they influence forecasting, and (2) create and institute procedures that help limit the damage from cognitive biases.  Our family business advisory professionals can help with both tasks; give us a call to discuss your needs today.

“[He is] the epitome of the child with rich parents who wakes up on third base and thinks he hit a triple.”A recent article in the New York Times about the bickering Neumann family caught our eye with that description of an entitled family member.  The taunt is cutting enough without context, but the depth of the family’s issues comes into clearer focus when we learn that the quote is from a woman describing her own father.  Though not a family business fight, the Neumann family strife does revolve, predictably enough, around money: specifically, the disputed sale of enormously valuable artwork owned by the family. Perhaps most disconcerting is not the specifics of the Neumann family travails, but the broader overall trends in intra-family legal disputes noted in the piece.  According to one partner at the Los Angeles law firm, Weinstock Manion quoted in the article, “We can’t hire enough attorneys.”  That comment alone is a sad commentary on the inability of a successful family business to guarantee family harmony. So how should family business directors think about their role in making sure their family does not turn into the Neumann’s?  In our experience, it is important for directors to think about this question in terms of both preventing family strife from starting and de-escalating volatile situations that already exist.The Ounce of PreventionAmong the responsibilities of family business directors is providing guidance and oversight to the risk management function of the firm.  Family businesses face manifold risks associated with the operating environment, industry and economic conditions, capital availability and the like.  But directors cannot afford to overlook the risk of shareholder dissension to the business.  Certainly, there are no guaranteed strategies for preventing shareholder discontent, but in our experience, most cases of serious shareholder angst are rooted in communication failures and breaches of basic economic fairness.Prioritize CommunicationFamily business directors seeking to minimize the risk of shareholder in-fighting need to prioritize effective shareholder communication.  Shareholders crave and deserve regular, objective information regarding the performance and outlook for the family business.  One of our colleagues relates the advice of his mentor in the asset management business: “Clients don’t leave because they lost money, they leave because you didn’t communicate with them while they were losing money.”Effective shareholder communication requires more than sending detailed financial statements to shareholders at random intervals.  Family business directors who prioritize communication establish a schedule of timely communication throughout the year that focuses on turning financial statement data into a clear narrative regarding the company’s strategy, recent financial performance, and outlook for the future.Commit to Basic FairnessRetaining earnings only to acquire low-yielding assets that do not fit any discernable corporate strategy will likely raise hackles.Second is a commitment to basic fairness.  This means making corporate finance and operating decisions that benefit all shareholders, not just one generation or select employee shareholders.  Basic economic fairness manifests itself in multiple ways – here are a few examples:The family business has a coherent strategy that guides investment and distribution decisions. If the shareholders understand and approve of the strategy, reinvestment of earnings to fund attractive capital projects in lieu of distributions will generally not frustrate shareholders.  On the other hand, retaining earnings only to acquire low-yielding assets that do not fit any discernable corporate strategy will likely raise hackles.The family business has a clearly defined capital structure target. If shareholders know what the target capital structure is, the rationale for it, and have been asked for input regarding risk tolerance, the likelihood of debt-triggered shareholder anxiety is reduced.  If instead, the family business borrows money (or refuses to borrow prudent amounts of money) at random without any long-term goal or objective, shareholder distrust is likely to rise.Family shareholders who also work in the business are paid fairly. Managing a family business is hard.  Non-employee shareholders are occasionally guilty of thinking that managing the business should be a form of volunteer work, while family business insiders sometimes think that non-employee family members aren’t entitled to any economic fruits of their labors.  Both of these perspectives are misguided, and left unchecked, can mushroom into serious strife.  Since the potential for mistrust can run so high when it comes to compensation, this is a great reason to have a few truly independent directors on the board to help provide insight regarding what a real market-equivalent wage is for positions held by family members.  In the end, appropriate transparency is crucial.The Pound of CurePrevention is never totally effective.  Sometimes the acrimony has reached a point that family business directors need to find a way to de-escalate the situation for the good of the business.  Below, we suggest a few paths forward.Objectively Evaluate Shareholder ComplaintsThe first step is for family business directors to objectively assess the economic merit of the various complaints of the disgruntled family members.  If the complaints have merit, then appropriate changes should be made.  Framing the dispute in terms of business decisions that have rational economic answers can help de-personalize the situation and make a workable resolution much more likely.Identify Shareholder ClientelesFraming disputes in terms of business decisions that have rational answers can help de-personalize the situation and make a resolution much more likely.As family business directors, how well do you really know your family shareholders?  Outspoken Uncle Jerry may be the one calling for changes, but timid Aunt Tess may feel exactly the same way.  Directors can benefit from having a mechanism to gauge shareholder attributes and preferences.  If done well, this process can reveal groups of shareholders that have similar attributes and preferences.  If a given clientele is large enough, it may be appropriate to consider structural changes that specifically address the clientele’s needs.  This may involve a distinct class of shares or spinning off a particular operating division.Willingness (and Will) to SeparateFinally, the disagreement may be so fundamental that the best path forward for all parties is to redeem the shares of the disaffected shareholders.  For shareholders being redeemed, this requires a willingness to forego potential future distributions and capital appreciation from the family business.  For the remaining shareholders, this means taking on additional financial risk to pay for the redemption.  For both parties, a redemption transaction requires agreement as to the price paid and terms of payment.  Converting arguments to economic transactions forces both parties to carefully assess how strongly they really feel about the sources of disagreement and may help them disentangle the personal and business components of the dispute.ConclusionThe biggest threat to the sustainability of your family business may not come from competition or evolving technologies.  It may come from the family itself.  As a family business director, you should be attuned to this risk and take the steps necessary to help prevent, or at least de-escalate such situations.  For an outside perspective on the economic merits of a family dispute that threatens your business, call one of our family business advisory professionals today.

This post is the first of four installments from our Basics of Financial Statement Analysis whitepaper.  In this series of posts, our goal is to help readers develop an understanding of the basic contours of the three principal financial statements. The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company. The balance sheet summarizes a company’s financial condition as of a particular date.Similar to a photograph, the balance sheet does not record any movement, but preserves a record of the company’s assets, liabilities, and equity at a particular point in time.The fundamental accounting equation, as illustrated in Exhibit 1, is intuitive: Assets = Liabilities + Equity.The balance sheet “balances” because what the company owns (the left side of the balance sheet) is ultimately traceable either to a liability (an amount that is owed to a non-owner) or equity (the net or residual amount attributable to the company’s owners).In broad strokes, the balance sheet relationships are analogous to the economics of home ownership – the equity in one’s home is equal to the excess of the value of the house at a particular time over the corresponding mortgage balance.Equity value can grow through either (1) appreciation in the value of the house, or (2) repayment of the mortgage.In either case, equity is the residual amount.Principal Asset & Liability GroupingsAn experienced reader of financial statements can learn a lot about a company’s operations, strategy, and management philosophy by reviewing the balance sheet.The relative proportion of the major asset and liability groupings will differ on the basis of whether the company is a manufacturer, retailer, distributor, or service provider.Similarly, the relative proportion of liabilities and equity provides insight into the risk tolerances and financing preferences of the company’s managers and directors.Exhibit 2 summarizes the principal asset and liabilities groupings for operating companies.While many of the concepts are similar, analyzing the financial statements of financial companies (banks, insurance companies, etc.) is outside the scope of this article.Cash & EquivalentsCash is a surprisingly slippery asset in the context of balance sheet analysis.On the one hand, cash is king, and it is essential that the company have sufficient cash to meet obligations as they come due.No company has ever gone bankrupt because it had too much cash.On the other hand, cash balances beyond what is needed to operate the business safely don’t really accomplish much.Especially with today’s low interest rates, cash is a sterile asset that does not contribute to the company’s earnings.The appropriate cash balance for a business will depend on factors like seasonality and upcoming debt payments or capital expenditures.Working Capital (Current Assets less Current Liabilities)The designation “current” is applied to assets if they are likely to be converted to cash within the coming year and liabilities if they are likely to be paid within the coming year.The net of current assets over current liabilities is referred to as working capital.Working capital is often an underappreciated use of capital for businesses.Investments in accounts receivable and inventory are no less cash expenditures than purchases of equipment or the acquisition of a competing business.The cash conversion cycle is central to working capital analysis.As shown in Exhibit 3, the cash conversion cycle is a measure of operating efficiency for the business.Measuring the time from cash outflows for inventory purchases to cash inflows from collection of receivables, the cash conversion cycle provides perspective on the amount of working capital required to operate the business.A shorter cash conversion cycle frees up capital to be reinvested in more productive assets in the business or distributed to shareholders.For some companies with limited inventory needs or predominately cash sales, the cash conversion cycle can be very short, or even negative (meaning cash is received from customers before it is paid to suppliers).As discussed further in a subsequent section, trends in working capital balances can signal whether the company is accumulating stale inventory or is at risk of future charges for bad debt.Net Fixed AssetsThe balance of net fixed assets represents the accumulated capital expenditures of the business over time less accumulated depreciation charges.In contrast to inventory purchases and operating expenses, which offer only short-term benefits to the company (inventory has to be replenished and workers need to be paid again next week), capital expenditures are expected to provide benefits to the company over a multi-year horizon.As a result, such expenditures are “capitalized” on the balance sheet and expensed bit by bit over the service life of the asset in order to match the cost of the asset to the periods during which the company benefits from owning the asset.Depreciation is the annual charge that reflects the apportionment of the cost of a long-lived asset to the periods that benefit from the asset’s use.Over the life of the asset, the cumulative depreciation charges will equal the cost of the asset.In other words, the capital expenditure is charged to earnings as an expense over time.At a given point during the asset’s life, therefore, the balance sheet will show how much was paid for long-lived assets (the “gross” balance) and the accumulated depreciation charges that have already been recognized for the use of the asset, with the difference between those two figures being the balance of net fixed assets.Exhibit 4 illustrates the balance sheet presentation for long-lived assets over time.Analysis of net fixed assets is subject to two limitations associated with historical cost accounting.First, current accounting rules do not allow the values to be adjusted to current market value.This can be especially problematic for real property which might be expected to appreciate.For example, land that was acquired for $500 decades ago may have a current market value that is considerably higher.However, the balance sheet will continue to report the land at its original cost (land is not depreciated for accounting).Second, depreciation is an accounting technique for allocating the cost of long-lived assets to different accounting periods – it is not intended to be a forecast of the future value of an asset.In Exhibit 4, the net balance of the subject asset at the end of Year 2 is $500.That is not an estimate of the asset’s market value at that date, which might be $500 only by coincidence.As a result of these limitations, analysis of the fixed asset accounts should generally focus on relative proportions to other balance sheet components (i.e., does the company own or lease its primary facilities) and changes at the margin (are annual capital expenditures greater or less than annual depreciation charges) rather than absolute values.Goodwill & IntangiblesNot all of the company’s valuable assets are presented on the balance sheet.The historical cost accounting model only captures assets that the company has acquired in exchange for cash.Some assets, such as tradenames, technology, customer relationships, and workforce accrue slowly over time rather than as the result of a discrete transaction.For example, the accumulated advertising expenses of the company, which build the value of the tradename over time, are expensed as incurred, and never reach the company’s balance sheet.For many companies, these intangible assets can actually be more valuable than the tangible assets that are found on the balance sheet.The major exception occurs when one company buys another.In this case, Company A (the buyer) will record the hitherto unrecorded intangible assets of Company B (the company acquired) on Company A’s balance sheet.Since a transaction has occurred, the intangible assets of the acquired company will now be presented on the buyer’s balance sheet, as explained below, while the buyer’s internally-generated intangible assets will continue to be ignored.The excess of the amount paid for the business over the net tangible assets of the acquired business is added to the buyer’s balance sheet as either a specific intangible asset or goodwill.Certain identifiable intangible assets such as customer relationships and tradenames are amortized (analogous to our depreciation discussion in the preceding section), while goodwill (the amount left over after all other tangible and intangible assets have been recognized) is not subject to amortization, but is periodically tested for impairment.As with fixed assets, current accounting rules do not permit assets to be written-up to market value, so the analytical value of the goodwill and intangibles is limited.The principal questions to consider when evaluating goodwill and intangibles balances include:Has the company historically grown organically or through acquisition?If the balance of goodwill and intangibles is modest, the company has relied on internal organic growth, whereas if the balance is large and growing, the company is fueling growth through acquisition.Has the company been a successful acquirer?While some identifiable intangible assets are subject to periodic amortization, a sudden decrease in the balance of goodwill corresponds to an impairment charge, implying that the acquisition giving rise to the goodwill has underperformed relative to expectations.Interest-Bearing DebtThe operations and assets of the company are financed through either debt or equity.Evaluating the subject company’s capital structure is an important element of balance sheet analysis.Using debt increases the potential return – and risk – to the company’s shareholders.In order to assess whether the subject company is conservative or aggressive in its use of debt, it is helpful to compare the debt balance to other measures of financial performance and condition.Relative to shareholders’ equity.One obvious point of comparison is to equity, the other potential funding source.Comparing debt to the reported shareholders’ equity on the balance sheet is a simple and quick measure of the company’s reliance on debt compared to equity.When doing so, however, remember that the balance sheet reports historical cost figures, not current market values.While the current market value of debt is unlikely to stray too far from the balance sheet figure, the current market value of equity will often bear no relationship to the balance sheet.Relative to market capitalization. When calculating the weighted average cost of capital, the appropriate weightings on debt and equity should reflect market value, not balance sheet amounts.For public companies, market value of equity is known, but for private companies, it must be estimated.In neither case can the number be read off the balance sheet.Relative to earnings. A common measure of debt capacity is to relate the balance of debt to EBITDA (we will define and discuss EBITDA in a subsequent section of this series).Lenders commonly reference this measure in assessing a borrower’s ability to service a given debt load.Assessing the company’s debt burden is a key element of reading a set of financial statements.Ultimately, there is no single “correct” amount of debt for a company.The right amount of debt is a function of multiple factors, not least of which is the risk tolerance of the company’s shareholders.Shareholders’ EquityFor most operating businesses, reported shareholders’ equity bears little or no relationship to market value.As a result, analysis should focus on the period-to-period change in the equity balance rather than the absolute dollar amounts.In fact, most financial statements include an explicit reconciliation to help the reader evaluate changes in equity during the period.As summarized in Exhibit 5, the major components of the reconciliation of shareholders’ equity include the following items:ConclusionThe balance sheet provides a point-in-time summary of what the company owns and what the company owes.Experienced financial statement readers can learn a lot from the balance sheet, but the primary limitations are that not every asset is represented on the balance sheet (i.e., homegrown intangibles) and the historical cost of some long-lived assets (i.e., land) may be very different from current market value.WHITEPAPERBasics of Financial Statement AnalysisDownload Whitepaper

Over the weekend, the New York Timespublished an opinion column by Chuck Schumer and Bernie Sanders in which the senators decried the increasing prevalence of stock buybacks among the country’s largest publicly traded companies.  On Messrs. Schumer and Sanders’ reading, share repurchases epitomize a corporate philosophy that prizes shareholder value at all costs and gives short shrift to the long-term sustainability of such companies, negatively affecting workers and other stakeholders.  Whatever the public policy merits of the positions outlined in the column, it does acknowledge and highlight two essential characteristics of share buybacks.  First, from the perspective of the business, redeeming shares is economically equivalent to paying dividends.  Second, using capital to repurchase shares can limit the amount of capital available for investment to grow the business.Reading the column made us think about shareholder redemptions for family businesses: Do shareholder redemptions hurt or help family businesses?  Of course, that question does not have a simple answer.  Not all shareholder redemptions are created equal, so in this post, we’ll outline three possible redemption scenarios and identify what attributes suggest whether a given shareholder redemption will help or hurt a family business and its relevant stakeholders.Scenario #1 – Excess Liquidity and Limited Reinvestment OpportunitiesThe family business in our first scenario has historically retained all earnings.  As the company has matured, attractive investment opportunities have become increasingly scarce, and management has successfully avoided the temptation of investing in capital projects promising inadequate returns.  As a result, the family business has accumulated excess liquidity. The company elects to redeem one branch of the family shareholder tree that is geographically and socially removed from the rest of the family and has expressed a desire to achieve liquidity.  The shareholder group collectively owns 25% of the outstanding shares and can be redeemed for $100.  Following the redemption, the market value balance sheet now looks like this: Following the transaction, the remaining shareholders endure less of a drag on returns from low-yielding cash assets, and the company retains ample financial flexibility to meet strategic investment opportunities that may arise.  In this case, the shareholder redemption was clearly a positive outcome for all the shareholders, and did not trigger any negative consequences for employees or other interested stakeholders. Scenario #2 – Excess Borrowing Capacity and Moderate Reinvestment OpportunitiesIn our second scenario, the family business operates in a growing industry presenting moderate reinvestment opportunities.  The founding and second generations have been averse to debt, seeking to repay outstanding balances as quickly as possible.  At present, there is no debt outstanding.  The market value balance sheet is summarized below. As the third generation has assumed primary leadership of the family business, they have prioritized diversification and reducing the concentration of family wealth in the business.  In order to fund investments outside the business, the directors elect to redeem 25% of the outstanding shares, funding the redemption through a bank loan.  The post-redemption market value balance sheet is summarized below. In this case, the shareholder redemption accomplished two things: (1) helped secure the family’s financial foundation by establishing a basket of wealth that is not tethered to the fortunes of the family business, and (2) potentially reduced the family business’s overall cost of capital through the prudent use of available financial leverage. From the perspective of other employees and other interested stakeholders, the outcome is perhaps a bit more mixed. While the post-redemption financial leverage is by no means imprudent, the risk of financial distress in the event of softening economic conditions is heightened. As a result, employment levels and wages may be under greater scrutiny if a recession were to occur.At the same time, use of a more optimal capital structure may reduce the hurdle rate used to evaluate capital investments, making growth opportunities relatively more attractive.Further, since the family has reduced its financial dependence on the business, the shareholders may actually be more willing to take risk inside the business and pursue growth more aggressively, with positive consequences for employment and wages.Finally, depending on what form the family’s diversifying investments outside the business take, there may be positive externalities for the community at large through investment in start-up enterprises, real estate development, or other activities.Scenario #3 – Optimal Capital Structure and Abundant Reinvestment OpportunitiesIn our final scenario, the family shareholders of a growing family business have been feuding for years.  With tensions reaching a breaking point, the directors have concluded that redeeming the dissenting group’s 25% ownership interest is the only way to preserve family ownership of the business.  Industry fundamentals are attractive, and the family business has identified a strategy that promises abundant opportunities for financial rewarding capital investment.  The company has relied heavily on debt financing in recent years to execute on its growth strategy. The Company’s existing lenders have little appetite for extending further funds to finance the $100 redemption.  The family has no desire to accept equity investment from outside sources, so the redemption is financed with a high-yield loan from a so-called mezzanine lender.  The loan is costly both with respect to the interest rate and the inclusion of equity warrants, which the family business has the right to redeem at exercise.  The market value balance sheet following the purchase is summarized below. For the remaining shareholders, the redemption has defused a volatile family situation, but at the cost of assuming a much riskier ownership position.  The greater post-transaction financial leverage has magnified both the potential upside and downside for the remaining shareholders.  Of perhaps even greater significance, the obligation to use operating cash flows to service the redemption financing will “crowd out” capital investment, and may impair the company’s ability to execute on its strategy.  This diversion of cash flow away from attractive investment opportunities is a very real opportunity cost to the remaining shareholders, which we can think of as the cost of family dysfunction. For employees and other stakeholders, the repercussions of this shareholder redemption are uniformly negative.   The elevated financial risk increases the exposure of the company to even temporary downturns, as lender covenants may force management to adopt more of a short-term perspective than it otherwise would.  The limited financial flexibility is likely to cause growth to slow, shrinking opportunities for promotions and wage growth.  Finally, the post-redemption capital structure may increase the likelihood of the business being sold.  Depending on the characteristics of the buyer, a sale of the business may have negative consequences for both employees and the local community.  In other words, the costs of family dysfunction are not confined to the family. ConclusionSizable shareholder redemptions can serve a number of purposes in a family business.  Though clearly not an exhaustive list, in this post we have laid out three representative scenarios for major shareholder redemptions and the likely consequences for both family shareholders and other stakeholders.Your family business is unique.  If you are contemplating a shareholder redemption, our experienced family business advisory professionals can help you and your fellow directors assess the likely outcomes for all the relevant parties and chart the best path forward.

This post is part of our “Talking to the Numbers” series for family business leaders.  In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements.  Asking better questions will lead to better financial and business decisions. In our last post in this series, we focused on operating income, which is a critical measure for evaluating the performance of management since it is unaffected by financing and tax decisions made by the board of directors.  Net income, on the other hand, reveals how those board-level decisions influence your family business’s earnings and ability to pay dividends.  Everyone likes to talk about EBITDA and EBIT – and those are important metrics – but only net income measures the increase in the family’s wealth from owning the business. Exhibit 1 summarizes the different “tests” that a family business faces as we move down the income statement.For the family business to be truly profitable, operating income must be sufficient to cover financing costs.  And taxes are a fact of life, so Uncle Sam must take his share before the real profitability of your family business can be discerned.Financing CostsAnalysts often refer to operating income as EBIT, or earnings before interest and taxes.  Interest expense is the cost of financing the portion of the family business funded by debt.  All financing sources – both debt and equity – have costs, but only the cost of debt is measurable by accountants. (We’ll address the cost of equity in a future post.)  So interest expense is what shows up on the income statement.The amount of interest expense on the income statement depends on the amount of debt on the balance sheet and the rate charged by lenders.  The relationship between balance sheet leverage and interest burden for our data set is summarized in Exhibit 2.Reviewing the data in the exhibit above, we can discern the strong positive correlation between balance sheet funding and the interest coverage ratio.  The principal exception to this relationship is in the energy sector, where depressed operating earnings have increased the proportion of EBIT that is required to pay interest costs.How risky is your family business from an operating perspective?From a balance sheet perspective, companies tend to use more financial leverage in industries that rely on large investments in physical assets (telecommunications and utilities), and less in industries that rely more on human capital and intellectual property (such as information technology).From an income statement perspective, recurring revenue and predictability of earnings are also indicators of debt capacity.  To illustrate this, we sorted the companies in our data set into two groups on the basis of observed year-to-year volatility of EBIT.  The companies demonstrating less volatility had median debt to invested capital ratios of 43%, while the median for companies in the higher volatility group was 35%.For family business directors, the key questions around financing costs include:What is the appetite for risk among our family shareholders? Are our family shareholders willing to accept greater financial risk in exchange for the opportunity for higher returns?How risky is our family business from an operating perspective? Do we have good visibility into future earnings from year-to-year, or do operating earnings vary markedly from period to period?Income TaxesUnlike financing costs, income taxes are proportional to pre-tax earnings.  As a result, income taxes do not affect the risk profile of a family business, but they do influence the returns – and dividend paying capacity – of a family business.  We make a couple observations when studying our public company data set, both of which are evident in Exhibit 3.First, the effective tax rate for public companies (income tax expense as a percentage of pre-tax income) has historically been less than the prevailing statutory rate.  Second, the effective tax rate is inversely related to company size: the effective tax rate for large cap companies in our data set was just under 28%, while the effective tax rate for small cap companies was a bit over 33%.  We suspect this is attributable to a couple factors: (1) the largest companies likely have the greatest access to the most sophisticated and effective tax strategies, and (2) the large cap companies likely earn a greater portion of their income in lower-tax international jurisdictions than do small cap companies.How does your family business’s effective tax rate compare to the statutory tax rate?For family businesses, there is the added wrinkle of deciding whether to adopt a tax pass-through structure.  Many family businesses elect to be organized as S corporations (or other pass-through forms), while public operating companies are generally organized as C corporations.  While the S election eliminates one layer of taxation, it is not necessarily the optimal structure for all family businesses, particularly following the implementation of the Tax Cuts and Jobs Act of 2017.The most important thing for family business directors to understand about the S election is that the legal and economic consequences of the election are reversed.  Legally, the S election removes the obligation to pay income tax on corporate earnings from the corporation.  However, economically, the S election relieves shareholders of the obligation to pay dividend tax on distributions from the corporation.Let’s unpack that a bit.Though an S corporation does not have to write a check to the IRS, its shareholders are required to do so for the full amount of taxes on the earnings “passed-through” to the shareholders.  These taxes are due whether there is a corresponding distribution from the company or not.  Therefore, an S corporation has to make a distribution to its shareholders sufficient to make them whole on the pass-through tax liability they are now legally obligated to pay.  So from an economic perspective, the company still has to pay taxes on its income; those taxes are just routed through the shareholders as distributions.  But having paid those taxes, the shareholders have no further obligation for taxes on additional distributions received from the family business.As a result, the economic benefit of the S election to family business shareholders will be most pronounced for businesses that have the capacity to distribute a substantial portion of net (after tax distribution) earnings.  Shareholders of family businesses that do not plan to make significant after-tax distributions may, in fact, be worse off under an S election, since the personal tax rate (29.6% assuming eligibility for the qualifying business income deduction) is higher than the C corporation tax rate (21%).Family business leaders should seek answers to the following questions when thinking about income taxes:How does our family business’s effective tax rate compare to the statutory tax rate? Are there available strategies that could reduce – or at least defer – the tax drag on net income and dividend capacity?  A penny of taxes saved really is a penny earned.Should our family business be organized as an S corporation? What is the likely future relationship between dividend payments and earnings reinvestment?  What used to be a slam-dunk analysis in favor of the S election is no longer nearly so straightforward.  The reduction in C corporation tax rates may have tipped the scales back in favor of C corporation status for some family businesses.ConclusionSo how much money does your family business really make?  EBITDA is an important measure for a lot of reasons, but there are significant claims on the cash flow measured by EBITDA before it trickles down to the family shareholders.  As a family business director, the decisions you make with regard to financing and tax structure can have a material effect on how much money the business really makes.  Contact one of our experienced family business advisory professionals today to discuss how best to approach these important decisions.

Publicly-traded Ashland Global Holdings (ticker: ASH) recently announced a series of steps intended to pacify activist investor Cruiser Capital, which owns approximately 2.5% of the company’s shares.  Cruiser has proposed four new directors at Ashland, citing a number of factors contributing to their dissatisfaction with the status quo in a November 2018 letter to the board:Ashland’s refusal to engage with industry experts recommended by CruiserCruiser’s belief that Ashland is “severely undervalued”Cruiser’s belief that Ashland “has demonstrated persistent operational underperformance”Cruiser’s belief that the board needs new voices to better represent all shareholders In an effort to head off a protracted and potentially embarrassing proxy fight, Ashland announced earlier this month that it would add two new directors, adjust board committee composition and leadership, and have one long-term director step down.  Whether Ashland’s proposed moves will placate Cruiser remains to be seen.The source(s) of contention among shareholders can simmer for years, ultimately yielding a toxic stew of resentment, strife, or even litigation.Privately-held family businesses are not exposed to the threat that an activist investor such as Cruiser Capital will accumulate a significant ownership position.  But does that mean that “shareholder activism” is something that family business directors don’t need to take seriously?  We don’t think so.In our experience, while family businesses are not vulnerable to activist investors, they may have disgruntled family shareholders to deal with.  Given the tangled personal dynamics in family business, directors would probably prefer to deal with a third-party activist investor like Cruiser Capital than an unhappy sibling or cousin.  Since family business ownership interests are illiquid, the source(s) of contention among shareholders can simmer for years, ultimately yielding a toxic stew of resentment, strife, or even litigation.We noted the specific items Cruiser was taking umbrage to above – what would a list of disgruntled family shareholder complaints look like?  The most common points of contention include the following:The family business is not paying a sufficient dividendThe family business is being run by the wrong family membersThe family business is not making the right investmentsThe family business board needs some fresh facesThe family business holds too much cash or other non-operating assetsThe family business is engaging in related party transactions on an unfair basisThe family business is not as profitable as it should beThe family business management team is over-compensated The list could certainly go on.  Sometimes such complaints have merit, and sometimes they don’t.  Yet even a perceived problem is a real problem to the discontented family shareholder. The authors of a 2018 article on the Harvard Law School Forumon Corporate Governance and Financial Regulation identify three components of an effective response by public companies to activist investors.  The recommendations translate well to family business boards dealing with one or more disgruntled family shareholders.1. Objectively Consider the Activist’s IdeasOf course, all families are different, but just because Uncle Harry makes a recommendation does not necessarily mean it’s wrong.  It is difficult, but necessary, for family business directors to lay aside whatever personal dynamics may be at work and objectively evaluate the economic merits of the proposed action.  This could involve going beyond intuition and “gut feel” for a question and gathering relevant data that can inform the decision.  Family shareholder activism will naturally be perceived by management and the board as personal (and in some cases the complaints may be truly personal and nothing more).  However, family business directors have a duty to make appropriate decisions for the long-term sustainability of the business even if their feelings have been hurt.  Sometimes, a major change is the right thing to do, even if it is uncomfortable.  The presence of independent non-family board members or trusted advisors can help family directors filter out potentially distracting personal dynamics and evaluate proposals on their merits.2. Look for Ways to Build ConsensusThe authors of the article suggest finding points of agreement with activist shareholders.  In the context of family businesses, the first step is to demonstrate a commitment to objectively evaluating the shareholder recommendation by actually talking to the shareholder about his or her concerns and proposed action.  Stonewalling or ignoring the shareholder will only make the situation more combustible.  Engaging with the shareholder may reveal that a relatively simple “fix” may exist that neither the frustrated shareholder nor the board had previously considered.The second step would be to solicit input regarding the contested issue from a broader selection of family shareholders.  This can be done through informal conversations or through a more structured confidential survey process.  Soliciting other opinions may confirm that the disgruntled shareholder is merely giving vent to what are ultimately personal frustrations, or it may reveal to the board that there is, in fact, a broad consensus among family shareholders that the issue is a real problem that needs to be addressed.  In either event, the process will demonstrate to the activist shareholder that their concerns are being taken seriously.3. Tell the Company’s StoryThe best defense, as they say, is a good offense.  Similarly, the best way to deal with disgruntled family shareholders is to foster positive engagement with all shareholders before any of them become disgruntled.  Senior management and the company’s directors should always be telling the company’s story to the family group.  There are three basic levels of family business storytelling:History and LegacyEvery family business has a “founding myth” that informs the company’s culture and ethos.  At appropriate family forums, senior managers and directors should tell and re-tell the company’s story so that it becomes firmly embedded in the family’s DNA.  Some even advocate using dedicated spaces to serve as continuous reminders of the company’s history and legacy.Industry Dynamics and StrategyFamily shareholders should have the opportunity, through periodic education opportunities, to understand the broad contours of how the relevant industry works and the family business’s place in that industry.  Non-employee family shareholders should understand the primary production inputs required, the value-added processes of the company, the attributes of customers, key regulatory issues, and the nature of competitive rivalry in the industry.  This background knowledge will provide the basis for shareholders to understand the company’s basic strategy and the implications of that strategy for dividend policy, capital budgeting, and financing decisions.Ongoing Performance ReportingThe sad truth is that public companies treat their anonymous shareholders better than many family businesses treat their family shareholders.  Public companies provide regular, detailed communication to their shareholders regarding how the business is performing and what the future looks like for the business.  Yet many family businesses do not have a schedule of regular communication with shareholders to keep them informed on the performance or outlook for the business.  Merely sending out financial statements is not enough, however.  Management and directors need to convert the raw financial data into information that tells the company’s story.Most cases of family shareholder strife can be traced to a failure to communicate.We’ve never heard about a disgruntled family shareholder that complained about knowing too much about the family business or receiving too much relevant communication from the company.  Rather, most cases of family shareholder strife can be traced to a failure to communicate.  The most appropriate intervals, format, and content for shareholder communication will not be the same for every business, but an effective communications program will include all three of the elements discussed above.ConclusionAre all of your family shareholders positively engaged with the business?  The cost of failing to engage with shareholders in a constructive way can be very high.  Whether it is providing an independent perspective on shareholder disagreements, helping develop consensus on contentious issues, or crafting an effective shareholder communications program, our family business advisory professionals are eager to assist you and your fellow directors in promoting positive shareholder engagement.  Call us today to discuss your situation in confidence.

Let’s start with the good news: the last U.S. recession ended almost ten years ago.  So for nearly a decade, family businesses have been operating in a climate of sustained (though rarely flashy) economic growth, which has helped contribute to strong balance sheets, revenue and profit growth, and investments in innovation.Now the bad news: the next U.S. recession is closer than it has ever been.  We are not professional economists, and we make no predictions regarding when the next recession will commence.  However, we do not believe that the business cycle has been repealed, and that another recession will eventually occur.  It may or may not be in 2019 (for the record, we hope it’s not), but one is eventually coming.As a director, now is the best time to think about how your family business is positioned for the next recession, whenever it comes.  In this post, we review some ways family business directors can prepare their companies to survive (and perhaps even thrive during) the next recession.Operating EfficiencySustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business.One of our family business clients told us a long time ago that it’s easier to make good decisions when you don’t need the money.  We have always thought there was a lot of wisdom in that.  Sustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business.  When business is going well, it can become easy to put off hard decisions regarding expense management.  But today, when you don’t “need” the money, is the time when you are likely to make the best decisions in support of the long-term sustainability of the family business.  If you wait until you are feeling the pressure in the heat of a downturn, it will be harder to make appropriate expense management decisions.Are there areas of your business that are not operating efficiently? Right now, before the next recession strikes, is the best time to evaluate vendor relationships, human resources, and operating procedures with a view to making sure your family business is in fighting trim.Are there underperforming business lines or territories that need attention? When consolidated profits are strong, weak business units can avoid scrutiny.  Are there business lines that you should consider divesting while it’s still a seller’s market?Balance Sheet StrengthManaging the balance sheet is a continual trade-off between efficiency and flexibility.  We often write about the perils of “lazy” capital in family businesses, yet some measure of financial flexibility can help sustain family businesses during economic slowdowns.  Balance sheets can be fortified in advance of a recession by shedding underperforming or non-operating assets and using all or some of the proceeds to reduce outstanding indebtedness.  Bankers prefer to lend money to those who don’t need it, so now could be an optimal time to expand borrowing limits on lines of credit, re-negotiate loan covenants, etc.Has your family business accumulated non-operating assets during the economic expansion that are limiting the company’s financial flexibility?What are the sources of capital available to your family business? Does the company have unused capacity on revolving credit agreements?  What covenant provisions could potentially impair the company’s ability to access undrawn financing or otherwise limit financial flexibility during a recession?Competitive DynamicsAn economic disruption may present opportunities for patient family businesses.One oft-touted benefit of family businesses is the ability to maintain a long-term focus and avoid the short-termism that can afflict non-family public companies.  Taking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity.  You don’t have to outrun the bear as long as you can outrun the other hunters.  Now is the time for management teams and boards to do a careful assessment of competitive and industry dynamics with a view to identifying what opportunities might arise for the family business to solidify its long-run competitive position during a recession.If your industry were hit with a recession, which players would be most negatively affected? What strategies would be appropriate for your family business if competitors were to experience financial distress?Would a prolonged recession prompt one or more of your competitors to consider selling assets? If so, do you have an acquisition “wish list” for the next buyer’s market?Operating LeverageOperating leverage refers to the prevalence of fixed (as opposed to variable) operating costs in your family business’s capital structure.  When revenues are expected to increase, operating leverage is everyone’s friend since the earnings impact of a growing topline is magnified by expanding profit margins.  Unfortunately, the magnification effect also works in reverse, as stagnating or shrinking revenues at family businesses with significant fixed operating costs will trigger more dramatic declines in profitability as margins contract.What does your family business’s operating cost structure look like? Are the company’s operating costs primarily fixed, or do they vary somewhat proportionally with revenues?Has your family business benefited from operating leverage during the economic expansion? Are there available opportunities to shift to a greater emphasis on variable costs?Revenue CyclicalityThe cyclicality of revenue refers to the sensitivity of a family business’s revenue stream to overall economic growth.  Companies that sell non-discretionary goods or services exhibit less revenue sensitivity since customers need such products and services regardless of the economic environment.  Demand for food, personal care products, healthcare, and similarly situated industries can soften during a recession as consumers trim budgets, but the sensitivity is muted relative to that for discretionary goods and services (automobiles, home renovations, leisure goods, etc.) that consumers can more readily forego or defer when belts need to be tightened.How sensitive is your family business’s revenue to the economy? If your company operates in an inherently cyclical industry, are there any strategies available to reduce the company’s revenue exposure to an economic slowdown?ConclusionWe sincerely hope that the next recession doesn’t start for a long time.  Whenever it does start, though, you need to be prepared.  As a family business director, you will probably never be able to make your business “recession proof” but now is the time to evaluate what steps are prudent to prepare for the next downturn.  Our family business advisory professionals have lived and worked through several recessions (and have the scars to prove it).  Give us a call to discuss positioning your family business for the next one today.

This post is part of our “Talking to the Numbers” series for family business leaders. In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements.  Asking better questions will lead to better financial and business decisions. When engaging in shop talk about a client project, our colleagues inevitably start by asking, “What business is the client in?”  In nearly all cases, the appropriate response to the question is a brief description of the client’s industry.  But for a small minority of clients whose financial performance is truly extraordinary, the correct response is that they are in the “money making” business.  For these clients, the particular “it” of what they do is secondary to the fact that they make a lot of money doing it.  Has your family business joined the exclusive club whose members are in the “money making” business?Has your family business joined the exclusive club whose members are in the “money making” business?The income statement reveals the profitability of your family business.  You can think of the income statement as a series of increasingly difficult tests.  If the company can charge a price for its goods or services greater than the cost of production, it will have passed the first test, and gross profit will be positive.  The second test is this: Can the family business sell enough units to cover its overhead expenses?  This test is harder, as it requires the business not just to be profitable on a per-unit basis, but to generate enough volume to support the selling, general and administrative expenses necessary to operate the business.  Looking at our data, we observe that just five companies failed the first test (i.e., reported negative gross profit), but 69 companies failed the second test.Exhibit 1 summarizes median operating margins by industry.  The sum of the two stacked columns is the median gross margin for each industry (gross margin = operating margin + S, G&A).  In general, some of the volatility in gross margin by industry gets smoothed out a bit at the operating margin level.  For example, the relatively high gross margin for industries like healthcare and information technology is largely offset by high overhead costs.  On the other hand, lower gross margin sectors such as industrials and materials, have lower overhead burdens.Three broad themes relevant to family businesses emerge from our consideration of the operating income data.Operating Leverage is Real, so Revenue Growth is ValuableFor family businesses that are focused on long-term sustainability, focusing on revenue growth is not optional.  Standing still is generally a recipe for a slow (or perhaps even fast) painful death.  The cost of doing business rises every year, and revenue growth is essential to maintaining profitability.  To the extent a business has fixed costs – and all do to some degree – faster revenue growth can contribute to margin enhancement.  Exhibit 2 summarizes the operating leverage enjoyed by the companies in our analysis.  Consistent with our analysis in a prior post, we divided our universe of companies into three groups based on their observed historical revenue growth.As noted in Exhibit 2, the median operating margin for the high growth companies increased over the period, from 10.9% to 12.0%, while the median operating margin for the low growth companies decreased by approximately 240 basis points.  As noted in the rightmost column, the effect of operating leverage (both positive and negative) is to magnify the impact of changes in revenue on earnings.  For the high growth companies, operating leverage multiplies a 15.4% revenue growth rate to an 18.2% earnings growth rate.  For the low growth companies, shrinking operating margins contributed to an 8.0% decline in earnings despite revenue falling a more moderate 2.5%.Operating leverage matters to family businesses.  As directors think about operating leverage, the following questions are good to mull over.How much “slack” is there in the current overhead structure? Could our family business absorb a 5% increase in revenue without incurring additional overhead?  10%? 20%?How would our customers respond to a price increase? For some businesses, a modest price increase can be the quickest route to revenue growth with little to no impact on operating costs.  How easy would it be for customers to switch to a competitor in the event of a price increase?  Or, would competitors be likely to follow suit?Operating Margin is a Component of Risk ManagementOperating margin provides a buffer against the inevitable rough patches that any business faces.  For family businesses, layoffs and other austerity measures prompted by economic downturns or other business headwinds are especially stressful.  One perspective on margin as a component of risk management is the concept of a breakeven point.  The breakeven level is the sales volume that will generate enough “contribution margin” to cover the business’s fixed costs.Estimating the breakeven level for your family business requires an assessment of which costs are fixed (over the relatively short-term), and which are truly variable with the amount of sales.  Making a precise calculation is not the point, however; understanding how sensitive operating income is to changes in sales is more important than calculating precisely what level of sales corresponds to breakeven operating income.Since public companies aren’t required to disclose their fixed and variable costs, Exhibit 3 illustrates the concepts using two hypothetical family businesses.Company A and Company B currently generate the same 10% operating margin.  But breakeven analysis reveals that Company A (with a greater proportion of variable to fixed costs) is better able to withstand a reduction in sales.  Operating income for Company A does not fall to $0 unless sales tumble by a third, while revenue slipping by just 15% causes Company B to begin losing money.  Panel B illustrates how a higher operating margin reduces the breakeven level for both companies.  In other words, operating margin is not just about cash flow and profits, but is also an important element of risk management.  Family business leaders attuned to risk should consider questions like these when analyzing operating margin:Does it make sense to consider changing the cost structure to emphasize fixed or variable costs more? If there is a risk that future revenues will decrease, a variable cost structure will reduce the breakeven level, whereas if the outlook is for robust revenue growth, a fixed cost structure will provide a boost to earnings growth.What is my family business’s exposure to a potential economic downturn? Does the business operate in a counter-cyclical business that has historically weathered recessions with ease, or do even mild recessions pose an existential threat to the business?  We are not predicting when the next recession will occur, but that there will be one, we are quite certain.  The best time to plan for that eventuality is before it comes, when the flexibility to adapt is greatest.Diligence in Expense Management is RewardedNo family business can save its way to prosperity: you really do have to spend money to make money.  However, diligence with regard to operating expenses – in flush times as well as bad – pays dividends.To test this theory, we reviewed operating expenses for the companies in our data set.  Year-over-year growth in operating expenses across the group varies dramatically.  Since extreme changes are likely the result of acquisitions or dispositions, we focused on the subset of companies for whom year-over-year operating expense growth ranged from -2.5% on the low side to +7.5% on the high side.  We then further divided this group into those whose expenses grew less than +2.5% (a rough proxy for inflation), and those whose expense grew at rates higher than inflation.  Exhibit 4 summarizes relevant data for these two subgroups.The companies that were more diligent managing operating expenses were far more likely to see revenue grow faster than operating expenses.  Those that failed to contain operating expenses were more likely to see margins slip because of expense growth outpacing revenue growth.Family businesses let spending discipline slide at their own peril.What opportunities exist at my family business for optimizing labor costs? Are there capital investments that can promote labor efficiency?How does the structure of our sales & marketing function fit with our product offerings and markets served? Are there opportunities to enhance the effectiveness and efficiency of our selling and marketing efforts?How is our administrative staffing? Do we have the right people in the right places with the right tools to succeed? Operating income is the foundation of your family business’s ability to pay dividends, invest in the future, and obtain attractive financing.  What business is your family business in?

At a recent meeting with longstanding family business clients, management mentioned that one of their independent directors had introduced the term “lazy capital” into the family’s vocabulary.  We had never heard that term before, but it perfectly encapsulates something we see at too many family businesses: an undisciplined capital allocation process that tolerates sustained underperformance.  We ran across a couple articles this week that, while written with public companies in mind, made us think about the perils of “lazy” family capital.Capital, Culture & CommunicationThe first article posted by Big 4 accounting firm EY was entitled “Is Your Capital Allocation Strategy Driving or Diminishing Shareholder Returns?”  In the piece, EY offered eight leading practices for allocating capital, two of which made us think about our family business clients.Number three on EY’s list was this: “Establish a ‘cash culture’ that prizes cash flow and does not tolerate unnecessarily tying up capital.”  Perhaps it is more natural for public companies to prioritize a “cash culture” than it is for family businesses.  After all, family businesses have the advantage of not being on the quarterly reporting treadmill, or worrying about the day-to-day or week-to-week changes in share price.  Yet, a “cash culture” need not result in unhealthy short-termism.  For family businesses, a “cash culture” can help provide the foundation for long-run sustainability.  The managers of a family business with a healthy “cash culture” understand that family capital does have alternative uses outside the family business, and are focused on being good stewards of the capital that the family has entrusted to them.  As a result, “cash culture” family businesses are more flexible, more attuned to emerging risks and opportunities, and ultimately more accountable to the family.Consistent and credible communication lays the groundwork for the difficult capital allocation decisions that enhance the long-run sustainability of the family business.The seventh item on the EY list was to “Align capital allocation, strategy, and communications.”  Relative to public companies, some family businesses are late to the party when it comes to sophisticated capital budgeting tools.  However, despite the merits of net present value, internal rate of return and other quantitative concepts (which are many), those capital budgeting tools accentuate, rather than diminish, the importance of a clearly-articulated corporate strategy to allocating capital properly.  Quantitative tools can be used (whether intentionally or not) to support proposed capital projects that do not advance the family business’s strategy.  The quantitative greenlight should be viewed as a necessary, but not sufficient, condition for approving capital projects.  Knowing that corporate strategy is essentially the art of saying “no” at the right times, successful family businesses require a compelling and simple answer to the “why” question: Why is the proposed project a good fit for us?Public companies work hard to ensure that corporate strategy is effectively communicated to existing and potential shareholders.  The results of failing to do so can be disastrous – if public company shareholders don’t understand or don’t believe or simply don’t know what the company’s strategy is, they can vote with their pocketbooks by selling shares.  When public company investors head for the exits, the share price becomes depressed, leaving the company vulnerable to hostile takeover or vulture investors.Since family shareholders do not have ready liquidity, does that diminish the importance of communication for family businesses? No.  If family business directors fail to communicate well, family shareholders eventually become disengaged, suspicious, and far too often, litigious.  Family businesses simply have too much at stake not to take communication seriously.  Consistent and credible communication lays the groundwork for the difficult capital allocation decisions that enhance the long-run sustainability of the family business.Putting the Family Business on a (Capital) BudgetA recent “Head to Head” feature in the Financial Times (subscription required) pitted two economists against each other on the topic of share buybacks.  One economist, citing the baleful influence of aggressive share repurchases, argued that they should be strictly curbed, while the other praised the effectiveness of buybacks in promoting a long-run perspective on the part of company managers.  The specific arguments put forth (with varying degrees of cogency) don’t need to concern us here, since they apply to public companies.For family businesses seeking vigilance against “lazy” capital, what is the proper role of share repurchases?But for family businesses seeking vigilance against “lazy” capital, what is the proper role of share repurchases?  Most family business directors are rightly wary of wild swings in annual per share dividend payments.  However, one side effect of that concern is that when financial performance is strong, undistributed capital at the family business may be inclined to put on the stretchy pants and become “lazy.”  A disciplined dividend policy can actually result in an undisciplined reinvestment policy.  When retained capital is plentiful, it becomes more tempting to approve marginal capital projects, or those with only a tenuous connection to the family business’s strategy.  Repurchasing shares can function as the release valve that allows family business directors simultaneously to maintain a steady annual dividend and keep the family business on a prudent financial diet when it comes to capital investment.The biggest challenges surrounding share repurchases for family businesses are getting the price right and communicating with shareholders.  A price that is too low will take economic advantage of selling shareholders, while a price that is too high may cause a proverbial run on the bank.  Shareholders need to be fully informed about why the repurchase is occurring, at what price, and what their options are with regard to tendering shares.Share repurchases won’t be a good fit for every family business.  For some, a periodic special dividend may fulfill the same function.  But they are a key tool available to family business directors in the ongoing fight against “lazy” capital.

The tyranny of the urgent imposes itself on family business leaders just as it does on everyone else.  In this series of posts, we will offer various to-do lists for family business directors.  Each list will relate to a particular family business topic.  The items offered for consideration won’t necessarily help your family business survive the next week, but instead, reflect priorities for the long-term sustainability of your family business.In last week’s post, we explored how to respond to unsolicited acquisition offers.  This week’s to-do list is about being prepared for such offers if and when they come.Gauge Family Members' Appetite for a Sale of the BusinessDo you know what your family members think about a potential sale of the business?  Would they be aghast at the thought of selling the fruit of great-grandfather’s labors?  Would they be reluctant to sever the economic ties that bind the extended family together?  Or, would they welcome the opportunity to harvest the gains that have accrued through the family’s efforts?  Would they like to diversify their holdings?  Would the thought of being emancipated from the shackles of economic dependence on the family be liberating?  Would your family relish the opportunity to just be a family without the mental overhead of being a family business?Getting the answers to these questions can be as simple as have a few informal conversations with key family members, or by including questions designed to uncover such preferences in an annual shareholder survey.  Either way, it is best not to assume you know how the family feels.  The best time to get an unbiased view of what the family thinks about selling is before the acquisition offer comes in.Identify the Attributes of an Acquirer to Whom the Family Would be Willing to Sell the BusinessIf the family is not opposed on principle to a potential sale, what sort of acquirers would the family find palatable?  As we previously discussed, what sellers want economically is a motivated buyer, whether that is a private equity firm or a strategic acquirer.  However, the family is entitled to have a preference as to who the next owner of the family business will be.  Is the family comfortable with a group of MBAs in a faraway city determining the fate of the business that bears the family name?  What about a competitor that may close certain locations or institute significant workforce reductions?  What would be the impact on the family legacy if the business gradually (or abruptly) melted away into the legacy operations of a larger acquirer?These questions don’t have right or wrong answers, but the answers will reflect the family’s culture and values.  Having clarity and consensus around these issues now will make responding to unsolicited offers that may be received later less stressful.Identify Steps That can be Taken to Improve the “Curb Appeal” of the Family Business  How often have you heard a friend or colleague remark that, after having fixed their house up for sale, they wish they had made the improvements years earlier so they could have actually enjoyed them?  The same regret can apply to family businesses.  The same adjustments that you would make to improve buyer perceptions will likely also make your family’s ownership of the business more rewarding.  So why wait?  Even if you have no plans to actively market your family business for sale, now is the time to clean up the balance sheet (disposing excess or non-operating assets, securing favorable long-term financing, etc.) and fix the leaks in the income statement (expenses that don’t relate to the operations of the business, and other potential “adjustment” items that a buyer will cause a buyer to question the “quality” of your business’s earnings).Assess Reinvestment Opportunities for the Family in the Event of a SaleAfter a sale, the family will have a pile of money instead of an operating business.  What comes next?  Will you distribute proceeds to the shareholders, or will you set up a family holding company to reinvest the proceeds?  What are the implications for the family of reinvesting versus distributing sale proceeds?  What sort of reinvestment strategy is likely to meet the needs of the family?  Marketable securities?  Real estate?  Another established operating business?  Venture capital?  How do the prospective returns on those asset classes compare to the returns you would expect from continued ownership of the family business?Interview Potential Financial Advisors that can Help the Family Evaluate Offers and Execute TransactionsDo you have an existing relationship with a trusted corporate finance team that can help you when an unsolicited offer arrives?  If not, it is better to shop around for that advisor now, rather than in the heat of responding to an offer that you did not set the timetable for.  A qualified advisory team will have deep valuation and transaction experience.  A great first step in developing such a relationship is having the advisor perform a set of calculations to help establish a benchmark range for evaluating potential acquisition offers.  A corporate finance advisor can also help evaluate potential acquisition opportunities that your family business may want to consider.The professionals in our Family Business Advisory Services practice have decades of experience helping family businesses evaluate and respond to unsolicited acquisition offers.  Call us to help you get started on knocking out your to-do list today.

Successful businesses don’t have to go looking for potential acquirers—potential acquirers are likely to come looking for them. Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors. Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but serious inquiries from legitimate buyers of capacity occasionally appear that require a response.What Kinds of Buyers are There?Buyers are generally classified into two categories.Financial buyers are groups like private equity funds that purchase businesses with a view toward earning a return on their investment over a finite holding period. These buyers generally use financial leverage to magnify their returns, and expect to exit their investment by selling the business to another buyer after three to seven (or maybe even ten) years. While financial buyers may have specific plans for making the business run more efficiently and profitably, they are generally not anticipating significant revenue synergies or expense savings from wholesale changes to the business. Rather, they tend to be more focused on incremental changes to boost value and clever financial engineering to be the principal engines driving their returns.Strategic buyers are competitors, customers, or suppliers of the business who have a strategic goal for making the acquisition. Such buyers certainly want to earn a return on their investment, but that return is expected to come from combining the target’s operations with their own, rather than through financial engineering. In other words, strategic buyers look to long-term value creation through assimilating the target into their existing business, not a short-term return from buying low and selling high. Strategic buyers may anticipate revenue synergies through the combination or may foresee the opportunity to eliminate operating expenses in either the acquired or legacy businesses to fuel cash flow growth. Distinguishing between financial and strategic buyers is important for evaluating unsolicited offers, but we suspect that a more important distinction is that between motivated buyers and opportunistic buyers. Successful family businesses will attract motivated buyers who have the capacity to pay an attractive price for the business, but should strive to avoid opportunistic buyers who are seeking to take advantage of some temporary market dislocation or cyclical weakness to get the business at a depressed price.Evaluating Acquisition OffersMost family businesses have no intention of selling; however, when a legitimate, unsolicited offer arrives, what do you do?Evaluating acquisition offers is ultimately the duty of the board of directors, not the family at large. Uncle Charlie may have strong opinions on the proposed deal, but if he is not a director, he does not have the responsibility or authority to respond to the offer. That does not mean that the directors will not care about Uncle Charlie’s perspective. As we’ve discussed, it is critical for the board to understand what the business “means” to the family, and the meaning of the business to the family may well inform how the directors evaluate the offer. For larger families, the prospect of receiving a potentially attractive unsolicited acquisition offer underscores the value of a regular survey process, whereby the board and senior management periodically take the pulse of the family on topics at the intersection of business and family.Family business directors should evaluate offers along several dimensions.Buyer MotivationWhat has prompted the offer? If it is a strategic acquirer, what sort of operational changes would be expected post-transaction? Will a sale result in facility closures, administrative layoffs, or discontinuation of the business name? Or, could the sale increase opportunities for employees and expose the brand to new markets? If the suitor is a financial buyer, what sort of debt load will they place on the company post-acquisition? Will the company’s ability to withstand normal economic downturns be compromised? Will the buyer want members of the family active in senior management to continue to run the business? The answers to these and similar questions should be considered in the context of what the business means to the family and help inform whether the offer should be entertained further.Buyer CapacityDoes the buyer have the financial capacity to actually execute the transaction if it is agreed to? If external financing is required, will it be available to the buyer when needed? Basic due diligence goes both ways. Going through a lengthy negotiation and due diligence process only to have the transaction fall apart at the closing table due to lack of financing will leave a bad taste in the family’s mouth.Price & Transaction StructureWhat seems on the surface to be an attractive price may, upon further examination, turn out to be a far less attractive transaction. A sale of stock may have a lower nominal price than a sale of assets, yet result in higher after-tax proceeds. A high nominal price may be subject to contingencies regarding future performance which cause the economic value of the offer to be far less. Or, a high nominal price may be payable, in part, in shares of the buyer rather than cash—what is the family’s appetite for trading stock in the family business for stock in a different business over which they will likely have no control? There are many other components of transaction structure, such as required representations and warranties or escrow provisions that can significantly influence how attractive an offer really is.Price is not EverythingJust because the price is adequate and the terms are acceptable does not mean that the timing is optimal for a sale. Directors should carefully weigh the potential outcomes for shareholders by deferring a transaction: Is the family better served by taking the bird in hand or waiting for more birds to materialize in the bush? If the company is on a growth trajectory or has its own acquisition opportunities to pursue, it may command a larger multiple down the road. Understanding the risks and opportunities associated with the timing of a transaction requires directors to be well-attuned to company, market, and industry dynamics. Family directors-in-name-only are unlikely to have anything meaningful to add to such deliberations.Reinvestment OpportunitiesDoes the family have a plan for putting sale proceeds to work? Once again, what the business “means” to the family comes to the fore. Will proceeds simply be distributed to the various branches of the family, to use or invest as they see fit? Or will proceeds be retained at the family level and redeployed in other assets for the benefit of the family? If so, are there reinvestment opportunities available that will “fit” the cash flow needs and risk tolerances of the family? Will such investments provide the same degree of family cohesion as the legacy business? A sale of the family business may have unintended, and potentially far-reaching consequences for the family.Responding to Acquisition OffersOnce the board has evaluated the unsolicited offer, there are essentially four responses to choose from:Reject the offer. If the directors conclude that the proposed price and/ or terms are unattractive, or if the timing of a transaction does not align with the broader goals of the family, the board may elect simply to reject the offer.Negotiate with the potential acquirer. If the directors conclude that the timing is right and that the suitor would be an attractive acquirer, the board may elect to negotiate with the buyer with a view toward consummating a transaction. If the perceived “fit” between the family business and the potential acquirer is good, proceeding directly to negotiating price and terms of the transaction may result in the quickest and smoothest path to close. However, without any exposure to the market, there is a risk that the negotiated price and terms are not really optimal. There is a reason private equity firms like to tout their “proprietary” deal flow to potential investors—direct negotiation with sellers presumably results in lower purchase prices than winning auctions does.Engage in a limited sale process. Given the potential for underpayment, directors may elect to discreetly contact a limited number of other potential acquirers to gauge their interest in making a competing bid for the business. The benefit of doing a limited market check is that it can generally be done fairly quickly without “putting the company up for sale” with the attendant publicity that the family may not desire. The initial suitor will, of course, generally prefer that even a limited sale process not be engaged in, and may seek some sort of exclusivity provision which precludes the seller from talking to other potential buyers. Directors will need to consider carefully whether the potential benefits of a limited sale process will outweigh the risk that such a process will cause the initial suitor to rescind their offer and walk away.Engage in a full sale process/ auction. Finally, the board may conclude as a result of their deliberations that the unsolicited offer signals that it is an opportune time to sell the business because pricing and terms are expected to be favorable in the market and the family’s circumstances align well with a sale. In a full sale process, the company’s financial advisors will prepare a descriptive investment memorandum for distribution to a carefully vetted list of potential motivated acquirers. After initial indications of interest are received, the universe of potential buyers is then narrowed to a manageable group of interested parties who are invited to view presentations by senior management and engage in limited due diligence with a view to making a formal bid for the business. With the help of their financial advisors, the directors evaluate the bids with regard to pricing, terms, and cultural fit, selecting a company with which to negotiate a definitive purchase agreement and close the transaction. A full sale process will likely involve the most time and expense, and may expose to competitors the family’s intention to sell, but carries with it the potential for achieving the most favorable price and terms.Bringing Together the Right TeamThere is a sharp experience imbalance in most transactions: buyers have often completed many transactions, while sellers may have never sold a business before. As a result, sellers need to assemble a team of experienced and trusted advisors to help them navigate the unfamiliar terrain. The transaction team will include at least three primary players: a transaction attorney, a tax accountant, and a financial advisor.Definitive purchase agreements are long, complicated contracts, and an experienced attorney is essential to memorializing the substantive terms of the transaction in the agreement and ensuring that the sellers’ legal interests are fully protected.Trusting the buyer to do your tax homework can be a very costly mistake.Business transactions also have significant tax consequences, and the tax code is arcane and littered with pitfalls for the unwary. Trusting the buyer to do your tax homework can be a very costly mistake. An experienced tax attorney is essential to maximizing after-tax proceeds to the family.The financial advisor takes the lead in helping the board evaluate unsolicited offers, setting value expectations, preparing the descriptive information memorandum, identifying a target list of potential motivated buyers of capacity, assessing initial indications of interest and formal bids, facilitating due diligence, and negotiating key economic terms of the definitive agreement. My colleague Nick Heinz leads Mercer Capital’s transaction advisory practice, and Nick likes to say that his job in a transaction is to run the transaction on behalf of the company so the company’s management can focus on running the business on behalf of the shareholders. Transactions can be time-consuming and mentally draining, and it’s simply not possible for company management to devote the necessary time to managing the transaction process and the business at the same time. An experienced financial advisor takes that burden off of management.When it comes to assembling the right team, business owners sometimes blanch at the cost. However, the cost of a quality and experienced team of advisors pales next to the cost of fumbling on the transaction. The family will only sell the business once, and there are no do-overs. As we recently heard someone say, “Cheap expertise is an oxymoron.”

The Family Business Director blog comes to you each week from Memphis, Tennessee.  Memphis is proud to be the home of AutoZone, Inc., one of the largest auto parts retailers in the U.S.  AutoZone founder and long-time director Pitt Hyde recently announced that he would not stand for re-election to the board of directors.Mr. Hyde’s announced transition highlights three lessons for family business directors and managers.Although publicly traded since 1991, AutoZone traces its roots to a family business.  Mr. Hyde’s grandfather founded Malone & Hyde, a grocery wholesaler, in 1907.  The first AutoZone store – originally “Auto Shack” before a bit of subsequent re-branding – opened in 1979, and the growing concept was spun out of Malone & Hyde in 1986.  Mr. Hyde turned over the reins as President and CEO of the company ten years later.Management transition is a sensitive topic for many family businesses.  Founders of successful family enterprises are by definition exceptional individuals.  The challenge for family business directors is ensuring that the unique attributes of key managers contribute to the sustainability of the family enterprise instead of crippling the business through unhealthy over-reliance or dependence on a single individual.  Mr. Hyde’s announced transition highlights three lessons for family business directors and managers.Lesson #1 – Think More Broadly About Managerial SuccessFor a senior executive of a family business, success must be defined more broadly than the current financial results of the business.  The notion of success should also encompass how the company is positioned to prosper after the executive’s tenure is over.  This broader view of success will not take hold automatically, so directors need to evaluate how they are equipping, encouraging, and incentivizing senior management to think about sustainability.Are your senior executives focused on building a business that can flourish in their absence?  Are you building a culture in which working yourself out of a job is a goal to be achieved rather than a fate to be feared?Lesson #2 – Commit to Developing a Successful Team & CultureCulture builds slowly in organizations, but once formed, culture is remarkably persistent even when there is turnover at the top.  Of course, culture can be either good or bad.  There have been plenty of stories in recent years about companies whose success has been undermined by a toxic culture.  Family businesses are no exception.  Ironically, a “family-first” culture at a family business can inhibit the retention of capable non-family executives that eventually become essential for the sustainability of the family business.AutoZone is known for a culture that is obsessively focused on the customer experience in their stores.  Culture is the environment that empowers the team to execute the founder’s vision on a greater scale than the founder possibly could by himself or herself.  At the time of Mr. Hyde’s retirement in 1997, the chain had grown from that original Auto Shack in Forrest City, Arkansas to approximately 1,500 locations.  In the following two decades, the culture and team that Mr. Hyde had developed grew the concept to over 6,000 stores.How do you and your fellow directors describe the culture of your family business?  Do the employees, customers, and suppliers who experience the family business’s culture every day describe it the same way?Lesson #3 – Develop a Passion for Things That Matter Outside the BusinessAlthough few would likely admit it, we suspect one reason that key executives avoid walking away from the family business is that they have not developed anything compelling to walk toward.  Mr. Hyde’s philanthropic endeavors have made, and continue to make, Memphis a better place to live.  Turning over management of a successful family business need not be followed by a “retirement curse.”  Whether a new business venture or philanthropy, family business executives who intentionally cultivate interests outside the family business are more likely to execute a successful transition to the next group of managers.Are you and your fellow directors encouraging senior managers to develop outside interests that will make eventual transition easier?Does it Really Matter: What’s the Financial Benefit?Family business directors are stewards of the financial resources that the family has allocated to the business.  So what are the financial benefits of focusing on management succession?  There are two principal benefits that directors need to be aware of.First, an emphasis on management succession increases the likelihood of continued financial success for the family.  AutoZone shares opened trading on April 2, 1991 at a (split-adjusted) price of $6.88 per share.  At the time of Mr. Hyde’s transition out of the President and CEO roles almost six years later, the share price had grown to approximately $25, a compound annual return for investors on the order of 25%.  The team and culture that Mr. Hyde left behind contributed to continued shareholder returns, with the share price today on the order of $800 (an annualized return over more than two decades of approximately 17%).Second, an emphasis on management succession actually increases the value of the family business in the present.  The flipside of failing to plan for management succession is allowing the family business to remain unduly dependent upon a single individual.  For multi-generation family businesses, such dependencies increase the risk profile of the company, which reduces the value of the business, and by extension, the family’s wealth.  Even when there is no intention to sell, directors should be mindful of the value of the family business and aware of steps they can take to enhance or protect that value.  Reducing key person dependency through active planning for management succession is an important step in doing so for many family businesses.Management succession needs and strategies will necessarily look different for every family business, but AutoZone provides a great case study for directors to consider.  Management succession is not just a human resources issue, but can have major financial repercussions for the family.  Our professionals welcome the opportunity to discuss in confidence how management succession is influencing the value and sustainability of your family business.For additional perspective on management succession, see Chapter 7 of our new book, The 12 Questions That Keep Family Business Directors Awake at Night.

The recent announcement that General Electric is slashing its shareholder payouts by more than 90% has put dividends in the headlines in recent days.  The news coverage provides an opportunity for family business directors to re-visit dividend policy at their own companies.  While we wouldn’t want to suggest that the GE dividend news tells savvy family business directors anything they didn’t already know, a few reminders about dividend basics seem fitting.Reminder #1: In the Long Run, Earnings Must Support DividendsDespite the often breathless reporting of the GE dividend cut, it really should not have been too surprising in the context of earnings struggles at the conglomerate over the past several years.  While the potential stability of dividends is often lauded, only profitable companies can sustain dividends.  The relationship between earnings and dividends is called the dividend payout ratio.  While a company may pay a dividend in excess of earnings in any given year, on a cumulative basis, the dividend payout ratio cannot exceed 100%.  The following table summarizes the dividend payout ratio at General Electric over the past twenty-five years. During the first ten years of our sample period (corresponding roughly to the peak of the Jack Welch era), General Electric paid out 47% of earnings to shareholders, retaining the rest for reinvestment.  Over the next decade, the dividend payout ratio increased to 57%.  This can be interpreted in one of two ways.  Either the company was retaining less in response to a more difficult investing environment, or earnings simply did not keep pace with dividends.  Where things become unsustainable is when dividends exceed earnings, as they did in the most recent five year period.  Sustained dividends in excess of earnings means that new investors are providing returns to existing investors, and that’s called a Ponzi scheme. What is your family business’s dividend payout ratio? Is it trending in a particular direction?  If so, is that intentional, or simply a matter of drift that eventually will need to be corrected?Reminder #2: Dividends Mitigate Shareholder RiskCorporate finance texts tend to emphasize the role and function of dividends from the company’s perspective, and downplay or ignore the shareholders’ perspective.  In family businesses, dividends are often viewed solely as a means of providing current income to finance shareholder consumption (and that’s not a bad thing – everybody likes a little mailbox money).  However, too many family business directors tend to ignore the role of dividends in mitigating the risk of shareholder returns.  On the far side of all the earnings turbulence described above, the GE share price is essentially unchanged over the past twenty-five years.  Despite having traded as high as $60 per share in 2000, GE shares are currently changing hands at about $10 per share, compared to about $8 per share in 1993.  For a buy-and-hold investor, capital appreciation has been negligible.  However, over that same period, shareholders have collected nearly $17 per share in dividends, and no amount of future market gyrations can take that away. Business value accrues slowly, but can evaporate quickly.  Even at good companies, like GE.  Even at stable family businesses.  When I was in business school in the late 90’s, GE was the epitome of a well-run company, and it would have been unthinkable to my cohorts and me that the company might decrease in value over the next two decades.  All businesses are susceptible to future decreases in value, whether of the slow-drip or sudden “black swan” variety.  For family business shareholders, who often don’t have the luxury of diversified portfolio holdings, dividend payments can provide a needed cushion to returns in the event of a material decrease in share value. Where have the returns to your family shareholders come from: dividends or capital appreciation? What do your family shareholders’ personal balance sheets look like?  Can they withstand a sudden (and sustained) decrease in share value?Reminder #3: Dividends Are a Signaling DeviceNot only do dividends provide current income and mitigate shareholder risk, but they are also an efficient means of signaling the board’s outlook for the company to shareholders.  The dividend cut at GE provides at least two important signals to investors.  First, the dramatic reduction signals to shareholders that there is no easy way out from the current mess.  GE is in capital preservation mode – the dividend is not being cut to fund suddenly abundant investment opportunities, but because the board expects earnings to remain depressed for some time.  Foregoing dividend payments will help shore up GE’s balance sheet and enhance the company’s ability to undertake the restructuring necessary for long-term sustainability.  Second, the GE board’s decision to preserve a $0.01 per share dividend signals to shareholders that the company remains on a shareholder-first footing.   Once the mess is cleaned up, shareholders should expect the dividend to increase.  If GE had cut the dividend entirely, shareholders may well wonder if the board would ever be inclined to bring it back.Business value accrues slowly, but can evaporate quickly.For family shareholders, the signaling effect of dividends may be even more pronounced.  Public company shareholders receive detailed financial reports every quarter, and the stock market provides a daily assessment of forward expectations for the company.  For many family shareholders, in contrast, the most tangible “report” they ever receive on the health of the family business is their dividend check.  Even if financial statements are available, many family shareholders don’t really know how to read them, or have the inclination to try.  But everyone knows how this year’s dividend check compared to last year’s.What is your current dividend signaling to your family shareholders? If you were to change the dividend, what signal would that send?  How effective is your shareholder relations program?  Do your family shareholders know the company’s core strategy and how dividend policy interacts with that strategy, at least in broad outline?Reminder #4 – Dividends Are Not a “Cost” to the CompanyThis one may be a touch pedantic, but we think it is important.  Various news outlets – including the Wall Street Journal – have discussed how much money the divided cut will “save” the company, as if cutting the dividend were akin to finding a new, cheaper source for office supplies.  Dividends are not an expense: they represent one of only two forms of returns to shareholders.  Shareholders are not vendors: they own the company.Dividends are not an expense: they represent one of only two forms of returns to shareholders.We often observe a similar phenomenon in family businesses.  Shareholders (especially those in younger generations) may be treated as if they don’t have a legitimate claim on the company, and a desire for dividends is seen as impertinent or selfish.  It may or may not make sense for a given family business to pay a dividend, but in no case are dividends a “cost” to the family business.Is your family business’s dividend policy rooted in an economic assessment of the available investment opportunities, or is withholding dividends a not-so-subtle strategy for manipulating and controlling family shareholders?In our experience, dividend policy is the most vexing financial issue facing family business directors.  If you need some help asking the right questions about your dividend policy, give one of our professionals a call to discuss your situation in confidence.

What is Step Zero?A qualitative approach to test goodwill for impairment was introduced by the Financial Accounting Standards Board (“FASB”) when it released Accounting Standards Update 2011-08 (“ASU 2011-08”) in September 2011 as an update to goodwill impairment testing standards under Topic 350, Intangibles—Goodwill and Other.ASU 2011-08 set forth guidance for an optional qualitative assessment to be performed before the traditional quantitative two step goodwill impairment testing process.This preliminary qualitative assessment is known as “Step Zero.”The goal of Step Zero is to simplify and reduce costs of performing the traditional quantitative goodwill impairment test process.According to ASU 2011-08, Step Zero allows entities “the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.”Step One is required only if the qualitative assessment supports the conclusion that it is more likely than not (i.e., likelihood greater than 50%) that the fair value is less than the carrying value.Otherwise, Step One of the goodwill impairment testing process is not required.Alternatively, Step Zero can be skipped altogether, and the traditional quantitative goodwill impairment test can be performed beginning with Step One.Industry ConsiderationsThe standards update release by FASB outlines the individual qualitative categories of the assessment.Specific qualitative events and circumstances to be evaluated include the economy, industry, cost factors, financial performance, firm-specific events, reporting unit events, and changes in share price.ASU 2011-08 defines industry events and circumstances as follows:“Industry and market conditions such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.”The process of evaluating an industry involves assessing each of these stated events and circumstances since the previous reporting period and determining how they affect the comparison of fair value to carrying value.By comparing current conditions to the prior period, an analysis of relative improvement or deterioration can be made concerning each industry factor and the industry as a whole.Increasing multiples, share prices, financial metrics, and M&A activity indicate that an industry is improving and suggests that it is more likely than not that the reporting unit’s fair value is greater than its carrying value. Decreasing multiples, share prices, financial metrics, and M&A activity indicate the industry is weakening and suggests that fair value may be less than the reporting unit’s carrying value.Industry AnalysisAn analysis of the S&P 1500, an index that includes approximately 90% of the market capitalization of U.S. stocks, reveals the prevalence of impairment in different industries. For example, of the companies reporting goodwill on their balance sheets, 25% of telecommunication, 17% of consumer staples, and 14% of consumer discretionary companies recorded goodwill impairment charges in 2017.On the other hand, the more robust performance of financial, information technology, and real estate companies is manifest in that only 4% of companies reporting goodwill in each industry recorded a goodwill impairment charge in 2017.Further analysis indicates that companies in the energy and telecommunication industries are currently more likely to be potential impairment candidates as 20% and 38%, respectively, of companies reporting goodwill have cushions (the amount by which market value of equity exceeds book value of equity) of less than 25%. Deterioration in the operating environment of these industries may result in an increase in goodwill impairment charges.Industries with fewer impairment candidates at the moment include real estate, utilities, and industrials.Industry considerations are particularly important to the qualitative assessment and provide valuable insight on the potential for impairment. The qualitative assessment is especially valuable in industries that are performing well as it is less likely that goodwill is impaired.Step Zero provides the opportunity to perform a preliminary qualitative analysis to determine the necessity of performing the traditional two step goodwill impairment test and can lead to a simpler, more efficient impairment testing process.The analysts at Mercer Capital have experience in, and follow, a diverse set of industries.We help clients assemble, evaluate, and document relevant evidence for the Step Zero impairment test. Call us today so we can help you. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

Earlier this year, we considered the impact of the Tax Cuts and Jobs Act of 2017 (“TCJA”) on purchase price allocations.In this article, we turn our focus to the impact of the TCJA on goodwill impairment testing.Changes to the tax code will affect both the qualitative assessment (often referred to as Step Zero) and quantitative impairment test.Qualitative AssessmentCompanies preparing a qualitative assessment are required to assess “relevant events and circumstances” to evaluate whether it is more likely than not that goodwill is impaired.ASC 350 includes a list of eight such potential events and circumstances.Quantitative AssessmentThe same features which, on balance, have made it more likely that reporting units will garner a favorable qualitative assessment also contribute to the fair value of reporting units under the quantitative assessment.Reduction in income tax rate.All else equal, a reduction in the applicable federal income tax rate from 35% to 21% increases after-tax cash flows and contributes to higher fair values for reporting units.Bonus depreciation provisions.The tax bill allows certain capital expenditures to be deducted immediately for purposes of calculating taxable income.While the aggregate amount of depreciation deductions is unaffected, the acceleration of the timing of tax benefits can have a marginally positive effect on the fair value of some reporting units.Interest deduction limitations.One potentially negative effect of the tax bill on reporting unit fair values is the limitation on the amount of interest expense that is deductible for tax purposes.For some highly-leveraged businesses, the interest deduction limitation can increase the weighted average cost of capital.We expect the interest deduction limitations to adversely affect only a small minority of companies.Increase in after-tax cost of debt.When calculating the cost of debt as a component of the cost of capital, analysts multiply the pre-tax cost of debt by one minus the corporate tax rate.The new lower tax rate will, therefore, cause the after-tax cost of debt to increase by a small increment.All else equal, an increase to the weighted average cost of capital has a negative impact on the fair value of a reporting unit.On balance, we expect the negative effect from higher costs of capital to be smaller than the positive cash flow effect from lower tax rates.ConclusionThe Tax Cuts and Jobs Act of 2017 is a material factor to be considered in both qualitative and quantitative assessments of goodwill impairment in 2018.While the provisions are not uniformly favorable to higher valuations, the balance of factors suggests that goodwill impairments will be less likely in the coming impairment cycle.To discuss how the new tax regime affects your company’s goodwill impairment more specifically, please give one of our professionals a call. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

This post is part of our “Talking to the Numbers” series for family business leaders.  In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements.  Asking better questions will lead to better financial and business decisions. It may be a tiresome cliché, but your family business really does make money buying low and selling high.  Gross margin measures the degree to which your family business is able to sell its goods or services for a price in excess of the costs to acquire the inputs needed to produce the product or service.  As we move down the income statement, the line below revenue is cost of goods sold, which defines itself quite nicely.  Gross profit is the amount of revenue left over after deducting cost of goods sold.  Gross margin is the ratio of gross profit to revenue.  It’s important to think about gross margin, because it tells you how much of a “mark-up” your customers are willing to pay for your good or service.  The higher the “mark-up” the more revenue will be available to cover operating expenses and generate an operating profit. Exhibit 1 summarized median gross margins for each industry sector during 2017: Exhibit 1 and the supporting data confirm several intuitions regarding what customers are willing to pay (i.e., your family business’s ability to buy low and sell high). It’s important to think about gross margin, because it tells you how much of a “mark-up” your customers are willing to pay for your good or service.Customers Are Willing to Pay for InnovationAmong the industry sectors, healthcare and information technology are the most fertile fields for innovation.  So it should not surprise us that these two industry sectors boast two of the highest gross margins.Digging a bit deeper into the data confirms the importance of innovation to customers.  Since revenue growth is a decent proxy for innovation, we sorted the companies in the IT sector by compound annual revenue growth (2013 through 2017).  Exhibit 2 summarizes the size, growth, and gross margin attributes for the high and low innovation groups.  The median gross margin for the fast-growing high innovation group (51.0%) exceeded that of the slow-growth low innovation group (44.5%). Family businesses cannot afford to neglect innovation. Is your family business investing in research & development to promote innovation that benefits customers?Is your family business listening to customers to discern where innovative solutions are most needed?Is your family business evaluating acquisition opportunities that would bring innovative product offerings to customers?Customers Are Willing to Pay for AccessThe telecommunications sector boasts the highest gross margins.  In other words, customers are willing to pay prices far in excess of the marginal cost to the telecom companies of providing the service.  This reflects in large measure the high fixed costs of providing telecom services and customers’ willingness to pay for access to those networks and the benefits they bring.While only a small proportion of family businesses operate in the telecom sector, the underlying principle is applicable to a broader range of companies.Is your family business where your customers need it to be? Are there opportunities for geographic expansion that would make it easier for key customers to do business with you?Does your family business think about capital investment strategically? Do you have a plan to deploy capital assets in a way that increases customers’ willingness to pay for the product or service you are offering?  How can your family business use capital expenditures to build and maintain a strategic competitive advantage?It is important to think about adding incremental value to the company’s product or service.Customers Are Willing to Pay for Added ValueThe lowest gross margins noted on Exhibit 1 are in the materials sector.  Companies in the materials sector sell production inputs to manufacturing firms in the industrials and consumer (discretionary and staples) sectors.  The companies in these sectors add value to raw materials, converting them into industrial and consumer goods.  The gross margins for the industrial and consumer companies are higher than those in the materials sector, reflecting their superior position in the value chain.Regardless of where your family business sits on the value chain, it is important to think about adding incremental value to the company’s product or service.Is there an adjacent product or service that your family business can provide to customers that will allow you to increase the value added by the business?Are there opportunities for vertical integration (whether through acquisition or direct capital investment) that would enhance the competitive position of your family business?Customers Are Willing to Pay for BrandsThe role of brands in customer behavior is critical in the consumer staples sector.  These companies sell basic consumer goods (food, cleaning supplies, personal care products, etc.) and rely heavily on marketing and branding to drive sales.  We sorted the consumer staples companies in our sample by gross margin, listing the twenty companies with the highest gross margins and the twenty companies with the lowest gross margins on Exhibit 3.There are undoubtedly a host of factors at work beyond just branding in the two lists noted above (for example, whether a company is a manufacturer or retailer).  Yet, on balance, the high margin group consists of more well-known and readily identifiable brands than the low margin group.  And the difference is not trivial: the median gross margin for the top 20 companies is 61% compared to 16% for the bottom 20 companies.For many family businesses, the family name doubles as the company brand.  But even when that is not the case, the health of the brand is important.Is your family business investing appropriately in marketing and branding? Successful branding initiatives require sustained investment.Does your branding strategy align with the story of your family business and the business’s competitive strengths?Does your family business’s risk management process take into account potential threats to the company’s brand? A quality brand takes years to build but only days to destroy. While our discussion in this post has focused on the price side of gross profit (what are customers willing to pay?), family businesses cannot neglect the cost side of gross profit (how much are we paying for inputs?).  A diligent procurement function can contribute to gross margin as much as the customer-focused strategies discussed above.  The most obvious buying efficiencies come from scale, which evident when we compare the median gross margin for the large cap (S&P500) companies of 42.1% to the 33.7% gross margin of the small cap (S&P 600) companies. From a customer-facing perspective, innovation, access, value added, and brand are critical components of corporate strategy influencing gross margin.  Family businesses should evaluate opportunities for enhancing gross margin along these dimensions while not ignoring opportunities for improved purchasing.

This post is part of our “Talking to the Numbers” series for family business leaders.  In this series of posts, our goal is to help family business directors ask the right questions when reviewing financial statements.  Asking better questions will lead to better financial and business decisions. The income statement is a natural place to begin analyzing a company’s financial results, and revenue is the natural starting point for that analysis.  We recently heard someone remark that everything good in business starts with revenue, and our experience working with family businesses of all stripes confirms that sentiment.  While the absolute amount of revenue can be instructive (i.e., are we looking at a $10 million business or a $100 million business?), it is the trend in revenue that is most revealing.  Is the business growing, treading water, or shrinking?Analyzing the Public Company DataTo gain a little more perspective on revenue growth for our benchmark universe of public companies, we pulled revenue figures for the five years ending with 2017.  Comparing the 2017 revenue figures to 2013 revenues, we calculated the compound annual growth rate (or CAGR) for each company.  For multi-year periods, the compound annual growth rate smooths out year-to-year variations and represents the overall annualized growth rate for the period.Exhibit 1 summarizes the compound annual growth rates for the benchmark universe.  (For some background on this data set, see the first post in this series.)The top panel of Exhibit 1 indicates how revenue growth is distributed for each industry.  For example, 16% of the consumer discretionary companies in our sample (the leftmost column), reported CAGRs between 2.5% and 5.0%, while 5% of such companies reported a CAGR in excess of 25%.  In other words, each vertical column sums to 100%.  The bottom panel indicates the median observed CAGR for each industry by index (which is a proxy for company size).Takeaways for Your Family BusinessPondering over this data for a while, we offer a couple of observations for family business directors.1. Industry Sets the Stage for Growth, but Does not Define It.The industry a business operates in is a powerful force in setting expectations for revenue growth.  The differences in median CAGR across industries in Exhibit 1 are not trivial.  At the extreme ends of the spectrum, energy company revenues over the period were hamstrung by a decline in oil prices (median CAGR of negative 8.2%), while healthcare companies were generally boosted by that sector’s growing share of the overall economy (10.9% annualized growth).However, the overall distribution of growth rates by industry is actually quite wide.  Take for example consumer staples (the second column from the left).  The median annualized revenue growth of 1.9% reflects a mature industry that – as a whole – is largely dependent on inflationary price increases for revenue growth.  And yet nearly a quarter of the companies in that industry generated CAGRs in excess of 10%.  What this suggests is that, even in mature, slow-growth industries, successful management teams can identify and execute on paths to revenue growth.Directors should be thinking about how industry dynamics are influencing revenue growth.In the context of a family business, directors should be thinking about how industry dynamics are influencing revenue growth.  For example, a compound annual growth rate of 3.5% over the period examined would be consistent with maintaining market share for an industrial company, gaining market share for a consumer staples firm, and losing market share for a healthcare business.  In other words, the same signal can carry different meanings for companies in different industries.  As a family business director, you should ask yourself questions like the following:Does our family business have a strategy that acknowledges the reality of the industry but identifies opportunities to increase market share profitably?What sorts of strategies are most likely to increase market share for our business within the industry? Differentiating on quality and service? Or becoming a value leader?Where is the low-hanging fruit for revenue growth: price increases, geographic expansion, adding an adjacent product line, marketing to new customers, or something else?2. Revenue Growth Can Be Organic or AcquiredFor the industry as a whole, revenue growth is all organic (i.e., selling more widgets at potentially higher prices).  However, for individual companies within an industry, revenue growth can be augmented by acquisitions.  Organic growth requires a sustainable competitive advantage.  Acquisition growth requires discipline to avoid overpayment.Real, long-term organic growth is hard.  Absent one or more strategic “moats” around the company’s market niche, profits draw competition.  What is unique about your family business that can contribute to sustained organic revenue growth?Supplementing organic growth with acquired growth brings its own set of challenges.  Like nearly everything else in business, investing for growth is subject to the law of diminishing marginal returns: the more growth projects a company undertakes, the less effective the projects are likely to become.  As a result, pursuing revenue growth without regard for the marginal efficiency of investment can actually prove detrimental to family shareholders.  In other words, revenue growth must always be evaluated relative to the cost to achieve it.What is unique about your family business that can contribute to sustained organic revenue growth?One simple measure of investment efficiency is the ratio of revenue to invested capital (the sum of debt and equity financing).  This ratio measures the revenue generated per dollar of capital used by management.  If the ratio decreases over time, it suggests that the incremental investments made to achieve revenue growth are becoming less effective.The data summarized in Exhibit 2 suggests that – in aggregate – the public companies in our data set demonstrated imperfect discipline with regard to pursuing revenue growth.  We sorted the companies in our sample by revenue growth, creating three subgroups of equal size.  While the overall revenue turnover slipped a bit for all companies over the period analyzed, the high growth companies fared no worse than the low growth companies: in other words, the high growth companies were not chasing growth recklessly at the expense of shareholder returns.Corporate investment may take the form of either capital expenditures or merger & acquisition activity.  Exhibit 2 also summarizes the relative mix of investment for the subgroups of companies.  The data suggests that the high growth companies rely more heavily on M&A, while the low growth companies tend to focus more on capital expenditures.  If we assume that capital expenditures are a (very imperfect) proxy for organic growth, this data confirms that the fastest growing firms are augmenting organic growth opportunities with strategic acquisitions.For family business directors thinking about revenue growth, this leads to some important questions.Does our family business have a culture that can accommodate growth through acquisition, or is organic growth the primary path forward?Are there logical acquisition targets that could boost revenue growth (at a reasonable price)?Does our company have the financial capacity to make an acquisition?Does our business have a qualified team of advisors to help execute on acquisition opportunities? In sum, revenue growth analysis for a family business should focus on industry dynamics and the opportunities for organic vs. acquired growth.

“You have to keep talking to the numbers until the numbers start talking back to you.”So goes the most memorable piece of advice regarding financial analysis I have ever received.  Chris Mercer passed it along to me, and Chris attributes the saying to a mentor of his while working at First Tennessee bank in the 1970s.  The admonition to keep talking to the numbers is a key component of our firm’s institutional DNA.  It seems to me that the maxim is underwritten by two fundamental premises:First, persistence is rewarded in financial analysis. One has to keep talking to the numbers before they yield up their secrets.  A surface reading of the financial statements will not necessarily reveal the Company’s underlying financial narrative.  Financial statements are best read with a highlighter, pen, and calculator in hand.  These are the tools necessary to move beyond simply discovering what the financial statements say to discerning what they mean.Second, there is an underlying coherence to the financial statements. With persistent prodding, the numbers will start talking back.  The numbers presented in the financial statements are not just random data, but rather cohere with one another in a logical way that sheds light on the real-world activities of the business.  In other words, financial analysis is about telling the company’s story, not just calculating ratios and making charts. Reading financial statements well is all about asking the right questions.  In this series of posts, our goal is to help family business directors ask the right questions of their financial statements.  Asking better questions leads to better financial and business decisions.The Data Set We Are UsingIn contrast to private companies, which tend to keep their financial information to themselves, public companies are required by law to publish their financial statements on a regular basis.  While the purpose of this requirement is to keep investors fairly and fully informed, one beneficial side effect is that these filings create a vast repository of financial statement data.  We downloaded the data set for the analysis presented in this series from the Capital IQ database.  We pulled data for companies in the S&P 1500 index, which includes large-cap (500), mid-cap (400), and small-cap (600) companies.  Financial statement data for financial institutions, insurance companies, and REITs (FIRE for short) looks and feels a lot different than data for operating companies like manufacturers, retailers, and services companies.  Since we wanted to focus on the latter, we screened out the former.Exhibit 1 summarizes the composition of the data set with respect to both industry and size.Having dispensed with the FIRE companies, our initial universe shrank by about 20%, from 1,500 to just under 1,200 companies.Understanding the Data:  Illustrative ExampleExhibit 2 provides a preview of the types of metrics that we will analyze and comment upon in the posts to follow.To briefly illustrate what we hope to provide for readers through this series, let’s compare the median measures for healthcare companies and industrials (the fourth and fifth columns from the left).  What can we discern from this data that will help family business directors ask better questions when reading financial statements?Reading financial statements well is all about asking the right questions.Measuring by EBITDA MarginAs measured by EBITDA margin, the healthcare companies are more profitable, wringing nearly twenty cents of cash flow out of each dollar of revenue, compared to just over fourteen cents for the industrials.  Among other things, profit margins reflect the competitive dynamics of an industry.  The higher margins for the healthcare companies are consonant with the prior observation regarding the centrality of innovation to modern healthcare companies.  Since the industry has a lot of greenfield space to work in, successful companies have greater opportunity to carve out a profitable niche protected from direct competition.  As the industry matures and growth slows, one might expect competition to increase and margins to come under pressure.How does the profitability of my family business compare to peers?Does my family business have a “strategic moat” that can help sustain superior profitability?Measuring by Forward EBITDA MultiplesThe forward EBITDA multiples indicate that investors would rather own a given dollar of EBITDA generated by a healthcare company than an industrial company.  Unlike a performance measure like EBITDA margin, valuation multiples incorporate market expectations for a company’s future.  As a result, multiples are positively related to expectations for growth and negatively related to the market’s assessment of risk.  On balance, the market assigns a higher multiple to healthcare companies than industrials.What are the principal risks facing my family business? What options are available for mitigating those risks?How would a potential buyer assess the growth prospects of my family business? Which segments or business lines are poised for the greatest growth?Better questions lead to better insights, which lead to better decisions.Profitability vs. EfficiencyWhile the healthcare companies are more profitable per dollar of revenue, the industrials are more efficient at generating revenue per dollar of capital invested in the business.  This may reflect a number of factors, among which is likely the nature of the respective asset bases.  Industrial companies have a significant portion of their invested capital tied up in tangible, brick-and-mortar assets like property, plant & equipment, while healthcare companies are more likely to use intangible assets (intellectual property and assembled workforces) to generate revenue.  In terms of return on invested capital, the industrials’ lower margin / higher turnover model actually wins out, generating pre-tax debt-free earnings equal to 14.1% of invested capital compared to 11.8% for the healthcare companies.How does my family business allocate capital to different segments or divisions?Do the managers of my family business have a clear mandate regarding shareholder objectives? Or, are performance expectations for managers ambiguous?Topics for AnalysisIn future posts, we will focus on individual elements of financial statement analysis, including:Revenue and Earnings PerformanceBalance Sheet CompositionReturn on Invested CapitalCash Flow :: Sources & UsesFinancial LeverageMarket Returns, Multiples & Risk Throughout, we will focus on learning to ask better questions of your family business’s financial statements.  Better questions lead to better insights, which lead to better decisions.

From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers. If family business directors are going to make good capital allocation decisions, they need to know what the right hurdle rate is. If the hurdle rate is set too low, the family may experience weak future returns. Setting the hurdle rate too high, however, introduces the risk that the family business will pass on attractive investment opportunities. In this post, we consider how the hurdle rate relates to the weighted average cost of capital.Should we set the hurdle rate for capital budgeting equal to the weighted average cost of capital (WACC), or should we set it higher than the WACC?Legendary wag and journalist H.L. Mencken once said that professors must have theories as dogs must have fleas. While a theory-infested business professor likely has a quick answer to the hurdle rate question, the practical answer is not so tidy for a real-life family business director.From a finance textbook perspective, the WACC is the theoretically correct rate to use when evaluating potential capital projects. Family business managers are stewards of capital entrusted to them by the family (and, potentially, lenders). The managers’ task is to allocate that capital to a portfolio of assets that earn returns in excess of the cost of capital. If a proposed capital project promises a return in excess of the cost of capital, taking on the project will increase shareholder wealth, and everyone goes home happy.Yet, many family businesses flout the textbook prescription and use hurdle rates for project evaluation considerably higher than the WACC. This practice is so widespread that it cannot simply be the result of CFOs-to-be falling asleep during capital budgeting class. Why, then, are incremental hurdle rate premiums so common?Why Premium Hurdle Rates Are UsedThere are two primary reasons companies elect to use premium hurdle rates in their capital budgeting analyses. For some companies, doing so is a hedge against potentially inflated cash flow forecasts submitted by overconfident managers. Other companies rely on premium hurdle rates as a capital rationing tool.Hedge Against Potentially Inflated Cash Flow ForecastsAccurately projecting future cash flows is difficult. In addition to the real uncertainties regarding future market and economic conditions, financial projections are subject to a host of cognitive biases that contribute to overconfidence and overly optimistic projections. These cognitive biases are the subject of a good deal of academic research, much of which is summarized entertainingly in Thinking, Fast and Slow by Daniel Kahneman. In sum, these biases are real and ubiquitous, and do not reflect any lack of good faith; they are simply part of the mental baggage of being human. Whether explicitly framed this way or not, setting a hurdle rate at a premium to the WACC acknowledges the likelihood that projections will be too optimistic.Ideally, however, family businesses should work to refine their capital budgeting process so that additional “projection risk” premiums are not necessary. If hurdle rates are set at a premium to the WACC, it is likely that managers’ cognitive biases will simply “recalibrate” to the new, higher, hurdle rate. In other words, a premium hurdle rate may work in the short term, but is ultimately an example of treating the symptoms rather than the disease.Rooting out cognitive biases is not easy, but if done can provide long-term benefits to the company. A first step is to simply raise awareness that such biases are real. When decision makers acknowledge the biases exist and how they work, they can work to consciously overcome them. Another step is adopting a formal program of tracking actual post-investment results for projections. Regularly reviewing prior investment decisions helps managers identify the characteristics of prior decisions (whether they turned out well or poorly). Knowing that the current decision on the table will be subject to review in future periods helps managers think more critically about the risks of a project. Finally, emphasizing return on invested capital (ROIC) as a measure of management performance can help limit overconfidence. ROIC helps corporate managers adopt a shareholder perspective since ongoing performance is judged not just on the basis of future operating results, but also the capital required to support the business. Making managers accountable for the capital committed to a project can contribute to more realistic projections of future results.Serve As a Capital Rationing ToolUnlike the imaginary companies that populate textbooks, real family businesses do not have access to unlimited amounts of capital. Even when there is a large pool of available capital, there may be other resource constraints that impose prudential limits on how many projects the company can undertake during a given period. In the face of capital (or other) constraints, using a premium hurdle rate can help narrow the list of potential capital projects to a manageable number. In other words, there are fewer projects with 12% returns than 8% returns. Using a premium hurdle rate can be a perfectly suitable way to ration scarce capital resources. However, we offer a couple of cautions for this practice. First, if there really are an abundance of capital projects that promise returns in excess of the WACC (which is what capital rationing implies), family business directors may need to investigate ways to alleviate the capital constraints. In the context of the funnel depicted above, finding additional capital (or management, or other resources) would benefit shareholders by limiting the opportunity cost of foregoing attractive investment opportunities. Second, family businesses should be wary of simply substituting a high hurdle rate for developing a clear strategy. For example, assume a company’s cost of capital is 10%. In our experience, a project with an 11% internal rate of return that advances the company’s strategy is preferable to a project which is expected to generate a 16% return, but does not promote the company’s strategy. In other words, a premium hurdle rate cannot replace a coherent strategy. Ultimately, the size of your family business’s capital budget cannot be assessed in isolation, but intersects with other strategic decisions regarding dividend policy and capital structure.ConclusionSo in the end, premium hurdle rates can be effective in taking into account that family businesses do not have the luxury of operating in the neat and tidy world of finance textbooks. However, it is critical that companies electing to use a hurdle rate premium not ignore the effect of cognitive biases on forecasting or the importance of corporate strategy in project selection. Treating the symptoms can be the right course of action in the short run, but family businesses concerned with long-term health should also treat the underlying disease.

Mercer Capital provides sophisticated corporate finance services to family businesses throughout the nation. We know that stewarding a multi-generation family business is a privilege that comes with certain responsibilities, and each family business faces a unique set of challenges at any given time.  For some, shareholder engagement is not currently an issue, but establishing a workable management accountability program is.  For others, dividend policy is easy, while next gen development weighs heavily. Through our family business advisory services practice, we work with successful families facing issues like these every day.Our new book The 12 Questions That Keep Family Business Directors Awake at Night addresses the most common questions and challenges facing family business directors.  Since we have striven for brevity—not to mention the fact that we don’t pretend to have all the answers—the chapters help you think through these questions. At the end of each chapter, we offer a list of potential action items to help family business leaders and directors prioritize which issues are most pressing to the long-term health and sustainability of the business. In the book we address:How Do We Promote Positive Shareholder Engagement? As families grow into the fourth and fifth generations, common ownership of a successful business can serve as the glue that holds the family together. However, as the proportion of non-employee family shareholders increases, maintaining productive shareholder engagement grows more challenging.How Do We Communicate More Effectively with Shareholders? Effective communication is a critical for any relationship. Multi-generation family businesses are complex relationship webs. Identifying best practices for communicating effectively with family shareholders is a common objective for family businesses.Does Our Dividend Policy Fit? Hands down, the most frequent topic of conversation with clients is establishing a dividend policy that balances the lifestyle needs and aspirations of family shareholders with the needs of the business.To Invest or Not to Invest? The flip-side of dividend policy is how to invest for growth. Can the family business keep up with the biological growth of the family? Is that a desirable goal? Regardless of the target, family business leaders are concerned about identifying and executing investments to support the growth of the family business.Should We Diversify? We find that a striking number of the family businesses diversify rather far afield from the legacy business of the founding generation. What are the marks of effective diversification for a family business?Does Father Always Know Best? Evaluating managerial performance is never easy; adding kinship ties to the mix only makes things dicier. The family business leaders we speak with are eager to develop and implement effective management accountability structures.How Do We Find Our Next Leader? Whether it comes simply through age or as a result of poor performance, management succession is somewhere on the horizon for every family business.Is There a Ticking Time Bomb Lurking in Our Family Business? Buy-sell agreements don't matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life's inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.What Is the Family’s Most Valuable Asset? Rising generations are naturally more diffuse than their forebears with regard to geography, interests, skill sets, and desires. Family leaders are interested in identifying appropriate pathways for the next generation to engage, learn, and grow in their contribution to, and impact upon, the family business.What Should We Do About Estate Taxes? Directors are keenly interested in tax-efficient techniques for transferring ownership of the family business to succeeding generations. While certainly important, there may be unanticipated pitfalls if estate and other taxes are the only factors considered when transferring wealth.How Should We Respond to an Acquisition Offer? Even if the family does not plan to sell, credible acquisition offers at what appear to be attractive financial terms need to be assessed. It is important to know how best to evaluate and respond to such offers.Who’s In and Who’s Out? There are many reasons family members may want to sell shares: desire for diversification, major life changes, funding for estate tax payments, starting a new business, or funding other major expenditures. What is the best way to provide liquidity to family shareholders on fair terms without sparking a run on the bank? For more on these topics, order a copy of our recently published book, The 12 Questions That Keep Family Business Directors Awake at Night.

This is the inaugural post for our Family Business Director blog.  By way of introduction, we thought we would anticipate a few questions that you might have.Who Are You Writing this Blog for?We are writing this blog for directors of family businesses.  Family business directors face a unique set of challenges: the strategic and long-term decisions that fall to any corporate director are overlaid with often complex family dynamics.Directors need to acknowledge the diversity of shareholder needs and preferences.For public company directors, shareholders are a nameless, faceless group of individuals and institutions “out there,” each of whom can come and go at their leisure. By contrast, family business directors bear a fiduciary responsibility to a finite group of siblings, aunts, uncles, cousins, and other kin, with whom they are likely to have some form of ongoing relationship outside of the family business.  These very specific shareholders are likely to have very specific preferences and perspectives on the family business.  Even non-family, or independent, directors will find that family dynamics intrude upon their decision-making.  We suspect the pressures and challenges associated with sitting at the intersection of business and family are under-appreciated.What Will You Be Writing About?Owning a successful business can serve as the “glue” that holds a family together across generations and different branches of the family tree.  Unfortunately, it can also be a source of contention, strife, and hostility. Within just a couple generations, it is not uncommon for economic interests and preferences among family members to diverge.  If family harmony is a good worth pursuing – and we think it is – directors need to acknowledge this diversity of shareholder needs and preferences.Dividend policy touches on the core of what the family business “means” to the family.Dividend PolicyIn our experience, the most consequential decisions that family business directors make relate to dividend policy.  But dividend policy for family businesses is never just about dividends.  Dividend policy touches on the core of what the family business “means” to the family.  Does your family business exist to grow, keeping up with the growth of your family as generations multiply through time?  Or, does your family business exist to provide financial independence to current family members through substantial dividends?Capital AllocationDividend policy decisions are not made in a vacuum.  If the quarterly dividend check is the picture that gets shareholder attention, corporate reinvestment is the negative image of that picture.  Cash that is paid to family shareholders as dividends cannot be reinvested to grow the business, while cash reinvested in the business for future growth cannot be distributed to family shareholders.  So, every decision about dividend policy is necessarily, and always, also a decision about corporate reinvestment.  We refer to this as capital allocation.Capital StructureCapital structure is the release value when there are tensions between dividend policy and capital allocation.  Family business directors are responsible for deciding how to finance the portfolio of assets that is the family business.Dividend policy, capital allocation, and capital structure are so inter-related that disagreement about any of them is really disagreement about all of them.  Every post we write will aim to help family business directors think about these fundamental corporate finance decisions in a fresh light, and apply these insights to their unique circumstances to enhance the sustainability of their family business and preserve family harmony. For more on these topics, check out our recently published book, The 12 Questions That Keep Family Business Directors Awake at Night. Who Are You?We are Mercer Capital, a boutique financial advisory firm with offices in Memphis, Dallas, and Nashville.  We have been working with multi-generation family businesses since 1982.  After 36+ years and 11,000+ client engagements, there aren’t too many family business situations our senior professionals haven’t seen.  In addition to consulting with family businesses regarding dividend policy, capital allocation, and capital structure, we provide independent valuation opinions, transaction advisory services, and litigation support services.How Do You Help Family Business Directors?We help family business directors make better dividend policy decisions based on the unique circumstances and needs of your family and business.  We do this through the following services:Customized board consulting. We help you and your fellow directors understand the implications of the decisions you are called upon to make.  We work with you to frame the decision to promote better outcomes, and help you formulate the relevant questions that need to be addressed and answered during board deliberations concerning your dividend policy, capital allocation, and capital structure decisions.Management consulting. We work with family business management teams to assess hurdle rates, develop sustainable capital budgeting processes, and evaluate potential acquisitions & divestitures.Independent valuation opinions. We provide independent, unbiased, and reliable valuation opinions for gift & estate tax planning, buy-sell agreements, and shareholder liquidity programs.Transaction advisory services. We help family business directors respond to acquisition offers, evaluate strategic alternatives, provide fairness and solvency opinions, and manage the marketing and sale of family businesses.Confidential shareholder surveys. By designing, administering, and summarizing the results of a confidential shareholder survey, we solicit relevant and timely shareholder feedback so you and your fellow directors can make fully-informed decisions in light of the preferences and risk tolerances of your family shareholders.Benchmarking / business intelligence. We turn available financial data from publicly-traded peers and other sources into relevant information that helps you and your fellow directors make better corporate finance decisions.Shareholder engagement. If your family business is to function as a source of unity rather than division, your family shareholders need to be positively engaged with the business.  We help you do this by developing and providing customized financial education for your family shareholders.  We present at family council meetings, shareholder meetings, and other gatherings on a wide variety of topics ranging from how to read your company’s financial statements to primers on the weighted average cost of capital, return on invested capital, and other topics.Shareholder communication support. Poor communication is the most common cause of family shareholder angst.  We help family business directors identify the appropriate frequency, format, and content of financial reporting to shareholders.  Making financial results accessible, understandable, and relevant to family shareholders is essential to achieving and preserving family harmony. Thanks for trying us out.  We’ve got lots of content that we are excited to share with you over the coming months and we look forward to getting to know you better.  If you like what you see, please refer us to your fellow directors.  It’s easy to sign up for weekly delivery straight to your inbox.

Successful businesses don’t have to go looking for potential acquirers – potential acquirers are likely to come looking for them.  Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors.  Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but occasionally serious inquiries from legitimate buyers of capacity appear that require a response.What Kinds of Buyers are There?Buyers are generally classified into two categories.Financial buyers are groups like private equity funds that purchase businesses with a view toward earning a return on their investment over a finite holding period. These buyers generally use financial leverage to magnify their returns, and expect to exit their investment by selling the business to another buyer after three to seven (or maybe even ten) years.  While financial buyers may have specific plans for making the business run more efficiently and profitably, they are generally not anticipating significant revenue synergies or expense savings from wholesale changes to the business.  Rather, they tend to be more focused on incremental changes to boost value and clever financial engineering to be the principal engines driving their returns.Strategic buyers are competitors, customers, or suppliers of the business who have a strategic goal for making the acquisition. Such buyers certainly want to earn a return on their investment, but that return is expected to come from combining the target’s operations with their own, rather than through financial engineering.  In other words, strategic buyers look to long-term value creation through assimilating the target into their existing business, not a short-term return from buying low and selling high.  Strategic buyers may anticipate revenue synergies through the combination or may foresee the opportunity to eliminate operating expenses in either the acquired or legacy businesses to fuel cash flow growth. Distinguishing between financial and strategic buyers is important for evaluating unsolicited offers, but we suspect that a more important distinction is that between motivated buyers and opportunistic buyers.  Successful family businesses will attract motivated buyers who have the capacity to pay an attractive price for the business, but should strive to avoid opportunistic buyers who are seeking to take advantage of some temporary market dislocation or cyclical weakness to get the business at a depressed price.Evaluating Acquisition OffersEvaluating acquisition offers is ultimately the duty of the board of directors, not the family at large.  Uncle Charlie may have strong opinions on the proposed deal, but if he is not a director, he does not have the responsibility or authority to respond to the offer.  That does not mean that the directors will not care about Uncle Charlie’s perspective.  As we’ve discussed in previous posts, it is critical for the board to understand what the business “means” to the family, and the meaning of the business to the family may well inform how the directors evaluate the offer.  For larger families, the prospect of receiving a potentially-attractive unsolicited acquisition offer underscores the value of a regular survey process, whereby the board and senior management periodically take the pulse of the family on topics at the intersection of business and family.Family business directors should evaluate offers along several dimensions:Buyer Motivation. What has prompted the offer?  If it is a strategic acquirer, what sort of operational changes would be expected post-transaction?  Will a sale result in facility closures, administrative layoffs, or discontinuation of the business name?  Or, could the sale increase opportunities for employees and expose the brand to new markets?  If the suitor is a financial buyer, what sort of debt load will they place on the company post-acquisition?  Will the company’s ability to withstand normal economic downturns be compromised?  Will the buyer want members of the family active in senior management to continue to run the business?  The answers to these and similar questions should be considered in the context of what the business means to the family and help inform whether the offer should be entertained further.Buyer Capacity. Does the buyer have the financial capacity to actually execute the transaction if it is agreed to?  If external financing is required, will it be available to the buyer when needed?  Basic due diligence goes both ways.  Going through a lengthy negotiation and due diligence process only to have the transaction fall apart at the closing table due to lack of financing will leave a bad taste in the family’s mouth.Price & Transaction Structure. What seems on the surface to be an attractive price may, upon further examination, turn out to be a far less attractive transaction.  A sale of stock may have a lower nominal price than a sale of assets, yet result in higher after-tax proceeds.  A high nominal price may be subject to contingencies regarding future performance which cause the economic value of the offer to be far less.  Or, a high nominal price may be payable, in part, in shares of the buyer rather than cash – what is the family’s appetite for trading stock in the family business for stock in a different business over which they will likely have no control?  There are many other components of transaction structure, such as required representations and warranties or escrow provisions that can significantly influence how attractive an offer really is.Price is not everything. Just because the price is adequate and the terms are acceptable does not mean that the timing is optimal for a sale.  Directors should carefully weigh the potential outcomes for shareholders by deferring a transaction: Is the family better served by taking the bird in hand or waiting for more birds to materialize in the bush?  If the company is on a growth trajectory or has its own acquisition opportunities to pursue, it may command a larger multiple down the road.  Understanding the risks and opportunities associated with the timing of a transaction requires directors to be well-attuned to company, market, and industry dynamics.  Family directors-in-name-only are unlikely to have anything meaningful to add to such deliberations.Reinvestment Opportunities. Does the family have a plan for putting sale proceeds to work?  Once again, what the business “means” to the family comes to the fore.  Will proceeds simply be distributed to the various branches of the family, to use or invest as they see fit?  Or will proceeds be retained at the family level and redeployed in other assets for the benefit of the family?  If so, are there reinvestment opportunities available that will “fit” the cash flow needs and risk tolerances of the family?  Will such investments provide the same degree of family cohesion as the legacy business?  A sale of the family business may have unintended, and potentially far-reaching consequences for the family.Responding to Acquisition OffersOnce the board has evaluated the unsolicited offer, there are essentially four responses to choose from:Reject the offer. If the directors conclude that the proposed price and/or terms are unattractive, or if the timing of a transaction does not align with the broader goals of the family, the board may elect simply to reject the offer.Negotiate with the potential acquirer. If the directors conclude that the timing is right and that the suitor would be an attractive acquirer, the board may elect to negotiate with the buyer with a view toward consummating a transaction.  If the perceived “fit” between the family business and the potential acquirer is good, proceeding directly to negotiating price and terms of the transaction may result in the quickest and smoothest path to close.  However, without any exposure to the market, there is a risk that the negotiated price and terms are not really optimal.  There is a reason private equity firms like to tout their “proprietary” deal flow to potential investors – direct negotiation with sellers presumably results in lower purchase prices than winning auctions does.Engage in a limited sale process. Given the potential for underpayment, directors may elect to discreetly contact a limited number of other potential acquirers to gauge their interest in making a competing bid for the business.  The benefit of doing a limited market check is that it can generally be done fairly quickly without “putting the company up for sale” with the attendant publicity that the family may not desire.  The initial suitor will, of course, generally prefer that even a limited sale process not be engaged in, and may seek some sort of exclusivity provision which precludes the seller from talking to other potential buyers.  Directors will need to consider carefully whether the potential benefits of a limited sale process will outweigh the risk that such a process will cause the initial suitor to rescind their offer and walk away.Engage in a full sale process/auction. Finally, the board may conclude as a result of their deliberations that the unsolicited offer signals that it is an opportune time to sell the business because pricing and terms are expected to be favorable in the market and the family’s circumstances align well with a sale.  In a full sale process, the company’s financial advisors will prepare a descriptive investment memorandum for distribution to a carefully vetted list of potential motivated acquirers.  After initial indications of interest are received, the universe of potential buyers is then narrowed to a manageable group of interested parties who are invited to view presentations by senior management and engage in limited due diligence with a view to making a formal bid for the business.  With the help of their financial advisors, the directors evaluate the bids with regard to pricing, terms, and cultural fit, selecting a company with which to negotiate a definitive purchase agreement and close the transaction.  A full sale process will likely involve the most time and expense, and may expose to competitors the family’s intention to sell, but carries with it the potential for achieving the most favorable price and terms.Bringing Together the Right TeamThere is a sharp experience imbalance in most transactions: buyers have often completed many transactions, while sellers may have never sold a business before.  As a result, sellers need to assemble a team of experienced and trusted advisors to help them navigate the unfamiliar terrain.  The transaction team will include at least three primary players: a transaction attorney, a tax accountant, and a financial advisor.Definitive purchase agreements are long, complicated contracts, and an experienced attorney is essential to memorializing the substantive terms of the transaction in the agreement and ensuring that the sellers’ legal interests are fully protected.Business transactions also have significant tax consequences, and the tax code is arcane and littered with pitfalls for the unwary.  Trusting the buyer to do your tax homework can be a very costly mistake.  An experienced tax attorney is essential to maximizing after-tax proceeds to the family.The financial advisor takes the lead in helping the board evaluate unsolicited offers, setting value expectations, preparing the descriptive information memorandum, identifying a target list of potential motivated buyers of capacity, assessing initial indications of interest and formal bids, facilitating due diligence, and negotiating key economic terms of the definitive agreement.  My colleague Nick Heinz leads Mercer Capital’s transaction advisory practice, and Nick likes to say that his job in a transaction is to run the transaction on behalf of the company so the company’s management can focus on running the business on behalf of the shareholders.  Transactions can be time-consuming and mentally draining, and it’s simply not possible for company management to devote the necessary time to managing the transaction process and the business at the same time.  An experienced financial advisor takes that burden off of management.When it comes to assembling the right team, business owners sometimes blanch at the cost.  However, the cost of a quality and experienced team of advisors pales next to the cost of fumbling on the transaction.  The family will only sell the business once, and there are no do-overs.  As we recently heard someone say, “Cheap expertise is an oxymoron.”If you have recently received an unsolicited offer for your family business, or would like to discuss whether selling the business now is right for your family, please give us a call to discuss your situation in confidence.

In this post, we share a recent whitepaper: "Capital Structure in 30 Minutes." Capital structure decisions have long-term consequences for shareholders.  Directors evaluate capital structure with an eye toward identifying the financing mix that minimizes the weighted average cost of capital.  This decision is complicated by the iterative nature of capital costs: the financing mix influences the cost of the different financing sources.  While the nominal cost of debt is always less than the nominal cost of equity, the relevant consideration for directors is the marginal cost of debt and equity, which measures the impact of a given financing decision on the overall cost of capital.  The purpose of this whitepaper is to equip directors and shareholders to contribute to capital structure decisions that promote the financial health and sustainability of the company. This whitepaper is the second in the "Corporate Finance in 30 Minutes Series." Learn more about the whitepaper series below. Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors and shareholders to contribute to capital structure decisions that promote the financial health and sustainability of their companies.Capital Budgeting in 30 MinutesCapital Budgeting in 30 Minutes assists directors and shareholders evaluate proposed capital projects and contribute to capital budgeting decisions that enhance value.Distribution Policy in 30 MinutesOf the three primary corporate finance decisions, distribution policy is the most transparent to shareholders. This whitepaper helps directors formulate and communicate a distribution policy that contributes to shareholder wealth and satisfaction.

Next Man (or Woman) Up?Perhaps no group is as proficient at the art of clichéd answers as football coaches. When confronted with the season-ending injury of a star player, the coach will inevitably stare stoically into the camera and solemnly declare “Next man up.” Whether the coach truly believes that the replacement player will be adequate, the cliché is intended to convey the idea that the coach has created such a “culture of success” that the “Process” (two of the newer clichés) that the team’s performance will be unaffected.From the perspective of family business, “Next Man or Woman Up” is one approach that the board of directors can take to management succession. Perhaps for some family businesses, management succession is as simple as pulling the next available candidate from the management depth chart. But we suspect that approach falls short for most family businesses. The combination of business growth, generational dynamics, and intra-family relationships that make family businesses unique precludes one-size-fits-all solutions to management succession. The primary questions associated with management succession are (1) Who will be the next leader of the business? and (2) How will the transition occur?First Question: Who?In our experience, many succession struggles are rooted in a failure to distinguish between being a good family member, a good employee, and a good business leader. The combination of native ability, education, character, social IQ, technical skills, and strategic savvy necessary to run a large business successfully is rare. The often-unspoken assumption that, since Dick has been a good son, or Jane a good daughter, that he or she is entitled to run the business when his or her turn comes up is unfair to the shareholders and employees of the business, not to mention Dick or Jane. While there are abundant examples of capable and energetic second, third or later generation family members that are great business leaders, it is a mistake to think that management of the business should simply be a matter of inheritance.The second common myth is that since Bill and Suzie have demonstrated themselves to be great employees (in whatever functional area) that they will, therefore, be great leaders. Being good at one’s job does not guarantee success as the leader of a family business. Further, as companies grow, new challenges may require a different set of leadership skills than were required in the prior generation. The skills and personality traits that made Uncle Phil the ideal leader of the business twenty-five years ago may be different from what Cousin Carlton needs to possess for success in the same role today.If the family has successfully distinguished family membership from family business management, it may be easier for the board to cast a wider net to find the best candidate to assume leadership of the business. Having an “outside” CEO does not mean the company has ceased to be a family business any more than hiring the first non-family employee on the shop floor did. Rather, it simply means that the directors have fulfilled their responsibilities to shareholders, employees and the community by seeking the right candidate for the job. Family members are by no means ruled out from consideration, but directors must acknowledge that the requisite skills may not reside in the family. And that’s okay. Having “professional” management may actually help family cohesion – and therefore business sustainability.In many cases, the combination of outside perspective and family loyalty that make a successful leader can be found among the family’s in-laws. Such “married-ins” are often sufficiently removed from family dynamics that they can see business issues for what they are, uncolored by what may be decades’ worth of emotional baggage. At the same time, their membership in the family may give a head-start in aligning economic incentives. In other words, “married-ins” will likely have plenty of skin in the game.Second Question: How?In the long run, management succession is inevitable: the proportion of managers that are eventually replaced is 100%. In the short run, however, there are generally three circumstances giving rise to management succession.1.     Planned Retirement: When the senior executive is approaching a natural retirement age, the directors should identify potential candidates to replace the retiring leader. With a multi-year planning horizon, the board can give due consideration to family candidates, develop mentoring opportunities for those candidates, and evaluate the performance of those candidates in areas of increasing responsibility. If it becomes apparent that no family candidates represent the right fit for the job, the board can extend the search to include existing non-family employees and non-employees.The appropriate retirement age for family business executives is a vexing issue. There simply is no one-size-fits-all for when a successful family business leader should step away. In our practice, we have seen examples of departures that – in hindsight – were premature, because the designated replacement was not yet ready to assume leadership. Perhaps more commonly, we see examples of businesses that plateau and stagnate because an aging senior executive refuses to move out of the corner office.2.     Performance-Driven Transition: We wrote in a previous post about the unique challenges associated with management accountability in family businesses. If the directors determine an existing senior executive is not generating acceptable results, it may be appropriate to seek a replacement. Family dynamics can make this an extremely difficult decision, and the prospect that such a decision may be in the best interest of the principal stakeholders (family shareholders, employees, local community, customers, suppliers, etc.) is one good reason to include qualified independent non-family members on the board. The independent directors can provide an objective assessment of managerial performance uncolored by internal family dynamics. If a performance-driven transition is necessary, the ultimate replacement should not be selected hastily; the long-run health of the business may be better served by a deliberate selection process, during which an experienced executive can manage the company on an interim basis.3.     Unexpected Vacancy: Finally, management succession may be forced upon the company because of an untimely illness, death, or other unforeseen circumstances. No business is immune to such circumstances, which underscores the need for directors to proactively think about management succession, even when the current leader is successful and expected to have a lengthy remaining tenure. When tragedy strikes, selecting the next leader should still be considered a measure-twice, cut-once project, with the long-term health of the organization taking precedence over the short-term desire to fill the position.As noted in the Harvard Business Review, recent research by Stephanie Querbach, Miriam Bird, and Nadine Kammerlander offers some interesting insights into best practices for management succession in family businesses. After studying over 500 management successions, they concluded the likelihood that successor-managers would be able to implement needed changes and improve the long-term sustainability of the family business was linked to three strategies: (1) limiting the power of the outgoing CEO subsequent to his or her retirement, (2) crafting a formal agreement regarding the how and when of power transfer, and (3) selecting a non-family successor. Of course, these observations reflect probabilities – they’re not absolute prescriptions for how every succession should occur. But they do provide a somewhat counter-intuitive perspective on the topic that family businesses would do well to consider.In the end, every management succession plan will be as unique as the family business it is designed for. But one constant for all family businesses is that now is the time to begin thinking and planning. “Next Man Up” may work in football, but your family business deserves better than that.

The following is an installment in our series “What Keeps Family Business Owners Awake at Night” Consider the following perspectives on diversification and risk:“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham“Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren BuffettThe appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.What is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.To illustrate, consider a family business deciding which of the following three investments to make: There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk – or variability of returns – of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice, in this case, should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.Diversification to Whom?Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough – or so the theory seemed to go – you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a – you guessed it – “core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets). Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions – ready liquidity and absolute shareholder freedom in constructing one’s portfolio – simply does not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.We wrote in a previous post about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only distribution and reinvestment policy, but also the role of diversification in the business. So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.

The following is an installment in our series “What Keeps Family Business Owners Awake at Night” Our multi-generation family business clients ask us about dividend policy more often than any other topic. This should not be unexpected, since returns to family business shareholders come in only two forms: current income from distributions and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy. In other words, distributions are the most transparent expression of what the family business means to the family economically. Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability. The business may “mean” different things to the family at different times (or, to different members of the family at the same time). In our experience, there are four broad “meanings” that a family business can have. These “meanings” are not mutually exclusive, but one will usually predominate at a given time. As discussed below, the “meaning” of the business has implications for the role of distributions.Meaning #1 - The family business is an economic growth engine for future generations. For some families, the business is perceived as a vehicle for increasing per capita family wealth over time. For these families, distributions are likely to take a backseat to reinvestment in the business needed to fuel the growth required to keep pace with the biological growth of the family.Meaning #2 - The family business is a store of value for the family. For other families, the business is perceived as a means of capital preservation. Amid the volatility of public equity markets, the family business serves as ballast for the family’s overall wealth. Distributions are generally modest for these families, with earnings retained, in part, to mitigate potential swings in value.Meaning #3 - The family business is a source of wealth accumulation. Alternatively, the business may be perceived as a mechanism for accumulating family wealth outside the business. In these cases, individual family members are expected to use distributions from the business to accumulate wealth through investments in marketable securities, real estate, or other operating businesses. Distributions are emphasized for these families, along with the (potentially unspoken) expectation that distributions will be used by the recipients to diversify away from, and limit dependence on, the family business.Meaning #4 - The family business is a source of lifestyle. Finally, the business may be perceived as maintaining the family’s lifestyle. Distributions are not expected to fund a life of idle leisure, but are relied upon by family shareholders to supplement income from careers and other sources for home and auto purchases, education expenses, weddings, travel, philanthropy, etc. These businesses typically have moderate reinvestment needs, and predictability of the dividend stream is often more important to shareholders than real (i.e., net of inflation) growth in the dividend. Continuation of the dividend is the primary measure the family uses to evaluate management’s performance. From a textbook perspective, distributions are treated as a residual: once attractive reinvestment opportunities have been exhausted, the remaining cash flow should be distributed to the shareholders. However, at a practical level, the different potential “meanings” assigned to the business by the family will, to some degree, circumscribe the distribution policy alternatives available to the directors. For example, eliminating distributions in favor of increased reinvestment is not a practical alternative for family businesses in the third or fourth categories above, regardless of how abundant attractive investment opportunities may be. The following table illustrates the relationship between “meaning” and distribution policy: The textbook perspective on distribution policy is valid, but can be adhered to only within the context of the “meaning” assigned to the family business. In contrast to public companies or those owned by private equity funds, “meaning” will generally trump dispassionate analysis of available investment opportunities. If family business leaders conclude that the “meaning” assigned to the business by the family does not align with the optimal distribution policy, the priority should be given to changing what the business “means” to the family. Once the change in “meaning” has been embraced by the family, the change in distribution policy will more naturally follow. A distribution policy describes how the family business determines distributions on a year-to-year basis. A consistent distribution policy helps family shareholders understand, predict, and evaluate distribution decisions made by the board of directors. Potential family business distribution policies can be arrayed on a spectrum that ranges from maximum shareholder certainty to maximum board discretion. Family shareholders should know what the company’s current distribution policy is. As evident from the preceding table, knowing the distribution policy does not necessarily mean that one will know the dividend for that year. However, a consistently-communicated and understandable distribution policy contributes greatly to developing positive shareholder engagement. So what should your family business’s distribution policy be? Answering that question requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce? Once the inward and outward perspectives are properly aligned, the distribution policy that is appropriate to the company can be determined by the board and communicated to shareholders. Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

Effective communication between management and shareholders is a key component of the long-term sustainability and success of any family business. The cornerstone of a thoughtful and effective shareholder relations program is education.Apart from a shared vocabulary and understanding of basic corporate finance concepts, family business managers will struggle to communicate the company's strategy and financial results to shareholders clearly.We have combined these whitepapers to help family businesses make strategic financial decisions and communicate those decisions to their shareholders.

The following is an installment in our series “What Keeps Family Business Owners Awake at Night” Communication determines the success of any relationship, and the relationships among shareholders of multi-generation family businesses are no exception.  In the early years of a family business, communication is generally informal (and continual), since the dining room often doubles as the board room.  As the business and family grow, the shareholder relationships become more complicated, and formal communication becomes more important. For a multi-generation family business, communication is not optional.  A failure to communicate is a communication failure.  When communication is lacking, the default assumption of shareholders – especially those not actively involved in the business – will be that management is hiding something.  Suspicion breeds discontent; prolonged discontent solidifies into rancor and, in some cases, litigation. In light of the dire consequences of poor communication, how can family business leaders develop effective and sustainable communication programs?  We suggest that public companies can provide a great template for multi-generation family businesses.  It is perhaps ironic that public companies – to whom their shareholder bases are largely anonymous – are typically more diligent in their shareholder communications than family businesses, whose shareholders are literally flesh and blood.  While public companies’ shareholder communications are legally mandated, forward-thinking public companies view the required shareholder communications not as regulatory requirements to be met, but as opportunities to tell their story in a compelling way. There are probably only a handful of family businesses for which shareholder communication needs to be as frequent and detailed as that required by the SEC.  The structure and discipline of SEC reporting is what needs to be emulated.  For family businesses, the goal is to communicate, not inundate.  At some point, too much information can simply turn into noise.  Family business leaders should tailor a shareholder communication program along the following dimensions:Frequency. Public companies communicate results quarterly.  Depending on the nature of the business and the desires of the shareholder base, less frequent communication may be appropriate for a family business.  The frequency of communication should correspond to the natural intervals over which (1) genuinely “new” information about the company’s results, competitive environment, and strategy is available, and (2) shareholders perceive that the most recent communication has become “stale”.  As a result, there is no one-size-fits-all frequency; what is most important is the discipline of a schedule.Level of detail. Public company reports are quite detailed.  Family business leaders should assess what level of detail is appropriate for shareholder communications.  If the goal is to communicate, the appropriate level of detail should be defined with reference to that which is necessary to tell the company’s story.  The detail needs to be presented to shareholders with sufficient supporting context regarding the company’s historical performance and conditions in the relevant industries and economy.  A dashboard approach that focuses on key metrics, as illustrated below, can be an effective tool for focusing attention on the measures that matter.Format/Access. The advent of accessible webcast and data room technology makes it much easier for family businesses to distribute sensitive financial information securely.  Use of such platforms also provides valuable feedback regarding what is working and what is not (since use of the platform by shareholders can be monitored).  Some families may have existing newsletters that provide a natural and existing touchpoint for communicating financial results.Emphasis. The goal of shareholder communication should be to help promote positive shareholder engagement.  To that end, the emphasis of the communication should not be simply the bare reporting of historical results, but should emphasize what the results mean for the business in terms of strategy and outlook for the future.  It is probably not possible to re-tell the company’s story too many times.  Shareholders that are not actively involved in the business will be able to internalize the company’s strategy only after repeated exposure.  What may seem like the annoying repetitions of a broken record to management will for shareholders be the re-exposure necessary to “own” the company’s story. Shareholder communication is an investment, but one that in our experience has an attractive return.  To get the most out of the investment, family business leaders must provide the necessary training and education to shareholders so that they will be able confidently to assess and interpret the information communicated.  With that foundation in place, a structured communication program can go a long way to ensuring that family shareholders are positively engaged with the business. Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

The following is an installment in our series “What Keeps Family Business Owners Awake at Night” Based on discussions with family business leaders from across the country at the most recent Transitions conference, we wrote an article addressing themes among attendees, and we continue the discussion in this article. One challenge noted by leaders of multi-generation family businesses was how to promote positive shareholder engagement.Why is Shareholder Engagement Important for Family Businesses?As family businesses mature into the third and subsequent generations, it becomes less and less likely that extended family members will be both shareholders and active participants in the business. As families grow numerically, they tend to become more geographically dispersed. Lack of professional involvement in the business, combined with geographic separation, can result in family shareholders feeling disconnected and becoming disengaged from the family business. A successful multi-generation family business can promote healthy family cohesion, but when shareholders are not positively engaged, the business can quickly turn into a source of stress and family strife.Some families choose to eliminate the existence of disengaged shareholders by limiting share ownership to those members that are actively involved in the business. While this may be an appropriate solution for some families, it can have the unintended consequence of creating distinct classes of economic haves and have-nots within the family. When that occurs, the business quickly ceases to be a center of family unity.For most businesses, there simply is no necessary link between share ownership and active involvement in the company. If public companies can function well with non-employee owners, surely it is possible for family businesses to do so as well. But to do so, family businesses will need to be diligent to promote positive shareholder engagement.What are the Marks of an Engaged Shareholder?It might be tempting to label non-employee shareholders as “passive”, but we suspect that term does not do justice to the ideal relationship between the company and such shareholders. “Actively non-controlling” hits closer to the mark but doesn’t exactly trip off the tongue. If “passive” is not the ideal, the following characteristics can be used to identify positively engaged shareholders.An appreciation of what the business means to the family. Engaged shareholders know the history of the family business in its broad outline. Few things promote a sense of community like a shared story. A successful family business provides a narrative legacy that few families possess. Engaged shareholders embrace, extend, and re-tell the story of the family business.A willingness to participate. Full-time employment is not the only avenue for participating in the family business. Engaged shareholders understand their responsibility to be active participants in the groups that are appropriate to their skills, life stage, and interests, which may include serving as a director, sitting on an owners’ council, or participating in a family council.A willingness to listen. Positively-engaged non-employee shareholders recognize that there are issues affecting the family business, the industry, and the company’s customers and suppliers of which they are unaware. As a result, they are willing to listen to management, regardless of whether management consists primarily of non-family professionals or their second cousins.A willingness to develop informed opinions. A willingness to listen does not mean passive acceptance of everything management is communicating. A competent and confident management team recognizes that non-employee shareholders have expertise, experiences, and insights that members of management lack. Engaged shareholders acknowledge their responsibility to develop and share informed opinions, not just gut reactions or prejudices.A willingness to consider perspectives of other shareholder groups. Engaged shareholders do not seek the benefit of their own branch of the family tree to the detriment of the others. Multi-generation family businesses inevitably have distinct shareholder “clienteles” with unique sets of risk tolerances and return preferences. Privileging the perspective of a single shareholder clientele is a sure way to promote discord.A commitment to deal fairly. Fairness needs to run in both directions: non-employee shareholders should not be penalized for not working in the business, and shareholders that do work in the business need to be fully and fairly compensated for their efforts. Fairness also extends to distribution and redemption policy, both of which can be used to this disadvantage of one group within the family. Engaged shareholders are committed to fair dealing in transactions with the business and within the family.How to Develop an Engaged Shareholder Base?The family business leaders we spoke with at the conference were eager to share and learn best practices around promoting shareholder engagement. The “how” of shareholder engagement is closely related to the characteristics of engaged shareholders noted above.Develop mechanisms for appropriate involvement. Not everyone can have a seat at the board, but family and owner’s councils can be great ways to broaden opportunities and prepare family members for greater involvement.Emphasize the privilege/responsibility of being a shareholder. This will look different for every family, but a visible commitment to charitable contributions and service opportunities can be a powerful signal to the family that being a shareholder involves a stewardship that transcends simply receiving dividends.Basic financial education. Family members will have many different talents, interests, and competencies. Offering rudimentary financial education (i.e., how to read a financial statement, and understanding how distribution policy influences reinvestment) can empower the healthcare professionals, educators, and engineers in the family to develop and communicate informed opinions on family business matters.Actively solicit shareholder feedback. While it is true that the squeaky wheel gets the grease, it is often the un-squeaky wheels that have the most valuable insight. Periodic shareholder surveys can be an effective tool for promoting positive shareholder engagement.Demonstrate a commitment to fair dealing. Shareholders who are also managers in the business need to be wary of the tendency to pursue empire-building activities at the expense of providing appropriate returns on the shares in the family business. Most of the intra-family shareholder disputes we have seen (and we have witnessed too many) are ultimately traceable to shareholders that over time became disengaged from the business. Family business leaders who focus on positive shareholder engagement today can prevent a lot of grief tomorrow. Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

We recently attended the Transitions West conference hosted by Family Business Magazine. The event brought together representatives from nearly 100 family businesses of all sizes. Through the educational sessions and informal conversations during breaks, we came away with a better appreciation of the joys, stresses, privileges, and responsibilities which come with stewarding a multi-generation family business.While every family is unique, a few common themes and/or concerns stood out among the attendees we met:Shareholder engagement: How many of your second cousins do you know? As families grow into the fourth and fifth generations, common ownership of a successful business can serve as the glue that holds the family together. However, as the proportion of non-employee family shareholders increases, maintaining productive shareholder engagement grows more challenging.Communication: Effective communication is a critical for any relationship. Multi-generation family businesses are complex relationship webs. Identifying best practices for communicating effectively with family shareholders was a common objective for conference attendees.Distribution policy: Hands down, the most frequent topic of conversation was establishing a distribution policy that balances the lifestyle needs and aspirations of family shareholders with the needs of the business.Investing for growth: The flip-side of distribution policy is how to invest for growth. Can the family business keep up with the biological growth of the family? Is that a desirable goal? Regardless of the selected goal, family business leaders are concerned about identifying and executing investments to support the growth of the family business.Diversification: A striking number of the family businesses represented at the conference had diversified rather far afield from the legacy business of the founding generation. What are the marks of effective diversification for a family business?Management accountability: Evaluating managerial performance is never easy; adding kinship ties to the mix only makes things dicier. The family business leaders we spoke with were eager to develop and implement effective management accountability structures.Management succession: Whether it comes simply through age or as a result of poor performance, management succession is somewhere on the horizon for every family business. By our unofficial count, most of the family businesses in attendance were still led by a family member (often enough by so-called “married-ins”). A meaningful minority, however, had professional (i.e., non-family) management teams.Next Gen development: Rising generations are naturally more diffuse than prior generations, with regard to geography, interests, skill sets, and desires. Family leaders were interested in identifying appropriate pathways for next generation leaders to engage, learn, and grow in their contribution to, and impact upon, the family business.Generational transfer/estate planning: Attendees were keenly interested in tax-efficient techniques for transferring ownership of the family business to succeeding generations. While certainly important, there may be unanticipated pitfalls if estate and other taxes are the only factors considered when transferring wealth.Evaluating acquisition offers: There’s a definite selection bias at a family business conference: attendees are necessarily shareholders of family businesses that have not been sold. Even if the family does not plan to sell, credible acquisition offers at what appear to be attractive financial terms need to be assessed. Family business representatives were interested in learning how best to evaluate and respond to such offers.Share redemption/liquidity programs: There are many reasons family members may want to sell shares: desire for diversification, major life changes (such as divorce), funding for estate tax payments, starting a new business, or funding other major expenditures. What is the best way to provide liquidity to family shareholders on fair terms without sparking a run on the bank? Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

Below is the transcript of the above video, Corporate Finance Basics for Directors and Shareholders. In this video, Travis W. Harms, CFA, CPA/ABV, senior vice president of Mercer Capital, offers a short, yet thorough, overview of corporate finance fundamentals for closely held and family business directors and shareholders. Hi, my name is Travis Harms, and I lead Mercer Capital’s Family Business Advisory practice. I welcome and thank you for taking a few minutes to listen to our discussion, “Corporate Finance Basics for Directors and Shareholders.” Corporate finance does not need to be a mystery. In this short presentation, I will give you the tools and vocabulary to help you think about some of the most important long-term decisions facing your company. To do this, we review the foundational concepts of finance, identify the three key questions of corporate finance, and then leverage those three questions to help think strategically about the future of your company. Let’s start with the fundamentals of finance: return and risk. Return measures the reward for making an investment.  Investment returns come in two different forms: the first, distribution yield, is a measure of the annual distributions generated by an investment. The second, capital appreciation, measures the change in the value of an investment over time.  Total return is the sum of these two components. This is important because two investments may generate the same total return, although in very different forms.  Some investments, like bonds, emphasize current income, while others, like venture capital, are all about capital appreciation.  Many investments promise a mix of current income and future upside. The most basic law of corporate finance is that return follows risk. The above chart compares the expected return required by investors and the risk of different investments.  Since investment markets are generally efficient, higher returns are available only by accepting greater risk. But what is risk? Simply put, risk is the fact that future investment outcomes are unknown.  The wider the distribution of potential outcomes, the greater the risk. While both investments represented above are risky, the dispersion of outcomes for the investment on the right is wider than that on the left, so the investment on the right is riskier.  Because it is riskier, it will have a higher expected return.  Now, whether that higher return actually materializes is unknown when the investment is made – that’s what makes it risky. For a particular company, the expected return is referred to as the company’s cost of capital.  From a corporate finance perspective, the company stands between investors (who are potential providers of capital) and investment projects (which are potential uses of the capital provided by investors).  The cost of capital is the price paid to attract capital from investors to fund investment projects. When evaluating potential investment projects, corporate managers use the cost of capital as the hurdle rate to measure the attractiveness of the project. Next, we will move on to the three essential questions of corporate finance. Corporate managers and directors should always be thinking about three fundamental corporate finance questions: First, what is the most efficient mix of capital? This the capital structure question – what is the mix of debt and equity capital that minimizes the company’s overall cost of capital?Second, what projects merit investment? This is the capital budgeting question – how does the company identify investment projects that will deliver returns in excess of the hurdle rate?And third, what mix of returns do shareholders desire? This is the distribution policy question – what is the appropriate mix of current income and future upside for the company’s investors? Let’s start with the first question: what is the most efficient mix of capital? You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet.  The right side of the balance sheet tells us how the company has paid for those investments.  The only two funding options are debt and equity.  Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company. You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet.  The right side of the balance sheet tells us how the company has paid for those investments.  The only two funding options are debt and equity.  Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company. If debt is cheaper than equity, you might assume that a company could reduce its cost of capital by simply issuing more and more debt.  That is not the case, however.  As the company uses more debt, the risk of both the debt and the equity increase.  And, as we said earlier, greater risk will cause both debt and equity investors to demand higher returns. Eventually, because the cost of both components is increasing, the overall blended (or weighted average) cost of capital increases with increasing reliance on debt.  The goal of capital structure analysis is to identify the optimal capital structure, or the mix of debt and equity that minimizes the company’s cost of capital. Now let’s move on to the second question: what investment projects should the company devote capital to?  At the strategic level, management’s job is to survey the landscape of potential investment projects, choosing those that are strategically compelling and financially favorable. From a financial perspective, a potential investment project is attractive if the return from the expected cash flows meets or exceeds the hurdle rate, which is the cost of capital. The appropriate pace of investment for a company is therefore related to the availability of attractive investment projects. If attractive investment projects are abundant, the company should reinvest earnings into new projects, and, if yet more attractive projects are available, borrow money and/or issue new equity to fund the investment.  If attractive investment projects are scarce, however, the company should return capital to investors through debt repayment, distribution of earnings, or share repurchase.  We can now begin to see how the three questions are related to one another.  Capital structure decisions are always made relative to the need for investment capital. This inter-relationship is illustrated above within the context of the two components of total return we discussed earlier.  Distribution yield provides a current return to shareholders from cash flow not reinvested in the business, while the cumulative impact of reinvested cash flows is manifest in the capital appreciation component of total return. This leads us to the final corporate finance question, which relates to distribution policy: what mix of returns do shareholders desire? While the operating performance of the business ultimately determines total return, the board can tailor the components of that return to fit shareholder preferences better. We’ve primarily been looking through the rearview mirror to assess what the company has done in the past; now it’s time to look through the windshield and think prospectively about capital structure, capital budgeting, and distribution policy going forward. First, capital structure.  In the long-run, the optimal capital structure will balance the cost of funds, flexibility, availability, and the risk preferences of the shareholders.  Now, that last factor – shareholder preferences – should not be overlooked.  Family businesses should not be managed for some abstract textbook shareholder, but rather for the actual family members that own the business. For example, while an under-leveraged capital structure reduces potential return on equity, it also reduces the risk of bankruptcy.  Some shareholders may view this tradeoff favorably even if it can be demonstrated to be “sub-optimal” from a textbook standpoint. Second, capital budgeting.  The attractiveness of investment opportunities should be evaluated with reference to future – and not past – returns.  Beyond the threshold question of whether such opportunities are in fact available, managers and directors should also consider financial and management constraints under which the company is operating and the desire of shareholders for diversification. Since family business shareholders lack ready liquidity for their shares, they may have a greater desire to diversify their investment holdings away from the family business.  In other words, they may favor foregoing some otherwise attractive investment opportunities in order to increase distributions that would help shareholders diversify. Third, distribution policy.  The appropriate form and amount of distributions should reflect shareholder preferences within the context of capital budgeting and capital structure decisions.  Perhaps most importantly, a clearly communicated distribution policy enhances predictability for shareholders, and shareholders like predictability. Family business shareholders should know which of the four basic options describes their company’s distribution policy. Finally, to recap, each of the three questions relates to one another. The company’s capital structure influences the cost of capital, which serves as the hurdle rate in capital budgeting decisions.  The availability of attractive investment projects, in turn, determines whether earnings should be retained or distributed.  Lastly, distribution policy affects, and is affected by, the cost and availability of marginal financing sources. For a deeper dive into some of the topics we talked about, we have several whitepapers and other resources that you can download from our website. The good news is that you do not have to have an advanced degree in finance to be an informed director or shareholder.  With the concepts from this presentation, you can make relevant and meaningful contributions to your company’s strategic financial decisions.  In fact, we suspect that a roomful of finance “experts” can actually be an obstacle to the sort of multi-disciplinary, collaborative decision-making that promotes the long-term health and sustainability of the company.  Our family business advisory practice gives directors and shareholders a vocabulary and conceptual framework for thinking about and making strategic corporate finance decisions. Again, my name is Travis Harms and I thank you for listening. If you’d like to continue the discussion further or have any questions about how we may help you, please give us a call. Travis W. Harms, CFA, CPA/ABV(901) 322-9760harmst@mercercapital.com

Football coaching legend Bill Parcells famously said, “You are what your record says you are.” Adapting that thought to the corporate world, one could say, “Your company is what its financial statements say it is.”Although we would not deny that there are important non-financial considerations in business, the remark strikes close enough to the truth to underscore the importance of being able to read financial statements.Accounting is the language of business, and financial statements are the primary texts to be mastered.Corporate directors need to be able to read financial statements to discharge their fiduciary duty to shareholders effectively.The ability to analyze financial statements gives shareholders the confidence to independently assess the company’s performance and the effectiveness of management’s stewardship of shareholder resources.The purpose of this whitepaper is to help readers develop an understanding of the basic contours of the three principal financial statements.The balance sheet, income statement, and statement of cash flows are each indispensable components of the “story” that the financial statements tell about a company.After reviewing each statement, we explain how the different statements relate to one another.Finally, we provide some guidance on how to evaluate projected financial statements.

Travis W. Harms, senior vice president of Mercer Capital, wrote a series of whitepapers that focused on demystifying corporate finance for board members and shareholders. In this whitepaper, he has distilled the fundamental principles of corporate finance into an accessible and non-technical primer. Structured around the three key decisions of capital structure, capital budgeting, and dividend policy, this whitepaper is designed to assist directors and shareholders without a finance background to make relevant and meaningful contributions to the most consequential financial decisions all companies must make. Mercer Capital’s goal with this whitepaper is to give directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion.Mercer Capital has significant experience valuing assets and companies in the oil and gas industry, primarily oil and gas, bio fuels and other minerals.  We also provide financial education services to family businesses.  We help family ownership groups, boards, and management teams align their perspectives on the financial realities, needs, and opportunities of the business.   Contact a Mercer Capital professional today to discuss your needs in confidence.Click here to read Corporate Finance in 30 Minutes.

To craft an effective corporate strategy, management and directors must answer the three fundamental questions of corporate finance.The Capital Structure question:  What is the most efficient mix of capital?The Capital Budgeting question:  Which projects merit investment?The Dividend Policy question:  What mix of returns do shareholders desire?These questions should not be viewed as the special preserve of the finance team.  To maintain a healthy governance culture, all directors and shareholders need to have a voice in how these long-term decisions are made.  This presentation is an example of the topics that we cover in education sessions with directors and shareholders.  The purpose of the presentation is to provide directors and shareholders with a conceptual framework and vocabulary to help contribute to answering the three fundamental questions.

Of all the well-worn clichés that should be retired, “maximizing shareholder value” is surely toward the top of the list.  Since private companies don’t have constant public market feedback, attempts to “maximize” shareholder “value” are destined to end in frustration.  While private company managers are not able to gauge instantaneous market reaction to their performance, they do know who their shareholders are.  Wouldn’t it be better to make corporate decisions based on the characteristics and preferences of actual flesh-and-blood shareholders than the assumed preferences of generic shareholders that exist only in textbooks?  If so, there is no substitute for simply asking.  Here’s a quick list of five good reasons for conducting a survey of your shareholders.A survey will help you learn about your shareholders. A well-crafted shareholder survey will go beyond mere demographic data (age and family relationships) to uncover what deeper characteristics owners share and what characteristics distinguish owners from one another.  We recently completed a survey for a multi-generation family company, and not surprisingly, one of the findings was that the shareholder base included a number of distinct “clienteles” or groups of shareholders with common needs and risk preferences.  What was surprising was that the clienteles were not defined by age or family tree branch, but rather by the degree to which (a) the shareholder’s household income was concentrated in distributions from company stock, and (b) the shareholder’s personal wealth was concentrated in company stock.  The boundary lines for the resulting clienteles did not fall where management naturally assumed.A survey will help you gauge shareholder preferences. The results from a shareholder survey will help directors and managers move away from abstract objectives (like “maximizing shareholder value”) toward concrete objectives that actually take into account shareholder preferences.  For example, what are shareholder preferences for near-term liquidity, current distributions, and capital appreciation?  Identifying these preferences will enable directors and shareholders to craft a coherent strategy that addresses actual shareholder needs.  Conducting a survey does not mean that the board is off-loading its fiduciary responsibility to make these decisions to the shareholders: a survey is not a vote.  Rather, it is a systematic means for the board to solicit shareholder preferences as an essential component of deliberating over these decisions.A survey will help educate the shareholders about the strategic decisions facing the company. While a survey provides information about the shareholders to the company, it also inevitably provides information about the company to shareholders.  In our experience, the survey is most effective if preceded by a brief education session that reviews the types of questions that will be asked in the survey.  Shareholders do not need finance degrees to be able to understand the three basic decisions that every company faces: (1) how should we finance operations and growth investments (capital structure), (2) what investments should we be making (capital budgeting), and (3) what form should shareholder returns take (distribution policy).  Educated shareholders can provide valuable input to directors and managers, and will prove to be more engaged in management’s long-term strategy.A survey will help establish a roadmap for communicating operating results to shareholders. Public companies are required by law to communicate operating results to the markets on a timely basis, and many public companies invest significant resources in the investor relations function because they recognize that it is critical that the markets understand not just the bare “what happened” of financial reporting, but the “why” of strategy.  Oddly, for most private companies, there is no roadmap for communicating results, and investor relations is either ignored or consists of reluctantly answering potentially-loaded questions from disgruntled owners (who may, frankly, enjoy being a nuisance).  A shareholder survey can be a great jumping-off point for a more structured process for proactively communicating operating results to shareholders.  An informed shareholder base that understands not only “what happened” but also “why” is more likely to take the long-view in evaluating performance.A survey gives a voice to the “un-squeaky” wheels. A shareholder’s input should not be proportionate to the volume with which the input is given.  While the squeaky wheel often gets the grease, it is prudent for directors and managers to solicit the feedback regarding the needs and preferences of quieter shareholders.  Asking for input from all shareholders through a systematic survey process helps ensure that the directors and managers are receiving a balanced picture of the shareholder base.  A confidential survey administered by an independent third party can increase the likelihood of receiving frank (and therefore valuable) responses. An engaged and informed shareholder base is essential for the long-term health and success of any private company, and a periodic shareholder survey is a great tool for achieving that result.  To discuss how a shareholder survey or ongoing investor relations program might benefit your company, give one of our senior professionals a call.

Of all the well-worn clichés that should be retired, “maximizing shareholder value” is surely toward the top of the list.  Since private companies don’t have constant public market feedback, attempts to “maximize” shareholder “value” are destined to end in frustration.  While private company managers are not able to gauge instantaneous market reaction to their performance, they do know who their shareholders are.  Wouldn’t it be better to make corporate decisions based on the characteristics and preferences of actual flesh-and-blood shareholders than the assumed preferences of generic shareholders that exist only in textbooks?  If so, there is no substitute for simply asking.  Here’s a quick list of five good reasons for conducting a survey of your shareholders.A survey will help you learn about your shareholders. A well-crafted shareholder survey will go beyond mere demographic data (age and family relationships) to uncover what deeper characteristics owners share and what characteristics distinguish owners from one another.  We recently completed a survey for a multi-generation family company, and not surprisingly, one of the findings was that the shareholder base included a number of distinct “clienteles” or groups of shareholders with common needs and risk preferences.  What was surprising was that the clienteles were not defined by age or family tree branch, but rather by the degree to which (a) the shareholder’s household income was concentrated in distributions from company stock, and (b) the shareholder’s personal wealth was concentrated in company stock.  The boundary lines for the resulting clienteles did not fall where management naturally assumed.A survey will help you gauge shareholder preferences. The results from a shareholder survey will help directors and managers move away from abstract objectives (like “maximizing shareholder value”) toward concrete objectives that actually take into account shareholder preferences.  For example, what are shareholder preferences for near-term liquidity, current distributions, and capital appreciation?  Identifying these preferences will enable directors and shareholders to craft a coherent strategy that addresses actual shareholder needs.  Conducting a survey does not mean that the board is off-loading its fiduciary responsibility to make these decisions to the shareholders: a survey is not a vote.  Rather, it is a systematic means for the board to solicit shareholder preferences as an essential component of deliberating over these decisions.A survey will help educate the shareholders about the strategic decisions facing the company. While a survey provides information about the shareholders to the company, it also inevitably provides information about the company to shareholders.  In our experience, the survey is most effective if preceded by a brief education session that reviews the types of questions that will be asked in the survey.  Shareholders do not need finance degrees to be able to understand the three basic decisions that every company faces: (1) how should we finance operations and growth investments (capital structure), (2) what investments should we be making (capital budgeting), and (3) what form should shareholder returns take (distribution policy).  Educated shareholders can provide valuable input to directors and managers, and will prove to be more engaged in management’s long-term strategy.A survey will help establish a roadmap for communicating operating results to shareholders. Public companies are required by law to communicate operating results to the markets on a timely basis, and many public companies invest significant resources in the investor relations function because they recognize that it is critical that the markets understand not just the bare “what happened” of financial reporting, but the “why” of strategy.  Oddly, for most private companies, there is no roadmap for communicating results, and investor relations is either ignored or consists of reluctantly answering potentially-loaded questions from disgruntled owners (who may, frankly, enjoy being a nuisance).  A shareholder survey can be a great jumping-off point for a more structured process for proactively communicating operating results to shareholders.  An informed shareholder base that understands not only “what happened” but also “why” is more likely to take the long-view in evaluating performance.A survey gives a voice to the “un-squeaky” wheels. A shareholder’s input should not be proportionate to the volume with which the input is given.  While the squeaky wheel often gets the grease, it is prudent for directors and managers to solicit the feedback regarding the needs and preferences of quieter shareholders.  Asking for input from all shareholders through a systematic survey process helps ensure that the directors and managers are receiving a balanced picture of the shareholder base.  A confidential survey administered by an independent third party can increase the likelihood of receiving frank (and therefore valuable) responses. An engaged and informed shareholder base is essential for the long-term health and success of any private company, and a periodic shareholder survey is a great tool for achieving that result.  To discuss how a shareholder survey or ongoing investor relations program might benefit your company, give one of our senior professionals a call.

Over the past decade, we have been retained by several investment funds to assist them in responding to formal and informal SEC investigations regarding fair value measurement of portfolio investments. Reflecting back on those engagements yields a couple observations and reminders for funds and fund managers as they go through the quarterly valuation process.First, fund managers should recognize that valuation matters, and it will really matter when something has gone awry. To that end, we recommend that funds:Document valuation procedures to follow (and follow them). Since valuation requires judgment, disagreements are inevitable. However, are you following the established valuation process? In hindsight, judgments are especially susceptible to second-guessing if established policies and procedures are not followed.Designate a member of senior management to be responsible for oversight of the valuation process. Placing valuation under the purview of a senior member of management demonstrates that valuation is an important function, not a compliance afterthought.Create contemporaneous and consistent documentation of valuation conclusions and rationale. No valuation judgment is “too obvious” to merit being documented. On the other side of the next crisis, what seems reasonable today may appear anything but. The middle of an investigation is not the best time to re-construct rationales for prior valuation judgments.Second, it is important for fund managers to stay abreast of evolving best practices (or know people who do). Fair value measurement for illiquid portfolio investments is an evolving discipline. We recommend that funds:Solicit relevant input from the professionals responsible for the investment, auditors, and third-party valuation experts. Relying on appropriate professionals demonstrates that the fund managers take compliance seriously and are committed to preparing reliable fair value measurements.Check your math. In the glare of the regulatory spotlight, few things will prove more embarrassing than elementary computational errors. The proverbial ounce of prevention is certainly worth the pound of cure.Disclose the valuation process and conclusions. Just like potential investors do, regulators take comfort in transparency.The best time to prepare for a regulatory investigation is before it starts. Call us today to discuss your portfolio valuation process in confidence.Originally published on Mercer Capital's Portfolio Valuation Newsletter: Second Quarter 2017

Travis Harms, CFA, CPA/ ABV, Senior Vice President at Mercer Capital, recently published a blog post on Mercer Capital’s Financial Reporting Blogcontemplating the appropriate amount of cash for a company to hold.  This topic is especially pertinent to the oil and gas industry, in which 70 companies went bankrupt last year.  Now as companies have started to increase capital expenditures again, they must consider how much cash they should keep as a cushion while considering the effect of this low-yielding asset on value. When it comes to money, “enough” is the hardest word to define in the English language.  The challenge of defining “enough” extends to corporate managers deciding what cash balance is appropriate.Cash balances can provide a cushion against unanticipated adverse events in the business. The moment companies need cash is usually the worst time to try to raise capital.  Having sufficient cash on hand to weather an unexpected downturn in the business can help shareholders avoid dilutive capital raises at inopportune times.On the other hand, cash is a very low-yielding asset. Large allocations to cash weigh down the returns to invested capital.  If capital providers recognize the risk-reducing attributes of cash and reduce their return expectations accordingly, the effect of a large cash balance on value is probably negligible.  If, instead, investors view the cash investment no differently than any other capital allocation, and fail to reduce their return expectations, then a large cash balance will be detrimental to value. As shown in Table 1 above, investors provide debt and equity capital (the right side of the balance sheet), which the company then allocates to a portfolio of assets (the left side of the balance sheet).  The enterprise value of the business represents the “engine” that generates operating cash flow (of which EBITDA is often considered a proxy).  Since cash balances do not generate EBITDA, cash and other short-term investments are excluded from enterprise value. In the current yield environment, the investment return on cash balances is nil.  As a result, cash balances represent a drag on the weighted average return on the company’s assets.  In both private and public companies, minority investors do not have any direct control regarding the allocation of the capital they provide.  Corporate managers and directors need to evaluate the effect of large cash holdings on both the returns provided to capital providers and the required returns demanded by capital providers.  In the balance of this post, we examine data from public markets to assess shareholder preferences with regard to cash holdings. Summary of the DataWe examined data pertinent to this question for non-financial companies in the S&P 1000 at the end of 2016.  The S&P 1000 index is a combination of the S&P MidCap 400 and the S&P SmallCap 600.  At December 31, 2016, the companies in the S&P 1000 index had market capitalizations ranging from about $200 million on the small end up to approximately $10 billion.Table 2 summarizes pertinent data by industry. Measured as a percentage of market value of invested capital (MVIC, or the sum of equity market capitalization and total debt), median cash balances for the various industry groups range from a low of 0.4% for utilities, to a high of 11.1% for information technology. We considered a number of characteristics that may contribute to industries allocating more or less of their capital to cash.  The relationships between cash balances, capital expenditure intensity and expected revenue growth are not very compelling.  In contrast, as shown in Table 3, there does appear to be a degree of correlation between cash balances and beta.  Correlation is not causation, of course.  However, what the data does begin to suggest is that higher-risk companies tend to hold more cash than lower-risk companies (if risk is measured using beta). This observation is consistent with the risk-reducing properties of cash mentioned above.  Companies in riskier industries may hold more cash as a buffer against unexpected adverse changes.  While this is intuitive from the perspective of corporate managers, the question remains as to whether shareholders perceive value in the allocation of capital to cash. What is Cash Worth?Analysts typically calculate valuation multiples relative to enterprise value – in other words, on a “cash-neutral” basis.  The principal merit of this approach is the recognition that, all else equal, a company with greater cash reserves should be worth more than a company with lesser cash reserves.  This approach also recognizes that cash balances do not contribute to the generation of operating cash flow.  Implicit in this approach, however, is the assumption that shareholders give full dollar-for-dollar credit for cash held on the balance sheet.This is undoubtedly true at the time of a transaction for a private company, as purchase agreements inevitably include target working capital levels with dollar-for-dollar adjustments to the negotiated purchase price for excess or deficit working capital relative to the target.However, it is not necessarily the case that minority investors facing a potentially lengthy holding period have the same perspective. Such investors may view large cash balances as no more than negative net present value capital projects that diminish value. Table 4 below summarizes the two potential extreme positions.In the scenario on the left, investors assign the same enterprise value multiple to the high and low cash companies. This behavior is consistent with the notion that allocating resources to cash results in a corresponding reduction to the cash-hoarding company’s weighted average cost of capital.  In other words, investors value the risk-mitigating properties of cash.In the scenario on the right, investors are unimpressed by management’s ability to hold onto cash. Since return expectations are not modified by the large cash balance and the cash balances do not generate any material cash flow, the ratios of MVIC to EBITDA are identical for the two companies. In an effort to screen out potential noise associated with industry factors, we examined the data summarized in Table 2 further by industry to discern which of the two possibilities more closely reflects investor attitudes toward corporate cash balances.  In order to avoid unduly small sample sizes, we examined the four most populous industries (consumer discretionary, healthcare, industrials, and information technology).  We sorted the companies within each industry by cash balance (measured as a percentage of MVIC), dividing each industry into cohorts of equal thirds.  Table 5 summarizes key results for each industry. Consideration of the data summarized in Table 5 yields a number of observations. Within the more mature consumer discretionary and industrials segments, cash balances are unrelated to company size, as the revenue for companies in Cohort 3 (least cash) is comparable to that of the companies in Cohort 1 (most cash). In contrast, cash balances in the faster-growing healthcare and information technology segments are inversely related to company size.  The cash-rich healthcare and IT companies are approximately one-half the size of the low-cash companies in the respective industries.While differences in beta within the industry segments are modest, the observed data points are generally consistent with the relationship between risk and cash holdings noted with respect to Table 2. Perhaps cash balances are viewed as a counter-weight to greater operating risk.Projected revenue growth is inversely related to cash balances for companies in the consumer discretionary and industrials segments. For companies in the healthcare and IT industries, however, the companies with the highest cash balances have the highest growth expectations.  Perhaps in these industries, cash balances are perceived by investors as “dry powder” for future positive-NPV projects.While differences in expected growth obscure direct observations regarding the impact of cash balances on WACC, data for the consumer discretionary and industrials segments more closely approximate the right side of Table 4, suggesting that investors in mature companies are unimpressed with large cash balances. For healthcare and IT, the data is more closely aligned with the left side of Table 4, suggesting that investors view cash accumulation as a reasonable strategy in industries in which positive-NPV projects are presumably abundant.ConclusionOne of the primary tasks of corporate managers and directors is capital allocation.  While cash balances can provide a safety net that allows corporate managers to sleep better at night, for shareholders, the risk-mitigating benefit of corporate cash balances is balanced by the corresponding drag on returns.  Based on the market data summarized in this post, the perceived availability of positive-NPV projects seems to influence investor preferences regarding cash stockpiles.Positive-NPV projects are presumably abundant in higher-growth industries such as healthcare and IT.  For firms in those industries, investors appear more likely to view cash as “dry powder” for future value-enhancing investments, and are more willing to bear the cost of lowered returns until such investments are identified and made.In more mature segments such as consumer discretionary and industrials, positive-NPV projects are presumably scarcer.  The value of large cash holdings among firms in these industries seems to be discounted by investors.For corporate managers and directors, cash balances should not be treated simply as a residual, but rather actively evaluated in conjunction with the firm’s capital budgeting and distribution policies.  Cash may be king, but shareholders aren’t necessarily monarchists.

From the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. Dividend policy addresses both how much cash flow should be distributed to shareholders and the ideal form of such distributions. In the context of a family business’s life cycle, directors can use dividend policy to manage the company’s capital structure and tailor the form of returns to better match family shareholder preferences. Diverse shareholder preferences and characteristics can enhance the attractiveness of share repurchases relative to dividends; however, executing share repurchases for family businesses bring its own set of considerations and challenges. The purpose of this whitepaper is to help family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction. This whitepaper is the fourth in the “Corporate Finance in 30 Minutes Series.” Learn more about the whitepaper series below.Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.

Switching costs for capital investment are high and do-overs are expensive. A capital project is simply any use of the family business’s capital resources in the present with a view toward earning a return on that investment over time, and may take the form of acquisitions, capital expenditures, research & development, or other investments. Net present value and internal rate of return are the two primary tools used to determine whether the forecasted marginal cash flows are sufficient to justify the proposed project. However, a healthy capital budgeting process goes beyond mere financial feasibility to address the proposed project’s “fit” within the overall corporate strategy. The purpose of this whitepaper is to assist directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.This whitepaper is the third in the “Corporate Finance in 30 Minutes Series.” Learn more about the whitepaper series below.Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.

Capital structure decisions have long-term consequences for shareholders. Family business directors evaluate capital structure with an eye toward identifying the financing mix that minimizes the weighted average cost of capital. This decision is complicated by the iterative nature of capital costs: the financing mix influences the cost of the different financing sources. While the nominal cost of debt is always less than the nominal cost of equity, the relevant consideration for directors is the marginal cost of debt and equity, which measures the impact of a given financing decision on the overall cost of capital. The purpose of this whitepaper is to equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business. This whitepaper is the second in the “Corporate Finance in 30 Minutes Series.” Learn more about the whitepaper series below.Corporate Finance in 30 MinutesIn this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.

Corporate finance does not need to be a mystery.In this whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.Structured around the three key decisions of capital structure, capital budgeting, and dividend policy, the guide is designed to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make.Our goal with this whitepaper is to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion. This whitepaper is the first in the "Corporate Finance in 30 Minutes Series." Continue reading the whitepaper series below.Capital Structure in 30 MinutesThrough this whitepaper, we equip directors to contribute to capital structure decisions that promote the financial health and sustainability of the family business.Capital Budgeting in 30 MinutesCapital Budgeting in 30Minutesassists directors in evaluating proposed capital projects and contributing to capital budgeting decisions that enhance value.Dividend Policy in 30 MinutesFrom the perspective of family shareholders, dividend policy is the most transparent element of corporate finance. This whitepaper helps family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction.

This article was originally published in the October 2014 issue of ABJ Journal. Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge as a sustainable going concern. Once a petition for Chapter 11 is filed with the bankruptcy court, the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of businesses. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan which specifies a reorganization value and which reflects the agreed upon strategic direction and capital structure of the emerging entity. In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:1The plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding, which provides for a liquidation of the business.Upon confirmation by the bankruptcy court, the plan will not likely result in liquidation or further reorganization. Within this context, valuation specialists can provide useful financial advice in order to:Establish the value of the business under a Chapter 7 liquidation premise.Measure the reorganization value of a business, which oulines both the haircuts required of pre-bankruptcy stakeholders and the capital structure of the emerging entity. A reorganization plan confirmed by a bankruptcy court establishes a reorganization value that exceeds the value of the company under a liquidation premise.Demonstrate the viability of the emerging entity’s proposed capital structure, including debt amounts and terms given the stream of cash-flows that can be reasonably expected from the business.Liquidation ValueThe value of a business under the liquidation premise contemplates a sale of the company’s assets within a short period. Inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value.In general, the discount from fair market value implied by the price obtainable under a liquidation premise is directly related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would apply to cash and equivalents while real estate holdings would likely incur potentially significant discounts, which could be estimated by analyzing the prices commanded by comparable properties under a similarly distressed sale scenario.Reorganization ValueASC 852 defines reorganization value as:2“The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.”Reorganization value is generally understood to be the value of the entity that emerges from the bankruptcy proceeding under a going concern premise of value. Typically, the largest element of the reorganization value is the business enterprise value of the emerging entity. Reorganization plans primarily make use of the discounted cash-flow (DCF) method under the income approach to measure the business enterprise value of the emerging entity. The DCF method estimates the net present value of future cash-flows that the emerging entity is expected to generate. Implementing the discounted cash-flow methodology requires three basic elements:Forecast of Expected Future Cash-flows. Guidance from management can be critical in developing a supportable cash-flow forecast. Generally, valuation specialists develop cash-flow forecasts for discrete periods that may range from three to ten years. Conceptually, one would forecast discrete cash-flows for as many periods as necessary until a stabilized cash-flow stream can be anticipated. Due to the opportunity to make broad strategic changes as part of the reorganization process, cash-flows from the emerging entity must be projected for the period when the company expects to execute its restructuring and transition plans. Major drivers of the cash-flow forecast include projected revenue, gross margins, operating costs and capital expenditure requirements. Historical experience of the petitioner company, as well as information from publicly traded companies operating in similar lines of business can provide reference points to evaluate each element of the cash-flow forecast.Terminal Value. The terminal value captures the value of all cash-flows beyond the discrete forecast period. Terminal value is typically determined by capitalizing cash-flow at the end of the forecast period, based on assumptions about long-term cash-flow growth rate and the discount rate. In some cases, the terminal value may be estimated through the application of curr ent or projected market multiples.Discount Rate. The discount rate is used to estimate the present value of the forecasted cash-flows. Valuation analysts develop a suitable discount rate using assumptions about the costs of equity and debt capital, and the capital structure of the emerging entity. Costs of equity capital are usually estimated by utilizing a build-up method that uses the long-term risk-free rate, equity premia, and other industry or company-specific factors as inputs. The cost of debt capital and the likely capital structure may be based on benchmark rates on similar issues and the structures of comparable companies. Overall, the discount rate should reasonably reflect the business and financial risks associated with the expected cash-flows of the emerging entity. The sum of the present values of all the forecasted cash-flows, including discrete period cash-flows and the terminal value, provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of the expected business enterprise value of the emerging entity, plus proceeds from the sale or other disposal of assets during the reorganization, if any. During the reorganization proceeding, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigations. The confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a single range of reorganization values or a single point estimate. Bankruptcy courts may permit certain post petition liabilities to facilitate the operation of the petitioning business during the reorganization process. In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders (creditors or equity holders) in the restructuring entity. The reorganization value is the value of the total assets of the emerging entity and represents all of the resources available to meet the post petition liabilities, and allowed claims and interests called for in the confirmed reorganization plan.Cash-Flow TestIn principle, a confirmed reorganization plan should not lead to a liquidation or further restructuring in the foreseeable future. A cash-flow test evaluates the viability of a reorganization plan following the conclusion of the restructuring under Chapter 11 protection.The first step in conducting the cash-flow test is to identify the cash-flows that underpin the reorganization plan. Conceptually, these cash-flows are available to service all the obligations of the emerging entity. As a matter of practice, since the reorganization value is usually developed using the DCF method, establishing the appropriate stream of cash-flows is often straightforward. Valuation analysts then need to model the negotiated or litigated terms attributable to the creditors of the emerging entity. In practice, this involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. Finally, the cash-flow test also documents the impact of the net cash-flows on the balance sheet of the emerging entity. This entails modeling changes in the asset base of the company as portions of the expected cash-flows are invested in working capital and capital equipment, as well as changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.ConclusionManagers of companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities — evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders — while continuing to operate the business. For this reason, it is common for a company that has filed for Chapter 11 to seek help from outside third party specialists to formulate a reorganization plan that can facilitate a successful navigation through the bankruptcy court. Valuation specialists can provide useful advice and perspective during the negotiation of the reorganization plan. The specialists can also help prepare the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court.Endnotes1 Accounting Standards Codification Topic 852, Reorganizations ("ASC 852"). ASC 852-05-8. 2 ASC 852-10-20

In the two short years since Aileen Lee introduced the term "unicorn" into the VC parlance, the number of such companies has steadily increased from the 39 identified by Lee’s team at Cowboy Ventures to nearly 150 (and growing weekly) by most current estimates. Pundits and analysts have offered a variety of explanations for the phenomenon, with some identifying unicorns as the sign that the tech bubble of the late 1990s has returned under a different guise, others attributing the existence of such companies to structural changes in how innovation is funded in the economy, and the most intrepid of the group suggesting that the previously undreamt valuations are fully supported by the underlying fundamentals given the maturity and ubiquity of the internet, smart phones, tablets, and related technologies.We suspect there is merit to each of these perspectives. As valuation analysts, however, what sets our hearts atwitter is the very definition of "unicorn", which is predicated on valuation. Since companies are christened unicorns upon closing a financing round, one would assume valuation to be self-evident. Alas, that is generally far from the case. Because of the common features of VC investments, the "headline" valuation numbers are not reliable measures of the market value of the underlying enterprises. As a result, the frequent breathless comparisons of the value of startup X to publicly traded stalwart Y are often overblown and potentially misleading.Consider the following example. The capitalization of a hypothetical freshly-minted unicorn, BlueCo, is summarized in the following table: With 200 million fully-diluted shares post issuance, the $5.00 per share Series E offering results in a headline valuation of $1.0 billion (on a pre-money basis, BlueCo’s headline valuation is $825 million). But is BlueCo really worth $1 billion? In other words, what does the Series E investment imply about the value of the stakes in BlueCo held by other investors? The value of the whole is equal to the sum of the individual parts. So, for BlueCo to truly be worth $1 billion, all 200 million fully-diluted shares must be worth $5.00 each. But the various share classes are not created equal. At each subsequent funding stage, investors in startup companies negotiate terms to provide downside protection to their investment while preserving the upside potential if the subject company turns out to be a home run. Such provisions commonly include some or all of the following: Liquidation preferences that put the latest investors at the front of the line for exit proceeds. This is especially advantageous in the event the Company fails to meet expectations (basically LIFO treatment: the last one in is the first one out).Cumulative dividend rights that cause the liquidation preference to increase over time. When such rights are present, the preferred investors not only stand at the front of the line, but are entitled to a return on their investment if there are sufficient proceeds.Anti-dilution or ratchet provisions that allow preferred investors to hit the reset button on many of their economic rights in the event the company is forced to raise money in the future at a lower price.Participation rights that allow the preferred investors to simultaneously benefit from the payoff to common shares while also recovering their initial investment via liquidation preference.A recent New York Times article highlighted additional, more exotic rights and privileges being attached to recent financings. For the sake of illustration, we will assume that the terms of BlueCo’s Series E preferred shares are generally favorable to the other investors: pro rata liquidation preference to other preferred investors, non-cumulative dividends, and no participation rights. Despite these relatively benign terms, owning Class E shares is clearly preferable to owning more junior classes. Consider the waterfall of proceeds under various strategic sale exit scenarios: Even under the relatively disappointing $400 million exit scenario, the Scenario E shareholders are entitled to return of their investment, or $5.00 per share, while the proceeds to more subordinate classes range from $1.14 per share to $3.00 per share. The following chart depicts the superiority of the proceeds for Series E preferred shares to Series A shares over enterprise exit values less than $1.0 billion: The area between the payoff lines for Class E and Class A preferred shares represents the incremental value available to the more senior Class E shares. Borrowing from the fair value measurement lexicon, if the recent Series E issuance price of $5.00 per share is consonant with market participant expectations, then that same group of market participants would rationally assign a lower value to the Class A shares. Valuation analysts use two primary techniques for estimating the magnitude of the difference in share value across the various classes. Examining the relative merits of the two techniques (the probability-weighted expected return method, or PWERM, and the option pricing method, or OPM) is beyond the scope of this blog post. Both models are reasonably intuitive but require numerous assumptions for which irrefutable support can prove elusive. We use the OPM to illustrate the impact of the rights and preferences of the most senior preferred shareholders on the economic value of a nominal unicorn. The two most subjective assumptions in the OPM are the time remaining until exit and the return volatility of the underlying business. The sensitivity table below depicts the implied total enterprise value of BlueCo (that would reconcile to the $5.00 per Series E preferred share transaction price) using the OPM under a range of assumptions for exit timing, given assumed volatility of 100%: Over the range of exit timing assumptions noted above, the implied total enterprise value ranges from less than $600 million to just over $800 million, meaningful discounts to the $1 billion headline number. The reliability of the OPM and the assumed inputs can be debated; however the point remains that, since the subordinate classes are necessarily worth less than Series E, the total enterprise value is less than $1 billion. So what? Is the preceding analysis just so much valuation pedantry? Perhaps, but we suggest that these observations reflect one practical peril of high valuations for late stage investors and management teams. The implied enterprise value based on rights and preferences of senior investors is relevant precisely because buyers in the exit markets for start-up companies – strategic sales and IPOs – assess the value of the entire enterprise, not individual interests. The exit markets assign a value for the entire company, exhibiting a serene indifference to how that value is allocated to various investors. This can result in unflattering headlines and unpleasant outcomes for late stage investors. Let’s return to the BlueCo example to illustrate. Assume that the appropriate assumptions for BlueCo from the sensitivity table above are three years to exit, implying an enterprise value of $748 million. In the year following the Series E investment, BlueCo management executes its strategy successfully, causing the enterprise value to increase 30% to $975 million. If BlueCo exits via a strategic sale at that point, none of the incremental enterprise value will accrue to the Series E investors; despite identifying an attractive company, and the strong execution of management, the Series E investors will receive their capital back with no return. If the exit occurs instead by IPO, things get even more awkward. In contrast to a strategic sale, an IPO is a pro rata exit, meaning that the realized return for the Series E preferred investors will actually be negative, despite the 30% increase in enterprise value. Further, the Company and its management team will likely be subject to some unfavorable press for executing a "downround" IPO, although in reality, it generated a handsome return for the investor group as a whole. So when is a unicorn really a unicorn? We hesitate to draw a bright line; circumstances and assumptions vary. Regardless of size, the lesson for investors and management teams at early-stage companies is to beware the headline valuation number. Appearances can be deceiving.

With more than 35 public registrants reporting nearly $40 billion of assets under management, business development companies, or BDCs, are increasingly important financial intermediaries, matching a wide variety of businesses needing capital with yield-hungry investors eager to provide it.Compared to private equity funds, BDCs have historically garnered less media and investor awareness, although the persistent low yield environment has helped to raise the profile of BDCs. Like private equity funds, BDCs invest in a portfolio of generally illiquid securities of privately held companies. Unlike private equity funds, which are structured as finite-lived investment partnerships, BDCs are publicly traded vehicles accessible to retail investors, providing permanent capital for investment. As long as certain distribution requirements are met, BDCs are not subject to income tax. Like any other publicly traded company, a BDC must file quarterly and annual reports with the SEC. These reports provide a window into the trends and economic factors influencing the broader universe of investors providing debt and equity capital to middle market companies.The purpose of this whitepaper is to review the principal financial statement components of BDCs with a view to clarifying the factors that are most likely to influence financial performance.