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.