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 Supply

With 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 Consider

What questions should family business directors begin asking themselves about this trend? Let us suggest five:

1. 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?
2. 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?
3. 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?
4. 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.
5. 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.