On a cold, gray day in February, I received a phone call from a friend whose family owned a large privately held business that was embroiled in a difficult and acrimonious transition. Due to confidentiality, I am changing the type of business and the owner’s name.
John was calling to discuss the latest heated fights and problems among his siblings who were equal shareholders of his family-owned business. His father had built a successful manufacturing business that produced high quality parts for large automotive manufacturing companies. The company supplied a wide variety of unique component parts to GM, Fiat Chrysler, Ford, and others. The business was a tier two supplier in the automotive world. The company had a long history of profitability and strong sales for over twenty years. Each year, the company generated around $3 to $4 million in profit for the family.
The business was managed by John’s father and mother. Both worked full time in the business, with his father focusing on sales and manufacturing and his mother handling the accounting, human resources duties, and everything else.
As John’s father got older, he attempted to bring all his children into the business. Unfortunately, John had no passion for the manufacturing industry and instead became a successful dentist with a large network of dental offices in Michigan, Ohio, and Indiana. John’s two sisters did not last long in the business and left as soon as they were married to raise their families. John’s youngest brother, Tim, stayed working in the business in the engineering and sales departments, like his father, and clearly had the desire and capability to run the business.
About two years ago, John’s father had a severe stroke and required extensive home care. John’s mother spent most of her time at home taking care of him. It was not long before the company began to struggle, missing product deliveries, paying suppliers late, and missing bid submission deadlines. The company’s large, long-established customer base quickly eroded.
John told me he met with his mother and father, pleading with them to come up with an immediate transition plan that would allow his brother to take over the business. Unfortunately, John’s father was in no condition to provide any guidance and his mother wanted all her children to have an equal share of the business. She told John they had a will that would leave John and each of his siblings with an equal share of the business. She said it would be up to him, Tim, and sisters to determine how to move forward.
John’s father soon died, and his mother did not live long afterward. John and his siblings were now faced with a daunting task: how to proceed with the transition of the business.
Unfortunately, with John’s parents deceased, he and his siblings each now owned 25% of the business, which became a major contentious issue. Tim approached John with a plan to keep the business in the family and build it into a much larger and more successful business.
John sent me a copy of his brother’s business plan. It was a robust plan for recapturing the lost customers and expanding over the next two years. I sent a redacted version to a senior level colleague in one of the big three automotive companies. His reaction was positive and believed the plan was achievable and potentially successful.
John and Tim called a family meeting to discuss the next steps following the death of their parents. John took the lead in presenting his brother’s plan to keep the business in the family and continue to operate it and make it grow over the next several years.
Unfortunately, John’s two sisters and their spouses were adamant that the business be immediately sold. They wanted their share of the money out of the business as soon as possible and did not want to wait. According to John, over the next two hours a heated debate ensued. They left the meeting in two camps: John and Tim wanted to continue to run the business and make it more successful and their sisters wanted to cash out and would not budge on their desire to sell immediately.
Over the next several months, the arguments and fights among John and his siblings continued. Tim became so tired of the arguing and fighting and was unable to get either of his sisters to sell all or part of her shares to him. Finally, he quit working at the company.
Sales continued to decline, profits fell, loan payments could not be made, and the company defaulted on its bank loans. John and Tim attempted again to get their sisters to agree to some type of sale, but nothing changed. The company was forced into bankruptcy. The process was long and costly, and when it was finally settled, John and his siblings were left with nothing.
This unfortunate saga could have been avoided with the proper planning when John’s father and mother were still healthy and running the company.
Business succession within the same family diminishes with each future generation.
However, over the thirty years in which I have worked in mergers and acquisitions for buyers and sellers, I know how hard it can be for a business to be successfully transitioned to the next generation. Although there is no real hard data collected on the transition success of a family business from one generation to another, most of the data I have seen states that less than one third of family businesses are successfully transitioned into a second generation. Additionally, less than 12% survive and are viable into a third generation, and only about 3% are owned and operated by the same family in the fourth generation and beyond.
As you can see, the fact that John’s family business did not have a successful transition plan in place happens frequently, regardless of the owner’s good intentions and hopes for their family.
For this reason, this is the first of a series of blog posts that will provide insight and best practices on business exits, successions, and transitions for business owners. Although the focus of this series of posts will be from the privately held business owner’s perspective, the content, suggestions, and recommendations still apply and will be helpful to many CEOs and boards of directors of public companies.
As the Founder and CEO of a long-established upper middle market M&A firm, I have worked with a vast number of business owners who have faced many of the issues that each of you will face as you provide the leadership and make key decisions for your business and its transition to another owner.
John’s family business did not face any uniquely unusual challenges. Most family businesses struggle with governance, leadership transitions, and survival. Although I will review in later posts some family business transition success stories, the instances of smooth continuity, harmony, and longevity are unfortunately, often the exception rather than the norm.
John’s parents, like most successful and active business owners, were good at planning and managing their business, but they had not invested their time or energy in preparing for their succession as owners or ensuring the future continuity of their business.
It is also important to note how valuable family-owned businesses are to the U.S. and global economy. Several recent research studies show that family businesses comprise an estimated 80% of companies worldwide and are the largest source of long-term employment in most countries. In the United States, they employ 60% of workers and create over 70% of new jobs.
These are not just small or medium-sized businesses. In one-third of S&P 500 companies, 40% of the largest firms in France and Germany, and more than 60% of large corporations in East Asia and Latin America, family members own a significant share of the equity and can influence key decisions, particularly election of the chairman and the CEO.
The bankruptcy of John’s family company could have been avoided if his parents had taken the time to position the company for success after they were no longer running it. Their mistake was similar to many business owners in that they were working hard in their business but did not give priority to thinking about a long-term succession plan.
There is a clear course of action they could have taken to ensure their business would survive into the next generation. As we look at the overall family situation and what occurred, Tim was the only one of their children who had an interest and the potential capability to take over the business from them.
Their mother’s desire that each of the children receive an equal share of the money from the business is an admirable maternal objective and not one that prevents a smooth transition to Tim. There are many business transition strategies that could have been implemented to allow Tim to become the majority owner, while still paying his siblings for their shares.
One potential transition plan they could have employed is a leveraged recapitalization of the business. If they had worked with their company’s existing bank to re-capitalize the company with additional bank debt, there most likely would have been sufficient cash for Tim to immediately purchase his sisters’ shares of the business and purchase some of John’s shares. John and his two sisters would then receive cash for their shares in the business and Tim would thereby own all of the business after paying his siblings a fair market value for what they had inherited. Tim would be the new majority owner and have sufficient time to implement his new business plan, increase the businesses sales and profits, and keep the business going.
When I described this deal structure to John, he said he would have been willing to wait for a longer time to liquidate his shares or even be a joint owner with Tim. He said he wished that he had contacted me earlier, while his father was still in good health.
Leveraged recapitalization is one of the first options I would explore for John’s family business. However, if the bank would not loan the company the full amount required to purchase the siblings’ shares, there are other options we could consider. For example, Tim could offer to buy a portion of his sisters’ shares up front and then buy the rest later. If they were adamant that they wanted to liquidate immediately, he could pay them as much as possible from the bank recapitalization loan and ask them to accept a short-term loan for the balance. This often occurs in the sale of a business where the seller cannot come up with the total purchase price. The seller gives the buyer a short-term loan to complete the sale. This is usually a five-year term loan that is similar to selling a home on a land contract and is often called seller paper. As you can see, there are plenty of better options than bankruptcy.
If John’s parents had agreed to allow Tim to buy the company, they could have easily executed this transition. The first step John’s parents would take is to have a professional business valuation completed to determine the fair market value of the business. This would ensure John’s mother that each of her children would know the value of their 25% share of the business. Each child would receive their fair share of the business as she desired. This professional valuation would be used by Tim to get the bank to agree to a leveraged recapitalization. Once the bank is confident of the valuation of a business and its future plans for success, they will be more likely to make a loan to complete the share buyout.
I have found that it’s prudent to be very candid with the bank’s leadership as to the purpose of the loan. Most banks will be reticent at first to give you the loan because the funds loaned will be leaving the company and paid out to shareholders. However, once they understand that the business will be increasing sales and profits, they will become comfortable with the leveraged re-capitalized deal structure.
There are other exit and transition options that John’s family could have considered that would not have resulted in the demise of the company and sending it into bankruptcy. The primary transition plan covered in this blog post is the leveraged recapitalization. During my thirty years of experience as a senior level investment banker focusing on mergers and acquisitions, we have implemented a wide variety of exit and transition plans for business owners.
In future posts I will discuss other exit and transition options, such as steps to prepare for a successful transition of the business to the next generation, getting your business ready to sell, understanding the value drivers of your business and how to maximize them, finding a premium buyer who will pay a premium price, getting private equity firms interested in buying your business, identifying potential strategic buyers, and other related topics.
In 2021, I will be launching a podcast that will focus on all the key issues business owners face in deciding the future of their business and making a successful exit and transition out of their business. My guests will be second and third generation business owners, current CEOs who have managed large privately held businesses for the family owners, professionals who help assist private business owners, and other interesting guests. More details regarding the podcast will be provided in upcoming posts.
For more information about my background and the services we provide to owners, please visit our website at www.mfsib.com.
I would appreciate hearing from you and your comments on this post.