Business succession perspectives on private equity

Over the next ten years, it’s likely that no fewer than one-half of successful, privately owned businesses will have a transition of ownership. Some will give up minority interests for new investment, while many more will sell majority control or essentially 100% of the assets of their companies.

Equity partners of many varieties will play a significant role in how this occurs. Venture capital will continue to deploy into rapidly growing and speculative startups. Private equity will take significant positions in companies, majority and minority, that have established track records, and are within niches that fit their own strategic investment plans.

Angel investors, independent sponsors and other equity partners will play roles as well.

While equity financing is a source of vital capital to any business in transition, family-owned businesses have deeper considerations that dictate who might be a wise choice as an equity partner.

Ernst and Young and Kennesaw State University partnered to survey 1,000 large and mature family businesses. The survey revealed that emphasis on family cohesion and profitable business growth resulted in the most satisfactory matching with equity partners. But any time a third party comes aboard, the longstanding vision of the original owners begins a process of slow compromise.

The appropriate risk-reward analysis for current owners is how much control are you willing to let go of in exchange for the infusion of equity capital?

Private equity investors are typically strong value-adding partners. They are commonly motivated by the return on investment to be generated when they eventually exit the business after scaling and finding a tailor-made buyer. This is typically a process of years, years during which they are highly dependent on the management team that is already in place.

Especially with respect to a family owned business, it becomes very common to see private equity partners as if they perceive the business strictly as a financial investment, without regard to a deep understanding of the driving philosophy that shaped the business. It is very difficult to address what comes down to personality in the terms of a contract.

But that rarely overrides the inherent value a private equity firm brings in terms of market knowledge, management skill, enhancing enterprise value, scaling and other benefits that private equity firms bring to the deal

Private equity may target returns as high as 25% on an acquisition. The founders share in these returns but do so only after significant dilution of their ownership stake in the company.

Non-Control Equity

Because of their particular skill set for managing companies to scale, it’s less common for PE firms to participate without control over company decisions than it is for some other investors, but there is plenty of capital available today, that is not targeting the dilution of owners’ voting rights.

Non-voting equity investors typically seek returns of 10-18% on a mid-market company – considerably less than private equity. Of course, there is a trade-off here too. These “preferred” equity investors typically receive dividends regardless of whether voting partners are being paid returns or not. They have a legal priority for payment ahead of those who participate with a controlling equity interest in the business. Economically, it becomes a hybrid of equity and debt.

Owners should have a clear idea of what they are willing to exchange for financing before committing. Warren Buffet once lamented that exchanging equity along with control was equivalent to turning your business into “a piece of merchandise”. But then again, you might want to remember that Mr. Buffet has acquired more control equity than all but a few investors in all of history.  So he clearly sees something good in that type of partnership.

Conclusion

For a family-owned business, succession would be very simple if you could just hand over the keys to the next generation seamlessly. Things rarely work that way. Instead, the family business owner of today must reflect very carefully on what it is that will enable them to achieve their overall financial and non-financial, business goals. If growth, scaling, and maximizing returns are your primary objectives, a private equity partner can be the ideal fit.

But if retaining control over the direction of the business into succeeding generations is your highest objective,  you should consider other options. In this market, there are certainly opportunities to pursue either way. Seek the counsel of experienced advisors to help map out the best path for your own business.

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