KENNESAW, Ga. | Nov 11, 2015

Research indicates that as many as 86% of middle-market, privately owned businesses in the US are positioned to make a generational transfer. In anticipation, family business owners will be tasked to evaluate potential financing options to support the transition. Businesses uncomfortable with the risks of leverage will look to obtain an equity partner. Though equity financing can be a source of essential capital to any transitioning business, there are additional considerations when selecting the appropriate equity partner to aid in the continuation of a family business. In a generational transfer, preservation is at the helm of the handover.

In a recent survey of 1,000 of the world’s largest and oldest family businesses, EY and Kennesaw State found that those focused on family cohesion and profitable business growth were the most successful. Thus, it is no surprise that conserving status quo is a key objective of a business seeking a generational transfer. The complicated reality however, is that once an equity partner is engaged, owners often see the daily operations of the business and the long-standing vision of the company compromised –the primary objective of the transfer lost.

In the evaluation of equity financing options, the exchange of control for financing is what it all comes down to. How much is a founder willing to give up to preserve the family business? If preservation is key, is equity financing really a viable option?

Equity Options:

Traditional Private Equity

Private equity has the ability to offer a family business value-add in addition to capital. Since its returns are generated on exit, the private equity firm is highly motivated to grow the business and increase sale value. Value-add can come in the form of resources, managerial experience, and established industry relationships. Depending on the long-term goals of a family, private equity can provide a business with the required confidence to expand beyond its current limits.

With an ownership interest in the company, a private equity firm requires a considerable amount of control over a business. This often includes seats on a company’s Board of Directors and noticeable influence over internal decision making. In order for private equity to bring true value to a business, owners need assurance that the firm sees eye-to-eye with the family on corporate objectives prior to engagement- to avoid disappointment.  It is not uncommon for businesses with a private equity investor to feel as though they are being viewed purely from a financial standpoint; with little attention directed towards understanding key success factors and the driving philosophy of the business. For many owners, specifically those looking to stabilize capital structure, the investment timeline offered by private equity is not attractive. They will inevitably find themselves back in the private equity market to refinance, and timing may or may not be favorable.

The Economics

Traditional private equity can target returns as high as 25% on an investment. While not a monthly cost, returns enjoyed by a private equity firm cost the entrepreneur dilution of their ownership in the company. With this form of financing, the ownership position of the equity firm is consistent from engagement through until sale; often providing a “free ride” to the private equity firm who may or may not have played a role in the company’s success.

Non-Control Equity

Non-control equity operates on the premise that control over an investment is not required when returns are based on top-line results, and when returns are not dependent on an exit through a sale of the business. In this structure, returns are made based on dividends that are adjusted based on top-line results. This removes the need for the equity provider to actively participate in the business’ operations in order to monitor the bottom-line, allowing control and vision to stay with the owners. Non-control equity confidently relies on the ability of the family to successfully run the business it built, and in doing so, dispels its own need for decision making control.

Non-control equity financing is structured as a long-term partnership with the intention of forming a comparatively untraditional relationship between the family and the capital provider.  With an indefinite investment horizon, the need to repeatedly engage a new equity partner to replace the previous is eliminated.

When it comes to non-control equity financing, the caveat is that it is specifically designed for “old-economy,” high cash-flow, growth businesses; businesses that are already paying out distributions to the owners. If a business has too many demands on its cash flow, a cash-pay dividend model would not be the right fit.

The Economics

Non-control equity targets returns of approximately 15-16% on an investment- a full 10% less than traditional equity. In addition to a dividend reset based on top-line results, both the dividend’s growth and decline can be capped to ensure that the majority of the upside remains with the entrepreneur. The end result is a lower cost, non-control partner that is limited in growth participation and does not rely on a forced exit.

Depending on the stage of the business, owners and successors should evaluate both types of equity financing in conjunction with their immediate and long-term goals for the business. Traditional private equity can offer a company in generational transfer an established toolkit and may be able to offer a minority ownership interest. But owners need to have a firm idea of what they are willing to exchange for financing before committing. To quote Warren Buffett, when dealing with any equity partner that relies on an exit for its returns, “In effect, the business becomes a piece of merchandise.”

On the other hand, non-control equity eliminates the ongoing cycle of having to replace equity partners with the goal of forming a long-term partnership and providing ongoing access to capital. Should the family business preparing for generational transfer be a growth company with preservation as the goal, non-control equity may prove to be a viable financing option.

-Forbes.com