A brother and two sisters receive equal amounts of non-voting stock in their father’scorrugated box company after a 1980 preferred stock recapitalization. The siblings are constantlyarguing at board meetings and family reunions. The brother runs the company. The sisters are passiveshareholders who claim he refuses either to pay dividends or to repurchase their stock. They arelocked into an illiquid investment and have found no way out.
The founder of a chain of musical instrument stores in Southern Florida realizes his son isnot as business-oriented as his daughter, who manages the stores. The son is also a profligatespender. To protect his financial future, the father puts 50 percent of the business in trust for hisson, with his sister as trustee. After the father’s death, the sister controls her brother’s sharesalong with the 50 percent she has inherited. When she tries to restrain his spending habits, he bringsa lawsuit to remove her as the trustee.
Patrick and Paul, two cousins who have been the best of friends for 20 years, have built asuccessful business marketing a line of salsa and chili sauces. When they went into business, the twoTexans did not draw up any formal agreement, vowing that they would dissolve the partnership beforeever letting it come between them. Seven years later the friendship has dissolved instead, because ofa running battle over the behavior and performance of one of their kids in management. The cousinswant to part ways, but can’t figure out how to divide or sell the business assets without weakeningthe company.
Everyone in a family business will recognize that these types of ownership disputes are quitecommon. The examples are real, though somewhat modified to protect company identities. “The mass ofmen lead lives of quiet desperation,” Thoreau suggested. There is perhaps no better way to describethe feelings of family members who are isolated and unable to extricate themselves from suchsituations without a protracted, costly legal battle.
Often what happens is that the family member running the business, perhaps on the advice ofprofessionals, tries to buy out the dissidents or former partners with cash from the business. If heor she takes, say, $5 million in cash out of the business, however, it means that the company nolonger has $5 million to reinvest in new products and technology or needed renovations. Inevitably,such a buyout will have an impact on the future value of that business.
Most attempts to resolve such conflicts do not pay sufficient attention to the needs of the businessor the individual needs of the parties to the dispute. The result is that the conflict tends toescalate, and the impact of the conflict gets more serious. Typically, each party will first seekcounsel from either a friend or a professional adviser, who quickly becomes an advocate for his or herposition. After consulting their lawyers, one of them may be interested in buying out the other. Anoffer is made. Perhaps a valuation expert is called in. But frequently, the valuator is not even askedto explore the impact of the various buyout options on the business itself. Instead, the dispute landsback in the laps of the lawyers. The parties may bring in a mediator (or a judge may order them to useone) to seek a compromise. The mediator may help negotiate a settlement that is acceptable, if nottotally satisfying, to both parties. But rarely is an effort made to weigh the effects of the buyouton the value and competitive position of the company.
If mediation does not settle the dispute, the time has come to go to court. By now, however, positionshave usually been “set in stone.” Unless one party has clearly suffered an egregious wrong, no onereally wins in litigation, as lawyers are the first to admit. The parties may succeed in resolving thedispute, but money, time, and family relationships will be lost.
Our consulting firm has successfully used an approach to preventing this frustration and resolvingownership conflicts both before and after they occur. This approach brings the business into theequation, focuses the parties’ attention on reasonable options, and at the same time fosters anagreement that allows the company to remain competitive in its markets and to survive.
STEP ONE: ANALYZE THE CONFLICT
Disputes are rarely caused by poor business performance. Most often, they arise because individualowners perceive that their needs are not being met.
The first step in resolving ownership conflict is to understand how the conflict arose and why it hasnot already been resolved. If the problem is one of miscommunication, for example, it may be settledsimply by getting the parties together in the same room to talk. But frequently, the concerns godeeper than originally thought, and involve fundamental needs that are not being met. Passiveshareholders may want more dividends. A parent in one branch of the family has been lobbying for a jobfor a son or daughter but gets resistance from the in-group of managers who favor their own branch.Younger shareholders want cash to pursue their own career interests, but the company lacks funds toredeem their shares.
The objective of the analysis is to identify the unmet needs of both the owners and the business, andto begin a process of bringing the two into balance so that a viable settlement can be achieved.Increasingly, psychologists with experience in family business issues and university-based familybusiness centers are being asked to facilitate these discussions.
While the parties to a dispute initially say they are determined to prevail, they usually have abottom-line position. Most of them simply want to walk away feeling they have been treated fairly. Weemphasize “most” because a few of our clients have, in fact, shown little interest in fairness. In oneof our memorable failures, the two clients dismissed the proposed solution because it failed toinflict sufficient pain on the other.
Often the controversy is based on a misperception. For an illustration, think back to our first caseof the two sisters who were fighting with their older brother. The sisters argued that they had fewliquid assets. While the brother in charge of the business paid himself a substantial salary, they hadto live on other income. For the most part, the two “outsiders” knew little about the business beyondwhat their brother was willing to share with them.
Our analysis provided an independent evaluation of the firm’s current performance and growthpotential, and an explanation of what shareholders could expect to receive from the sale of some orall of the company’s assets, either then or in the future. As it turned out, however, the sisters werenot as worried about the lack of income or liquidity as they were about some of the older brother’sventures. They feared that the risk-taking brother they had grown up with was once again taking bigrisks—this time with their money.
The analysis calmed their fears. We concluded that the brother’s investments were prudent, andperforming rather well to boot. With that discovery, the siblings put down their weapons and madepeace. The plan that emerged redeemed the interests of the two sisters. The crisis was resolved by acombination of asset sales, a leveraged stock repurchase, and the formation of a self-liquidatingfamily partnership.
STEP TWO: FOCUS ON THE BUSINESS
The needs of a business are relatively simple. A business needs management and capital. The job ofmanagement is to deploy capital wisely and to ensure that the business is competitive. The needs ofthe owners are more complicated, and in many cases, conflict with the needs of the business. Theprincipal reason for the complication is that investments in private companies are not liquid. Givenliquidity, shareholders who disagree with the way a firm is being run, or with its dividend policy, orwho simply want to put money elsewhere, can sell shares and quickly meet their objectives.
In a privately owned company, there are many ways to create an income stream or a distribution ofcapital. The impact on the remaining shareholders, though, is almost always substantially greater thanit would be in a publicly traded firm. For this reason, it becomes critically important for theshareholders to come to the table as a group with someone qualified to serve as an independent andunbiased guide to the process. Whether the end result is wholly satisfactory to any one constituencyis relatively unimportant. The critical factor in a resolution is that all constituencies feel thatthey have been treated fairly.
To develop options for the family or shareholder group’s consideration, we try to get them to look atthe business from the perspective of a securities analyst, to examine it as they would any otherinvestment. Then we gather economic data on the company and its industry (as an analyst would), fromwhich we form an independent opinion about the competitive position of the business, its performanceand future prospects compared with peers in its industry group.
Out of this exercise, a number of things about the company may become apparent. On the one hand, itmay be that the business, as currently owned and operated, is no longer competitive. This couldsuggest that the owners have three choices: 1) get competitive (quickly); 2) get out of the business(quietly), or; 3) sit back and watch the business deteriorate (painfully).
If the company is poised for a rapid expansion, on the other hand, it will obviously have to reinvestits profits, and then some. The analysis might also point to mixed results within the company, wherebyone profitable business or product is subsidizing other, less attractive ones. In such cases, the lessprofitable businesses might be sold in order to raise cash to buy out dissident shareholders or set upa stock redemption fund.
If the business is to grow, a consensus must be built around expected cash flows and risk, and byextension, a central notion of value. We base our analysis on estimates for a firm’s revenue growthpotential, its normalized profitability (adjusted, if necessary, for family accounting peculiarities),and the level of investment required. This analysis sets the stage for considering alternative ways tomeet shareholder objectives.
STEP THREE: GENERATE AN ACTION PLAN
With a clearer understanding of why the conflict exists and what the expectations are for thebusiness, the parties to the dispute have a basis for generating an action plan for changing theownership structure. More often than not, this is done by an iterative process, in which various options are considered one at a time and either discarded or improved upon until the parties canagree.
In family owned companies, it is usually far easier to reach a consensus on business issues than onthe emotional issues. By valuing the business and demonstrating the impact of alternative strategieson the magnitude and timing of available cash flows, the family members develop realistic scenarios.Gradually a consensus emerges on what’s best for the business, and by extension, what’s best for itsshareholders.
For example, in many of the businesses we work with, current profits explain less than half of thefirm’s value. The balance of the value is attributable to expected growth in the future. A growthcompany that is reinvesting much of its profit in support of its growth and has to borrow in the earlyyears to fund the shortfall will still often be worth more some years later than a mature businessthat produces a stable return, requires no investment, and can therefore pay out all of its earningsto its owners.
For most private companies, capital is a scarce commodity. If capital is to be used to cash out exitingshareholders rather than for reinvestment, that will reduce the company’s growth-option value and,consequently, the value of the firm. Thus, when owners are carving up the pie, they must realize thatthe size of their slice depends on when and how they choose to take it.
STEP FOUR: ALLOCATE RETURNS FAIRLY
The next question is how to allocate the expected returns among the parties fairly, withoutundermining the business. The owners’ objectives must be categorized and quantified—and they must bereasonable. In many cases, the first two objectives can be met, but the third is elusive.
In one recent case, we were working with four equal owners of a business which, as then operated, hada value of approximately $20 million. At the outset of the engagement, it was clear that the ownerswere not getting along. It was unclear what any of the partners would settle for, but a lot dependedon establishing a price for the business.
First, we appraised the business as it was then owned and operated. We then made various adjustmentsto this model, based on market and industry data and alternative scenarios. This permitted the ownersto compare operating, investment, and financing alternatives. For example, the most clearlydisaffected of the owners argued, probably correctly, that the industry leader would be willing to paymore than $20 million for the company. However, two of his co-owners, who together controlled 50percent of the stock, did not want to sell. Accordingly, that option was tabled.
What, then, was the first shareholder’s next-best option? He could exit relatively easily if thecompany borrowed $5 million from the bank to redeem his stock. The bank was willing to provide themoney, but would not risk loaning more than that for a buyout if any of the other shareholders alsowanted to exit. At that point, the wishes of a second shareholder became a significant unknown. Ifthat shareholder wanted to be bought out, too, an investor would have to be found to fund thetransaction.
Strategic investors were not interested in investing unless they could obtain an option to buy theremainder of the company. Each of the financial investors who was contacted, moreover, had a returnrequirement of more than 25 percent, which exceeded the returns being generated by the company.
The questions continued to flow. How should these choices be viewed or compared? What were the otherowners likely to do? Remember that the size of the pie will vary with investment in the business (thegrowth option). A withdrawal of capital today might reduce the value of the firm by more than theamount of capital withdrawn. A substitution of new capital for old, from either a bank or a newinvestor, might result in an unbalanced allocation of returns between the new investor and theremaining investors.
Here we showed that with $5 million less capital available for investment, the value of the businesswould shrink to $12 million. Buying one brother out at $5 million would leave each remainingshareholder with only $4 million of value. When this was understood, the brothers were able to reach acompromise figure of between $4 million and $5 million that was fair to all concerned. To avoidsimilar disputes from occurring, moreover, the three remaining shareholders took the occasion to reachclearer agreements on future stock transfers in their estate and succession plans.
SMALL STEPS TO GREAT LEAPS
The techniques involved in ownership conflict resolution must balance an understanding of the businesswith the requirements of the capital markets and the needs and objectives of the owners. Financialmodeling can answer some key questions, but only when combined with scenario planning does it emergeas a powerful problem-solving mechanism. A closely held business is an immensely flexible vehiclewhich, in most situations, can be restructured to meet the divergent needs of its owners.
Win-lose mindsets tend to focus on dramatic outcomes. Within a family business, smaller, practicalsteps are possible, and usually far more desirable. Among the strategies that can be employed toresolve disputes are: the split-off of a business unit or a piece of real estate; the gradual creationof a fund for share repurchases; a family leveraged buyout; or the creation of a family limitedpartnership to reallocate returns.
A neutral party obviously can be helpful in articulating the impact of various strategies on thebusiness and to the parties in an ownership dispute. A knowledgeable facilitator is particularlyimportant when some owners are involved in the day-to-day management of the business and others arenot. Very often the “outsiders” have far less business experience than the “insiders.” The outsidersmay even believe the insiders are withholding information from them. The presence of an objectivethird party who listens to the outsiders’ views and answers their questions helps to build trust andconfidence in the process.
Similarly, if outside financing is essential to resolving the dispute, the parties may want anunbiased professional to represent them in discussions with lenders, investors, and other financingsources. Finally, when the elements of a plan begin to take shape, each of the parties shouldunderstand the tax impact of the resolution. While this may require them to share some confidentialinformation, it is nonetheless essential to consider the tax consequences of any agreement to resolvethe dispute.
CONSIDER THE ALTERNATIVES
By this point, you may have concluded that the process we’ve described is too complicated or simplytoo demanding to pursue. But consider the alternatives. Without a thorough exploration of possiblescenarios, the choice is between the maintenance of the status quo or an escalation of the conflict.
So long as the needs of the business and the needs of its owners can be met, conflict can in mostcases be avoided. Most of the time it can be prevented by means of good ownership planning. Onemother, for example, told us that she wanted her husband to arrange his estate so that no shares inthe business were left in her name. Their children would then own and run the business. She didn’twant to depend upon the children for income or to get into business arguments with them. “They haveworked well with their father,” she said, “but I don’t want to be in business with my children, and Idon’t want to have to serve as a mediator in their fights.”
Another business owner agreed to forego investing in his company for a time—in effect, letting thebusiness shrink in size—in order to finance a buyout of his cousins. His said about the settlement:“Life is too short. The business will be smaller, but I’ve grown it before and I can grow it again,and, this time, the risks and the rewards will be mine.”
When conflicts do surface in a family business, there are usually alternatives to costly court battlesand the bitter feelings that are left in their wake. Life is too short not to consider thosealternatives.
Ross Adams and Patrick Ring are principals of The Baker-Meekins Co., a Baltimore-basedcorporate financial advisory firm specializing in family business strategies and ownership conflictresolution.