A five-member panel convened by Family Business agreed there is plenty of private capitalaround these days for family companies wishing to finance succession or take a leap to the next levelin size. The range of options can, in fact, be a little bewildering. Commercial banks provide workingcapital, and some do private placements. Many firms offer venture capital, sometimes in combinationwith a public offering. Others specialize in “mezzanine” financing, or subordinated debt. Smallerlenders and investment firms are popping up all over the country.
For our panel, we selected five whose firms are representative providers of long-term debt and equityfinancing. They met at the offices of United States Trust in Manhattan and talked for three hoursabout the market for capital in general and what family owned businesses in particular have to do toqualify for it.
Dirk R. Dreux IV of U.S. Trust moderated the panel, which included Harvey A. Mackler, a provider ofasset-based financing; Michael Carter, director of a regional investment bank in Connecticut; DonaldP. Remey, who specializes in supplying mezzanine financing for small and mid-sized companies; andThomas L. (Tad) Kelly II, a provider of private equity capital for closely held and family ownedcompanies.
Today investors have much stricter standards than they did in the deal-hungry Eighties, and businesseswith under $10 million in revenues still have a hard time attracting their attention. Nevertheless,there is lot of capital chasing deals and much of it is moving “down market” in search of qualifiedtakers. The discussion reveals much about how investors and lenders view the strengths andweaknesses of family firms, and should therefore be interesting and useful to all owners.
—The Editors
Dirk R. Dreux: As professional investors and advisors, what do you look for in a company?
Michael Carter: We become interested when management and the owners are passionate and 100percent focused on building the business. If they view their business as a job and not something thatabsorbs them 60 hours per week, we tend to lose interest.
Donald P. Remey: Michael is right. In today’s world, you need dedication and the willingness tospend long hours in order to survive and grow. But I would add one element: flexibility. We find thatsome people are so focused that they can’t adjust to market conditions and take advantage of newopportunities.
Harvey Mackler: As a debt player, our concern is more short term than all of yours. Our firsttask is to get repaid. When it comes to management, the first thing we look for, as we all learned inbanking, is character. That’s the first test. The second requirement for asset-based loans is adequatecollateral. We also look for other ingredients, such as their ability to keep the ship going rightand, as Don said, their ability to react to different market conditions.
Tad Kelly: We look at three things: The first is management, because, as an equity investor,unless you are prepared to be there every day you have to rely on management to add the value to thebusiness that you need. Second, the business has to have what we call a “defensible market niche.”Third, that business needs to be in an industry that has attractive growth and/or profitabilitycharacteristics. The analogy I sometimes use is to a world champion surfer: If he goes to a beach thathas no waves, it doesn’t make any difference if he’s a world champion.
Dreux: Mike, do you look only at industries with big upside growth potential?
Carter: The quick answer is no. In fact, we have worked with businesses in industries that areconsolidating and shrinking. We will back sensational people if their business can consistentlyoutperform their peers in the industry. In general, we seek businesses that are in the top 10 percentof their market.
Remey: Consolidation is a growing trend. Technology is driving that and making a lot ofefficiencies possible in industries that were previously family owned and very fragmented.
We’re involved in two particular cases. One that’s been around a long time is the garbage and trashbusiness, which has more efficient fleet management and routing because of new technology. The othercompany we invested in is a consolidator of ambulance services. It is a mature but growing business.Technology has had a tremendous effect on the economics of the business.
Dreux: I was in the oil and gas business during the mid-’80s, and that industry was, well,almost untouchable given the decline in commodity prices and the huge losses that the banks andinvestors took. Are there any businesses now that investors won’t touch?
Remey: Franchise businesses, because of the short time horizons and very localized nature ofthe business. A number of years ago we took a hard look at a number of franchisees and franchisors. Wecame to the conclusion that they couldn’t get big enough and the economies of scale weren’t there toattract our kind of capital.
Dreux: Do family owned firms have any special characteristics that would prevent you fromfinancing them?
Carter: Oh, definitely. Our very first step in financing is to look at the business owner’sobjectives. If they are not clear and focused, we pass. We recently were presented with a situation inwhich three different generations had three different sets of objectives. Clearly, that was not afinancable situation. So the business objectives have to line up, and with two or three generations,they rarely ever do.
Remey: Whether right or wrong, we have a bit of a bias against businesses where you have ahusband and wife or siblings involved. It makes a business somewhat less attractive because it reducesthe control and flexibility of the owner-entrepreneur. If there is a problem, you can’t fire someoneas easily as you can in another business.
Kelly: The family part of a family owned business can either be a great positive or a greatnegative. When we are looking at a family company, we do two sets of due diligence that are completelyseparate: One is on the business itself, and the other is on the family. Both of them have to come outwith a clean bill of health for us to move forward on the deal. That is part of what makes investingin this market a little trickier.
Mackler: Other than pure industry issues, personal problems are the largest single cause ofthe demise of businesses. And family just complicates the matter because, as Don said, it’s toughfiring your son or daughter or your spouse. Fortunately, we don’t worry about it as much going in [toa deal] because, as a debt player, we have priority over the equity investors.
It’s hard to generalize, but, you know, owners of family businesses are tough to communicate with attimes. You can’t tell them what they don’t want to hear.
Dreux: Does your due diligence include looking for a succession plan?
Mackler: We look at management succession first. What is the backup management? Who is here torun this company? We encourage families to retain control of ownership, but that is a two-edged swordin our business. The kids come along and say, “We have a better way, a better idea.” And the first“better idea” is to find a new lender!
We sometimes get stuck in the middle between a parent and child, two siblings, an uncle and nieceover who has the “right idea” or knows the “right way.” It’s difficult, but, again, as a secured debtplayer it’s not as big a concern going in.
Dreux: How do you do your due diligence?
Remey: We adopted a policy a number of years ago of not closing a deal until an outside privateinvestigator has looked into the backgrounds of the principal owners and officers of the business.Only one company has objected so far, and, in that case, we stepped away from the deal.
But most of the checks are financial and legal. Have these people been involved in any kind offinancial problems, in bankruptcy? For example, we discovered that one business owner had run up over$100,000 in credit card debt and walked away from it after the 1987 market crash. In another case, wefound in a background check that the manager of one of the properties had been charged with sexualharassment.
The second aspect of our due diligence is talking to as many people as we can about the company. Weask for a list of references, but that is just the starting point. We use that reference list to findout the names of other people who know the company.
One of the questions that I always ask management early on is: “We are going to investigate you andyour company in detail. Is there anything that, if I had unlimited time and perfect information, Iwill find out that you should explain before I find it?”
That question tends to smoke out certain things that business owners would prefer that I hear fromthem rather than somebody else.
Dreux: How about asking the hard questions about relationships between husband and wife, or afather and son, or two brothers? For example, “Who is in charge here?” “How do you guys get along?”“Is there any bad blood?”
Remey: We are very direct about it. We ask for specific examples of where there was disagreementand how it was resolved. We like to hear some stories on that. Sometimes we find out a lot about theway problems are handled in the business by going out with sales people or visiting withcustomers.
Carter: As intermediaries, we don’t go through quite the exercise that Don does but arecertainly thorough in asking the relevant questions. We look for a documented history ofaccomplishment. For example, we once investigated a 24-year-old fellow; he was the number one salesmanon his newspaper route. That is an early indicator of a successful entrepreneur. Usually, successfulentrepreneurs have a long list of accomplishments. Secondly, we try to figure out what drives theprincipals. What they tell you over the phone is what they you want to hear. So you have to be cleverenough to learn what motivates the person running the business.
Before we bring a transaction to an institutional investor like Don, we also make sure the person hasa very high level of integrity and a credible business plan.
Kelly: The gestation period for investing in a closely held or family business is quite long.It can last years. And we have all pursued transactions for years that didn’t get done because ofcertain family business issues.
We spend a great deal of time doing blind interviews with suppliers and customers of the company.Within the company, we talk to a lot of lower-level employees in addition to senior management. Youfind out a great deal about what the company’s principles are, whether there is a good culture there,and where the tensions are.
A simple technique is to ask different people the same question and see if you get the same answer. Wedo that up and down the organization. For example, we ask people, if they were running the business,what they would start doing, what they would continue doing, and what they would immediately stopdoing.
Dreux:Private equity capital is exploding and there’sbeen tremendous growth in the number of equity investors. You have to come “down market” in order toput all that capital to work. Yet, at the same time, investors’ cost structures make it prohibitive todo business with smaller companies. We have real contradictory forces at work here.
Carter: That is where investment banking firms like ours add significant value. By screening,packaging, and structuring financing opportunities, we “tee up” smaller transactions for institutionalinvestors. We eliminate a significant cost for these investors and make it easy for them to come to aquick yes or a quick no.
There is a tremendous amount of capital available, but for the most part, the smaller companies don’tknow how to access it. They don’t know how to go about seeking introductions in a professional manner.Investors are seeking high-quality transactions but are having a hard time finding them. This puts acertain type of high-quality, emerging-growth company very much in demand.
Kelly: There is a lot of money chasing a smaller number of transactions. We are seeingmultiples go up in this environment. I don’t think we’ll get back to some of the crazy things thatlenders and equity investors did in the late ’80s, but these capital providers are struggling to staywithin the stricter parameters that they set for themselves as a result of their experience duringthat period.
However, it’s important to put the abundance of capital in perspective. At least on the equity side,the majority of capital that has been raised is not even looking at the bulk of the family businessmarket. Studies have shown that 90 to 95 percent of closely held, family businesses have between zeroand $25 million in revenues. And this new capital has all been raised to look at $50 million, $100million, $200 million sales companies. The quality of a firm that is doing only $2 million in salesreally doesn’t matter; it is going to have a tough time attracting capital. Unfortunately, it’s assimple as that.
Carter: We are seeing niche private equity pools developing. Some of the new funds that havebeen developed are more focused than before. So you will find funds focused on family businesses, ormedia properties, or some other specific niche in which they have a track record. But I agree withTad: It’s so much easier to raise a $5-million than a $1-million equity placement. There should be alot more cheering for those who can raise $1 million. There are fewer players for small transactions,but they’re out there.
Remey: I would urge smaller businesses to develop relationships with local, smaller boutiques,which can be found in every city in this country. This is an advertisement for Michael’s type ofbusiness—the local boutique investment banker and financial advisor. We have a database of thousandsof them, because they are the people who bring us the deals.
Carter: We just closed on a transaction that provided $3.5 million in expansion capital for acompany with $2 million in revenues. Number one: We lived with that company for two years before wegot comfortable with them—which doesn’t make economic sense unless you are a local investment bankwith a long-term horizon. Number two: We took their business plan, ripped it apart, and put it backtogether again.
Dreux: They paid you for this, right?
Carter: Of course, but because they did not have any capital, we took most of our retainer inequity. Just as important, after the transaction we were on retainer for one year to assist thecompany in building value, introducing them to key strategic alliance players, and exploring potentialacquisition candidates.
Kelly: I think what we’re saying here is that the smaller the business, the more important itis to have a referral that will ensure that the company gets attention from potential investors. Iwould urge smaller businesses to use their advisors, their accountant or lawyer, for example, to helpthem reach prospective capital sources.
Remey: The good news is that there’s so much money around, and people will find it. To manyentrepreneurs, however, the cost of that capital sounds outrageously expensive. I mean, we are talkingabout over 20 percent a year compounded for five years—it is a big number. And these numbers are verydifficult for small businesses to generate. Yet that is the price of equity money. In fact, forsmaller amounts, the cost of capital is even higher, because the investor is taking a greater risk andthe transaction costs are high.
Kelly: Small businesses have to be realistic about the availability of capital for them. That’sthe best way to start thinking about how they can ameloriate their situation.
I had someone in my office the other day who is a running a $15 million-sales business that he startedfrom scratch. He had been looking around and seeing a lot of public companies with annual sales of $50million and $75 million. This guy was in a hurry to grow, and he came to me because he wanted to findout how to put a multiple on his earnings stream.
By the end of our discussion, he concluded that his situation was a pretty good one and that he oughtto relax and enjoy it. He was making a good living out of the business. He didn’t have to deal with alot of contentious ownership issues. The business was growing slowly but surely over time. I think Ihelped him realize that he should just keep doing what he is doing instead of being in such a hurry tomake something dramatic happen from a corporate finance or mergers-and-acquisitions standpoint.
Dreux: So in looking for companies that have the proven ability to get to the next level, youoften help owners to take stock of what they’ve got. They might find that it’s okay and they don’treally want to do what’s necessary to get bigger.
Kelly: Absolutely. One of the questions that I posed to this owner was: “Let’s say somebodycomes along who wants to buy your business. What would you do after you sell it? How much of yourday-to-day pleasure derives from just going to that business and running it and interacting with youremployees and customers, and so forth?”
People need to take stock and realize there’s a lot of psychic income from running a family ownedbusiness, whether it’s large or small.
Mackler: Small business owners have to review their objectives first; then they can figure outwhat kind of capital they need. Tad made his friend realize: “You’ve got a $15 million business,you’ve got a great life. What more do you want?” Now that might be the right answer for that person.But another owner may have a different objective.
If you’re thinking about selling the business, you are talking about capital for a sale as opposed togrowth. Then you have to deal with estate planning and the family control issues. Do I want to sell itto my children or to outsiders? How loyal am I to my employees. We all know that if you sell it to aninvestor, many people may eventually be cut. Would you rather sell it at a more moderate price tosomeone who will keep the people loyal to you?
Do I want freedom and independence? Or am I willing to give up some control [to an investor]? Theseare all questions that family business owners have to answer first. Then they can figure out whereeach of us [on the panel] fits in.
Dreux: What advice would you give family business owners about how and where to professionalizetheir companies? Where should they put most of their time and energy? My experience has been that theyare weak on the finance and administrative sides. They are also weak in the whole human resourcesarea; it is a huge minefield full of issues such as lack of job descriptions, wrongful dismissals,sexual harassment.
Mackler: The first thing we tell them is to surround themselves with good people. And thesecond thing we tell them is to listen to those people. Sometimes the very qualities that make peoplesuccessful entrepreneurs prevent them from listening to what you tell them.
Carter: First, we believe it is critically important to correctly motivate your key people. Wetry to work with them on compensation-incentive plans to ensure that the key people act like owners.Most of the time that involves giving them equity. In many situations we advise management tocreatively incentivize key people, because we are very concerned that a key scientist or a keymarketing person will leave for another $10,000 or $15,000. Second, we are not big believers inurging companies that don’t have a CFO to hire one. However, we believe that for a certain type ofemerging growth company, investing in a quality CFO will pay for itself in multiple ways.
Dreux: Define what a CFO can do in a $5 to $15 million company. In my experience with familybusinesses, the CFO is really an ex-accountant performing a controller type of function.
Carter: The position should be more than a controller. A CFO can bring financial discipline tothe company. The person can supply numbers that shed light on such questions as, Why spend a dollarhere rather than there? Why make that capital expenditure? Why invest time in this relationship orthat strategy?
The CFO should build the company’s systems to stay ahead of the growth curve. He or she takes a lot ofthe less productive tasks off the shoulders of the CEO, so the boss can stay focused on what is reallyimportant and driving the business forward.
With regard to the bigger picture, owners should spend time developing a mission and a strategic plan,so they can articulate for investors, employees, customers, and vendors where they are taking thecompany and why anyone should invest in it.
Remey: You have to view this from the standpoint of a business’s life cycle. The needs ofcompanies change as they grow. Certainly, a small business with under $5 million or $10 million inrevenues can’t afford a lot of overhead. When do you add that higher-priced CFO? When do you hire adirector of marketing, as opposed to putting another salesperson on the street? Businesses that aresuccessful identify the need for a higher-level employee as they grow. Adding people at the right timecan make a huge difference in pushing you forward. When you don’t do it, it can hold you back.
Letting go is another big issue in entrepreneurial and family businesses. As Harvey says, having goodpeople around you—and listening to them—is one of the hardest things to do. It is not just letting goyourself but letting other people go who can add value to your business.
Kelly: One indication of whether the entrepreneur is going to listen is whether there is aboard of directors or a board of advisors already in place. Whether they will listen to a board isanother question, but if they at least have one, it suggests they have realized there is some value inoutside advice.
Related to that and equally important is the management succession issue. Every business has to lookvery carefully at its key positions and ask the question: “What happens if that person gets hit by abus?” Smaller businesses that can’t afford to have a bunch of extra people sitting around have a hardtime addressing the “hit-by-the-bus issue.”
You don’t necessarily have to have a replacement for each manager within the business. But you shouldhave a plan for recruiting one in an emergency. If you have anyone in the company who is consideredcompletely irreplaceable, that is a risk factor. For an investor, it raises a red flag.
Dreux: A lot of people don’t know what it costs to work with different types of capitalproviders. No one likes to quote prices, I know, because every deal and every situation is unique. Butcan you give me some idea of your pricing?
Remey: Let me see if I can describe a framework and put each of our types of capital into it.At the senior debt level, Harvey’s level, you are looking at an interest rate related to prime or someother floating rate, plus fees, plus some balances. In today’s market that probably gets you up in the11 percent to 12 percent area.
We are in the mezzanine sector, which is subordinated debt. Historically, and today, the rate tends tobe in the high teens up to the low 20s. And equity capital’s expectations tend to be higher thanthat—25 percent and higher.
It is terribly important that small businesses understand the cost of capital. The money that goesinto these businesses has alternative places to go. Over the last 10 years, for example, the stockmarket has provided a return in excess of 15 percent. We don’t get funded unless we get competitivereturns. Not because we are greedy, but because we are in competition with other parts of the capitalmarket that fund our business.
Carter: Our pricing includes a retainer, a success fee, and a post-closing monthly retainer incertain situations. We believe in getting paid for results, and we make every effort to line up ourcompensation with our client’s objectives. In general, the success fee is 1 to 2 percent for debt, 3to 4 percent for mezzanine, and 5 to 8 percent for equity.
Kelly: We are looking for a compounded annual return of 30 percent. There is no interest rateon our investment. We are investing side by side with the entre- preneur or the family or themanagement team. Furthermore, we bring more to the table than just capital. We have expertise withinour firm that a small business could not afford to have in-house.
Dreux: What sorts of expertise?
Kelly: Besides corporate finance and mergers and acquisition expertise, we help owners andmanagement think through potential growth opportunities. My partner has spent his entire career inmanagement consulting, working with companies to develop market-entry strategies and enhance theirproductivity and throughput.
Having said that, rarely do we find that the owners and managers are not aware of opportunities intheir company and/or industry. What they have a difficult time doing is prioritizing them. We helpthem do this: In a world of limited resources, where do I put my first buck? Where is the low-hangingfruit?
They are so busy running their business day to day that they don’t have time to do the work necessaryto prioritize these opportunities. Contrary to the popular conception, we find that most closely heldand family owned businesses are actually quite lean. In general, they are not a bunch of fat companieswith a lot of family members on the payroll.
Dreux: What about the issue of control? Many business owners don’t like to be told what to do.They worry that you will get too involved and tell them, “Joe, you really need a CFO, or you have todo this or that.”
Kelly: Yes, the further down in the capital structure you are, the more influence you are goingto want to have. As an equity investor in businesses, we really are partnering with the owners and themanagement team. We therefore expect to have a commensurate say in the running of the business.
We are not that sensitive about having voting control. We are willing to take minority positions inclosely held businesses. While we may not have voting control, however, we do expect to have input onkey strategic decisions in the company. It is usually the business owners who are most open to outsideadvice that make the best investment candidates.
Remey: Our objective is to have this business become as successful as it can be. Our degree ofinvolvement and advice is to get the company to that goal. If the family owner views our advice(whether as a director, investor, or lender) as helping him to get to that goal and he internalizesit, is that control or is that help? It is control if he disagrees with it.
Dreux: What happens if they disagree?
Remey: Early on, I tell people we invest with that we will disagree on certain things. What Iwant from them is healthy, open, rational discussion of the pluses and minuses of what they want to doand why they want to do it.
My wife may disagree with that because she thinks I feel I always have the right answer! But, youknow, in any kind of discussion there is very often not a right and wrong answer. So at the end of theday I will support their decision if there has been an open discussion. If they are wrong oftenenough, however, I will want to have some way of replacing them. And that is where control reallybecomes an issue.
The Panel: Five Who Finance Family Companies
Michael Carter is managing director of Carter & Company, a “boutique” investment firm based inSouthport, Connecticut, which specializes in raising capital for entrepreneurial businesses, mergersand acquisitions, and business valuation.
Dirk R. Dreux IV (moderator) is director of Private Business Advisory Services for United States TrustCompany in New York and an advisor to many family companies.
Thomas L. Kelly II is a general partner of CHB Capital Partners in Denver. His prior experienceincludes over 10 years as a principal investing with the Bass family, Richard Rainwater, and relatedentities.
Harvey A. Mackler is executive vice-president of Gibralter Corporation of America, a subsidiary of UJBFinancial. The firm has provided asset-based loans of $1 million to $30 million to businesses, most ofwhich are family owned.
Donald P. Remey is managing director of BCI Advisers Inc. in Teaneck, New Jersey, which providescapital just above the equity level —so-called “mezzanine” financing. Over the last 12 years BCI hasinvested in 70 companies in a wide variety of industries.