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Family Business Management - Drucker's Rules Part II

Robert Swaim, contributing writer of the Drucker Files for the past two years, teaches a Master of Business Administration course Advanced Certificate Program in Executive Management based on Father of Modern Management  Peter F Druckers 60 years of writing, teaching and consulting.

Last month's article dealt with Druckers Rules for Family Business Management. Part Two deals with the Exit Strategies and Management Succession in the Family Business.

Research on Owners of Private Businesses

Several years ago, a leading accounting and consulting firm conducted a study of owners of private and family-owned businesses and discovered the following.

• They don t know the businesss value: 65 percent of business owners do not know what their company is worth. In other words, they are unaware of the fair market value of their business and what they could get for the business if selling the business is an exit strategy alternative they might consider. Knowing the value of the business is also important if the owner is considering other exit strategy alternatives, such as passing the business on to family members.
• They have no exit strategy or succession plan: 85 percent of business owners have no exit strategy or succession plan. The owner has not given any consideration to how or when they will eventually retire and who will take over the management of the business. This is often attributed to their reluctance to accept their own mortality   they will live forever, and the fact that their personal identity is intertwined with the business  they lose their identity if and when they leave their business. Also, many owners are unable to  give up their baby, similar to the father s concerns when their daughter gets married and he must give the bride away at the wedding ceremony.
• The majority of the owners net worth is in the business: 75 percent of the business owners net worth is tied up in their business. There is a prudent rule that suggests that not more than 20 percent of an individual s personal wealth should be tied up in any one investment. Obviously, most business owners have disregarded this rule. Having equity in the business is all well and good, but how does one convert this into cash for ones retirement?
• They have no personal financial and estate planning: 25 percent of senior generation owners have not done any estate planning to minimize their taxes or worked out how to convert the equity they have in their businesses into personal wealth and liquidity. It is one thing to pass the family business on to a son or daughter, but in so doing, how does the father get compensated for the work he put into starting and growing the business over the years?

Six Exit Strategies

"You develop an exit strategy the day you start the business."

-Richard Rodnick,

founder, former chairman, Geneva Companies

Richard Rodnick, founder and former chairman of Geneva Companies, a merger and acquisition firm in the United States, has a rule that the time to develop an exit strategy is the day you start the business.

As an example of practicing this rule, Rodnick had an exit strategy that he would sell Geneva Companies five years after he started it. He sold the company to the Chemical Bank of New York for in excess of $30 million.

Some would argue that this rule does not allow the owner to get full value for the company-that if he held on to the company for several more years, he might get considerably more money for the business.

To counter this argument, there is another interesting quotation. When Bernard Baruch, an individual who amassed a personal fortune in the mid 1900s was asked how he became so wealthy? he replied," I always sold too soon." 

Drucker also stresses that succession planning should not be left to the last minute, such as right after the owner-founder passes away and was buried yesterday. Therefore, let us briefly review the various exit strategies available to the business owner and then deal with succession planning as part on of the exit strategy alternatives.

Six Exit Strategy Alternatives

There are six main exit strategy alternatives available to the business owner to consider, excluding liquidation of the business. The first five deal with strategies to consider when there are no family members qualified or interested in taking over the management of the business, and the last strategy deals with succession planning where there are family members who potentially could take over. Actually, there are situations in the first five strategies where family members may still continue to manage the day-to-day operations of the company, but will no longer have a significant percentage of its ownership.

1. Selling to outsiders

This exit strategy involves selling the business to outsiders through a direct sale or possibly a merger where the other party gains a majority interest in the new business combination. Although it may be called a merger, usually for the owners ego   we merged with the multinational giant 100 times our size   most of these transactions are actually acquisitions.

Selling a privately owned business is more complicated then it may seem and the process of selling a business is too lengthy to include in this article. For additional insight on mergers and acquisitions, check out Drucker on mergers and acquisition in Business Beijing of March 2002   Issue 68.

2. Sell to insiders management, employees

Selling the business to its non-family member management and employees is another strategy usually considered. Oftentimes, management may be disenchanted with the lack of direction in the company when the owner-founder loses his energy and enthusiasm for growing the business. The owner-founder continues to lead a good life in terms of his or her personal compensation and perks, but has become conservative and averse to taking unnecessary risks. Thus, the company ages poorly, often resulting in loss of market share.

Management may feel new leadership can turn the situation around. The problem with considering this exit strategy however, is how will management and employees raise the financing required to acquire the business? Passing the hat around, so to speak, and asking management and the employees to contribute some of their personal savings to acquire the company generally will not even raise enough money for a downpayment on the acquisition. 

3. Selling to a partner or other shareholders

If the owner-founder has other partners or shareholders he might consider selling his interest in the business. Two issues arise here that need to be dealt with to implement this strategy. First, what is the value of the shares to be sold and do all shareholders agree on the value? This typically can be resolved by using an outside professional business valuation firm to establish the fair market value of the business and value of the shares. Second, as in the case of selling to management and employees, how will the other shareholders raise the financing to acquire the owner-founders shares? Agreeing to be paid out of future profits is a typical method. However, this leaves the owner-founder at considerable risk if the new management makes poor business decisions. Ideally, the shareholders should borrow the money to cash out the owner-founder and repay the lending institution from the future profits of the business.

4. Sales to equity funds, private investor groups

Equity Funds and Private Investment Groups (PIGs) can be an attractive exit strategy. In fact, this is one of the best strategies to consider. In investment banking industry terminology, this is called a re-capitalization or recap. Equity Funds and PIGs typically invest in a portfolio of businesses that meet their investment criteria (type of business, industry, geographic location, size in revenues) and will usually acquire a 60-80 percent ownership percentage, sometimes higher, in the business.

One of the major criteria of Equity Funds and PIGs is that there must be a strong management team in place in the business as they are typically not interested in running the day-to-day operations of the business, but only in providing strategic direction at the board level.  There should also be a certain degree of synergy with their existing portfolio of businesses such as same or related industry, market served, technology used.

If there are family members who are capable of, and interested in managing the business, this is an excellent way to meet the personal and business objectives of the owner-founder by allowing him to receive a significant payment while management and the remaining percentage of ownership in the business can be transferred to the next generation.

5. Selling to the public:  Initial Public Offering

Although there are some very large family businesses as mentioned in Part One of this article, the typical family owned business is generally too small to seriously consider an IPO as an exit strategy alternative. We will not discuss the IPO in detail other than to mention it is a time consuming and expensive process.

6. Transfer ownership to other family members-the succession plan

Succession planning is essential to ensure the future continuity of management of the business, particularly if there are other family members interested in, and capable of managing the business.

The quotation at the beginning of this article illustrates the importance succession planning has on the future of the business   The average life expectancy of the family business is 25 years.

Succession planning when there is single heir, son or daughter, is the least complicated model, if he or she desires to enter the business, and has the ability to eventually run the business. The models get more complicated when there are multiple heirs, older vs. younger children, sons vs. daughters, inactive family members, the spouse of the dead owner-founder, a second spouse, a son-in-law, and unrelated (non-family member) successors.

In the case where there are multiple heirs, succession planning should involve two entities in the planning process: a family council and an outside advisor. The role of the family council is to first define the responsibilities and qualifications required for the successor in terms of knowledge, skills and experience. Some suggest the following criteria be considered when identifying potential successors:

3-5 years employment in a job or jobs that have depended on competence, skill, and sustained performance, rather than on family-based relationships. Many also suggest that this experience should have been gained outside of the family business.

• Experience in directing the activities of others.
• Recognition for proven competence on the job.
• Evidence and ability to manage relationships, both with peers and with supervisors.
• Evidence of the ability and willingness to take initiative on the job.
• Evidence of having been a valued employee with legitimate contributions to make.

The next step for the family council is to then identify possible successors, either family members or non-family professional managers, but not to make the selection themselves.

This should be left, as Drucker suggests, to an outside, non-family advisor who can provide an objective perspective and eliminate the chance of potential conflict among the family members. As part of the selection process, it is also important to make it clear to everyone involved that they are not required to join the family business.

With respect to the spouse eventually becoming a successor if the owner-founder passes away, this depends on how much involvement she or he had in the business prior to the death. If there is another business partner, or business partners, they may not want the spouse involved in the business.

This potential problem can be resolved with a  buy-sell agreement established between the partners at the time of the formation of the business outlining how a partner s share in the business can be purchased in the future.

Once the successor has been identified, it is important to have a developmental plan for the individual to gain the necessary knowledge and experience to take over the management of the business. The extent of the developmental plan will obviously vary depending on the age and experience of the potential successor.

The son or daughter entering the business after working elsewhere in their first job will require considerable more development as compared to a non-family professional manager who is already performing in a key management position as suggested by Drucker in our first article.

Summary

The first article outlined Druckers Rules for managing and growing the family business and this part with how to ensure continuity through succession planning.

Various exit strategies available to the owner-founder when there are no apparent family members interested in eventually managing the business were briefly discussed.

We conclude with Drucker s two key points relative to succession planning and exit strategies  don t leave this important task until the last minute, and use objective, non-family advisors to assist in the selection process. Finally, no attempt was made to compare how the concepts presented in these articles relate or do not relate to Chinese family businesses. Although we feel many of these concepts would relate, history, tradition, and culture would most likely and unfortunately, cause these concepts to fall on deaf ears.