VENTURE CAPITAL FUNDING OF TRANSITION IN FAMILY-OWNED BUSINESS: AN EXPLORATORY ANALYSIS
NANCY UPTON BAYLOR UNIVERSITY WILLIAM PETTY BAYLOR UNIVERSITY ABSTRACT Research suggests that an unprecedented number of family firms will be transferred in the decade ahead. Financiers express concern that enough capital will be available over the relevant time period to adequately fund these transactions. One funding source available to family firms is venture capital. This paper reports the results of a national, random survey of venture capitalists (VC’s) regarding their decision criteria when investing in family business transitions. The findings reveal VC’s are eager to participate in transition financing. This participation is usually in the form of debt or preferred stock combined with sweeteners (warrants or conversion rights). The risk of transition financing is perceived as equivalent to third stage and bridge financing. The attractiveness of the investment opportunity is largely determined by the quality of the successor and the firm’s growth potential. INTRODUCTION In 1990 Fortune magazine estimated the value of capital invested in family and closely held businesses in the United States to be $2.4 trillion. They also noted that a majority of these firms remain under the control of entrepreneurs who founded them after World War II and the Korean Conflict. Within the next ten to fifteen years, virtually all of the members of this generation will die or retire. According to Avery and Rendall this will lead to the largest transfer of assets in this country’s history (4). The financial community questions whether sufficient capital will be available to finance the necessary transactions. Fay expresses reservations that enough capital will be available to finance so many transactions within such a short period of time and at prices that family businesses would consider adequate (22). Historically, banks provided a significant source of senior debt for ownership transfer. According to Yago highly leveraged transaction loans declined 40% resulting in $38.2 billion less in acquisition related debt available from commercial banks to firms with retiring owners (71). In the past few years a number of large, mature venture capital funds have identified family business transition funding as a lucrative niche. Additionally, several new funds have been created specifically to finance family firm transitions (40). While this is perceived to be a lucrative niche, no studies exist which examine the critical elements of family business transition funding. This paper provides a first look at the funding process, elements of deal structure, risk perceptions and critical factors influencing the decision to fund a transition. Practical implications for both family firm owners and venture capitalists are provided. LITERATURE REVIEW Family Business Transition Market It is difficult to estimate the size of the family business transition market. This is due to definitional ambiguity and lack of a well established national statistical series as well as a high quality, comprehensive data source (70)(33). Using a broad definition, the universe of U.S. family firms could include all sole proprietorships and a majority of partnerships and corporations. This would yield approximately 90% of all firms in the US or about 20 million. A definition which requires multiple generation involvement and direct family responsibility in management and ownership would lead to an estimate of about four million firms (60). Dreux conservatively estimates that there are 1.7 million family businesses, excluding sole proprietorships (18) (19). If, as Shanker and Astrachan predict, 13 percent of all family firms transfer ownership over the next decade, then the transition market size is somewhere between 225,000 and 1,000,000 firms (60). The question still remains: “Are these businesses the type that are attractive to venture capitalist?” According to Kelly 90 to 95 percent of family firms have revenues between zero and $25 million. He states: “...new capital has all been raised to look at $50 million, $100 million, $200 million sales companies. ....a firm that is doing only $2 million in sales...is going to have a tough time attracting capital.” (72, p. 17).
Venture Capital Decision Making Criteria A number of studies report the criteria venture capitalists' use when evaluating deals. Venture capitalists evaluate investments in stages and with a number of decision criteria (5). The initial screening stage determines the fit of the company seeking financing with the venture firms lending guidelines and the long-term growth and profitability of the industry (30). Tyebjee and Bruno found the initial screening criteria to include: (1) size of the investment, (2) technology and market sector of venture, (3) geographic location, and (4) stage of financing. The evaluation process included: (1) market attractiveness (size and growth), (2) product differentiation, (3) managerial capabilities, (4) environmental threats, and (5) exit strategy (66). In a subsequent study, MacMillian, Siegel and Subba Narasimha found the most significant criteria to be (1) entrepreneur and team, (2) proprietary nature of product, (3) market growth, and (4) required rate of return (10 times investment in five to ten years) (47). A number of studies have emphasized the importance of a quality management team (27) (34). No empirical studies reveal the criteria used for funding family business transitions by VC’s. However, Dreux details the following as fundamental investor criteria when assessing family firms: (1) strong management, (2) attractive economics (past earnings and a strategic plan demonstrating the ability to achieve attractive profits, (3) cash flow and accounting return on equity, (4), growing markets/market share, (5) proprietary products/services, (6) good technical capabilities, and (7) high potential investment returns(18, pp. 232-233). These are very similar to those identified earlier. Additionally, in the Autumn, 1995, issue of Family Business magazine an interview with representatives of private capital markets was presented which reveals criteria used to invest in family firms. According to Tad Kelly, general partner of CHB Capital Partners in Denver, “we look at three things: The first is management,...Second, the business has to have what we call a ‘defensible market niche.’ Third, ...needs to be in an industry that has attractive growth and/or profitability characteristics.” (72, p. 14). Additionally, he notes that the family can be a positive or a negative influence: “When we are looking at a family company, we do two sets of due diligence that are completely separate: One is on the business itself, and the other is on the family.” (72, p. 15). According to the limited literature, family firms may be seen as good prospects for a VC if there is a quality team in place, a good product/market and the potential for growth. The latter is of primary importance when determining the return required by the VC. Currently, returns are in the 20 percent plus a year compounded for five years with later stage transactions requiring 30% (72, p. 21) (64). According to Brophy, family businesses carry “an extra burden of prejudgment” when they approach the financial community. A number of misconceptions concerning family business exist. A review of the comparative literature suggests that family firms can be excellent investments (11). Strengths and Weaknesses of Family Businesses In terms of understanding strengths and weaknesses, research suggests that family firms have a tendency toward long-term strategies rather than a need for quarterly results, an aversion to debt, and an inclination to reinvest dividends (24). Family firms seems to outperform nonfamily firms on a number of dimensions, including financial (39) (43); productivity (42); product/service quality (46) (51); and level of concern for employees and communities (1) (2) (13) (16) (31). Using the Business Week “CEO 1000”, McConaughy found family controlled companies operationally more efficient, more valuable, having higher stock returns, using less debt and paying out fewer dividends than their nonfamily counterparts (48). Controlling for size, industry and managerial ownership, McConaughy found that superior performance was due to family control and not to the level of managerial ownership. McConaughy, Mendoza and Mishra report that public, family-controlled firms headquartered in the Chicago area (as tracked by the Loyola University Chicago Family Firm Stock Index) outperformed both the Crain’s Chicago and Dow Jones Industrial Average stock indices between 1990 and 1995 (49). However, evidence suggests family firms struggle with growth issues (54) and neglect strategic, succession planning and estate planning (3) (12) (15) (17) (28) (29) (61). In a survey of founders, Tagiuri & Davis found familyowned firms give growth goals a lower rank than nonfamily-owned firms (63). Past research indicates that inherited firms have lower growth rates than start-ups or buyouts (20) and do not adopt growth strategies (14). Barriers to growth in family firms include limited financial resources, reluctance to share ownership, desire to grow via internally generated funds, lower market share, less participation in global markets, and an overconcentration in industries which are less capital intensive and have lower barriers to entry (16) (9) (23) (25) (60). Mitigating factors include lack of skilled management (50) and goal conflict between active and non-active family members (21) (36). The presence of conflict among family members would most likely deter venture capital funding. One of the most important aspects of growth is the role of the successor generation in strategic regeneration (56) (67). Results are mixed as to whether a successor can outperform the previous generation. Blotnick studied the financial
performance of 837 profitable family firms before and after the succession event and found that less than 20 percent of the heirs had been able to maintain a growth rate that was sufficient to keep pace with inflation (10). He attributed the poor performance solely to the "reluctant" heir’s laissez-faire attitude toward joining and continuing the family firm. Begley and Boyd reported that founder firms grow more rapidly than those run by a successor (7). However, McConaughy discovered that firms controlled by second and later generations are operationally more efficient than founder controlled firms (48). In summary, family firms possess several positive characteristics that would influence the decision of a VC to invest including outstanding performance on a variety of factors. However, the fact that family firms struggle with growth and seem to over-concentrate in low growth industries are negatives. RESEARCH QUESTIONS In this exploratory stage of our research, we decided to concentrate first on the venture capitalists and their decision-making processes. We specifically wanted to know: · What are the key criteria used by VC’s when evaluating family firm transitions? How do they differ from the criteria already identified in the literature? · How are these deals structured? · The venture capitalist industry has shown a preference for less risk, later stage investing and earlier exits. Therefore, is family firm transition funding perceived as similar to later stage funding where risk is concerned? (64) · Are family firms subject to the “extra burden of prejudgment” as Brophy (11) suggests? A series of questions concerning perceptions of family business should reveal biases. METHOD A random national sample of venture capitalists was selected from a list published in Pratt's Guide to Venture Capital Sources, 1995 Edition. A total of 400 companies were selected and entered into a database. A letter describing the project, a survey instrument and a return envelope were mailed first class to the sample. To increase the potential returns, the letter indicated that those returning the survey would be entered into a funding database maintained by the Entrepreneurship program and would receive a copy of the research results. Of the total, 44 were returned as undeliverable; primarily due to forwarding orders expired. Sixty-two surveys were returned and 61 are usable. This paper reports the results of these 61 responses representing about a 15% return rate. While the number is small, a number of authors have detailed the difficulty of data gathering in this area (11) (47). Timmons and Bygrave write: "...venture capitalists are notoriously inaccessible to academic researchers. The industry is small in terms of the number of firms and professional and so active that the growth of research has become an onerous burden for the industry." (64, p. 45) The survey was developed in three stages. First, a review of the literature was prepared. From this the authors developed a preliminary survey. The survey was tested using eight VC firms, four of whom participate in family business transition funding. Input from the venture capitalists as to deal criteria, funding alternatives and general clarity were incorporated into the final version. We provided the VC's with a definition of family business as: "a firm owned and operated by two or more family members". Family business transition funding is defined as: "a transaction to fund the transition of the family firm to the next generation of leadership or ownership". In addition to general demographic data, the survey requested information on deal structure, importance of certain factors in making the deal, reasons why a venture capitalist would or would not participate in family business transition funding and the perceptions of risk in funding the transaction stage versus other stages. To try and determine how accurate their judgment about family of family business field, eight true/false questions were included in the survey. DISCUSSION The responding venture capitalists reported average assets of $137 million, a median of $55 million and a range from $2 to $750 million. Since the average size of venture capital funds are $49.5 million (65), our sample contains relatively large firms. On average, 488 requests for funds are received annually with half of the sample reporting 250 or less requests per year. Of these, about 2% receive funding. Finally, the majority of the firms participate in later-stage funding. Deal Structure Of the 61 returned surveys, 79% (48) indicated that they did participate in family business transition funding. Thirteen indicated they did not participate. The primary reasons for not participating were related to stage of funding (fund start-ups or emerging technology only) or growth issues. Written comments by non-participating firms included: usually
not growth-oriented businesses or atypically not rapid growth. When asked to indicate the type of funding most frequently used when participating in transition funding, 58% indicated they use preferred stock, 50% common stock, 40% subordinated debt and 23% senior debt. A combination of these funding types is used by a number of firms. Of the venture capitalists using debt or preferred stock, 52% responded that they always have the right to convert into common stock; 25% indicated they frequently have the right to convert; and four percent said they never have the right to convert. When asked if they have the right to attach warrants, the majority, 67%, replied they frequently or always (40% and 27%, respectively) have the right; and only two percent never have the right to attach warrants. The investors required rate of return for transition funding ranged from 10% to 50+%, with an average target required rate of return of 31% and a median of 35%. Of the 48 venture capitalists who participate in this type of funding, all but one indicated an exit strategy was essential. With respect to their investment horizon, only three respondents strictly limited their horizon to three or fewer years; 43 favored an horizon between four and seven years; and one would elect over seven years. When assessing the level of risk of funding a family business transition the respondents compared the perceived risk of funding a family business transition compared with other alternatives. Table 1 shows that family business transition funding is considered less risky than seed, start-up, R&D, other early stage, second stage funding, and turnarounds. The riskiness of family business transitions is considered about the same as third stage and bridge funding. Family business transition funding is perceived as more risky than LBOs and acquisitions. TABLE 1 Perceptions of Risk: Risk of Funding a Family Business Transition Greater Than Less Than Equal To % % % 10 90 0 16 80 4 14 84 2 21 77 2 26 72 2 49 42 9 48 45 7 58 24 18 17 79 4 58 29 13
Type of funding Seed capital Start-up capital R&D Other early-stage Second stage Third stage Bridge LBO Turnaround Acquisition Family Business Criteria
We asked the respondents to rank order six factors that would be critical to them in determining whether or not to participate in transition funding. Table 2 shows that overwhelmingly, the funders are interested in a growth business and a qualified successor. As noted earlier, one of the most important criteria for growth in a family firm is the presence of a qualified successor. A strategic business plan was viewed as somewhat critical, and as noted earlier, this is not a strong point of family firms. Surprisingly, a stable family was most often listed as least critical in their decision. Also having an outside board of directors was of little concern to the investors. TABLE 2 Critical Factors in Transition Funding Factors 1 Growth business Qualified successor Strategic business plan Entrepreneur willing to let go Stable family Outside board of directors 38% 37% 16% 16% 10% 2% Ranking (1=most critical...6=least) 2 3 4 5 16% 16% 33% 22% 10% 4% 20% 18% 20% 14% 13% 13% 12% 10% 18% 18% 17% 21% 8% 10% 12% 20% 13% 29% Weighted Score 2.54 2.65 2.82 3.29 4.23 4.65
6 76% 8% 2% 8% 38% 31%
Respondents were next asked to identify the number one reason they would not fund a particular family business transition. The primary deal killer is the family management team/successor. Venture capitalists would not fund a deal in which they lack confidence in the skills of the successor and family management team; where concentration of power is between
father/son or brother/brother; or in which unqualified family member are kept on the job. All three of these scenarios are quite common in the family firm. Their second concern involves inadequate profitability of the firm and its lack of potential growth. The third deal killer is absence of an exit strategy and low expected returns. Family Business Quiz The funders were given a family business quiz comprised of eight questions to be answered true or false. Their responses (Table 3) reveal that although the majority believe the number of transition funding will increase, it will not affect the availability of early stage financing. When queried about the capital available to fund transitions, the sample was divided over whether enough will be available. Despite evidence that family firms outperform nonfamily firms, this is not widely believed by our sample. However, most do not view family firms merely as small companies with limited resources. TABLE 3 Family Business Quiz Question True (%) There are 2 million family firms with revenues > than $1 million. 88 Family firms financially outperform nonfamily counterparts. 49 There is inadequate capital to fund all of the family firm transitions 50 over the next decade. Family firms are small businesses with limited resources. 40 Family firms do better if managed by someone outside the family 22 Family firm transition funding will pull ventures funds away from 15 early stage transactions. Family firms are poor risks for venture capitalist 19 There will be an increase in family firm transition funding in the next 95 decade
False (%) 12 49 50 48 78 83 79 5
IMPLICATIONS Family firms have various capital needs throughout the life of the business particularly during intergenerational transition. Although there are a variety of potential capital sources available, venture capital seems to be an attractive alternative (32). To attract funding, family firms should ensure that the successor generation/management team is equipped to grow the firm. Some bias toward outside management may exist and the successor may have to be over-qualified to operate the business. In addition to planning for growth that will allow the funder a 35-percent return, family firms should engage in regular strategic planning. When asked to rank factors critical in evaluating a funding decision, letting go was ranked low as was a stable family. However, when asked to give a reason why they would not fund a particular deal, a number of responses dealt with family conflict, unstable family members or inability of the entrepreneur and/or family to let go. Firms who seek funding should be aware that all these factors are probably important. There are a number of issues left unanswered. Further research should examine the issues of control in the transition deal. Are there any unique covenants or restrictions on family firm transition funding? What added value does the venture capitalist relationship bring to the family firm? An analysis of the success or failure of transition funding would be of great interest. Another area of inquiry includes the perceptions of family firms about the venture capital industry. What are the capital needs of these firms and how do they perceive they will fund transitions? Is this even an issue of discussion among family firms? A number of studies have reported that family firms ignore estate planning and have little idea of how much they will owe Uncle Sam (28) (29) (52). Petty, Bygrave & Shulman (55) found that the number one reason for selling the firm was related to estate planning. Prince and File (57) examined 749 family businesses that failed within three years of the founders' death and found failure tied to inadequate estate planning, insufficient capital to run the business and an inability to raise capital. These firms were successful prior to the founders' death with about 46% having over 100 employees. If transitions are to be effective, creating economic value for all concerned, there needs to be adequate preparation by the families and the independent investors involved in these transactions. A critical element in this process will be the acquisition of adequate financing to consummate these deals. For this to occur, we will need a greater understanding of the process than we have at present. Failing to do so will result in large sums of value that are currently locked up in family owned firms not being realized by the individuals who built and grew these companies. Equally important, it could deny the next generation the opportunity to build on the foundations laid by the founder.
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5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27.
28. 29. 30. 31. 32.
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