Read time: 3-4 minutes
“A big business starts small.” (Richard Branson)
If you speak with a lower middle market private equity fund about what they look for in an investment, their comments will often include something like, “We like to invest in founder- or family-owned businesses.” Others may introduce more complicated jargon and say, “We prefer to be the first institutional capital into a business.” These statements essentially mean the same thing. Why, though, does this matter? It matters because there are actually a lot of different types of entities from which you can buy a business, founders and families being one of them, and making an investment in each scenario may require a nuanced approach to dealing with the seller in question. For the sake of illustration, the table below highlights the common entities form which businesses are acquired.
|1. Founder or Family||Individuals or a collection of related shareholders that control a privately held company.|
|2. Venture Capital Fund||A professional source of early stage capital for founder-led businesses that show strong upside potential.|
|3. Private Equity Fund||Another source of professional capital though for established, profitable businesses.|
| 4. Employee Stock
|Often referred to as an “ESOP”, this is a benefit plan that gives workers an ownership interest in a company. ESOPs are overseen by a trustee who acts as a fiduciary to protect the assets of the ESOP for the beneficiaries.|
|5. Another Business||Other corporate entities that may seek to sell (or, “divest”, or “carve out”) operating units that are non-core or underperforming.|
|6. Public Company Shareholders||Public companies can be acquired from shareholders and “taken private” if they are willing to pay a premium to entice the shareholders to sell.|
So, given that many private equity funds pursue founder- or family-owned businesses as a strategy, they have clearly determined that acquiring from individuals as opposed to other investment groups or corporate entities is an attractive approach. This article will explain why, but first let’s understand where all these family-owned businesses came from by learning about the origins of entrepreneurship in the U.S.
A Brief History of Entrepreneurship in the U.S.
Ever wonder from where the word entrepreneur originated? Turns out it dates back to 1723, and we adapted it from the French word entreprendre which means “undertake”. Today, we define entrepreneur as follows1:
- Entrepreneur (än-trə-p(r)ə-‘nər): One who organizes, manages and assumes the risks of a business or enterprise
In the United States, entrepreneurship has a rich history that spans hundreds of years. Famous Economist and Nobel Laureate Milton Friedman once wrote, “Ever since the first settlement of Europeans in the New World, America has been a magnet for people seeking adventure, fleeing from tyranny, or simply trying to make a better life for themselves and their children.” One could even argue that America, as a nation, was in a sense built by investor-backed entrepreneurs. For example, in 1607 the Virginia Company of England sent three ships on a four-and-a-half-month voyage to colonize American plantations. The 100 or so passengers that disembarked settled and developed what became Jamestown, Virginia. Relevant here is that the Virginia Company was a joint-stock company which allowed for investment in ventures with limited liability if the business failed, which was a good thing because it ultimately went broke. You win some, you lose some.
While not often regarded for his entrepreneurial skills, Daniel Boone could be considered an early archetype of the American pioneer / entrepreneur who in 1799 departed Kentucky for a fresh start and settled along the Missouri River on a thousand or so acres of land then part of Spanish Louisiana. It was the Western migration of Boone and others that is credited with establishing the foundation for capitalism’s success in America. During this period, a majority of these pioneers were farmers, eking out a living on small family farms, and it’s important to keep in mind that the cost of failure for such pio-preneurs was not merely financial, many paid with their lives. In the early years, Westward migration proved challenging due to the limitations of undeveloped routes amidst the wilderness, but ultimately wagon-based travel became feasible followed by steam-powered locomotives which revolutionized human transportation. It was the railroads that were both fueled by and facilitated future entrepreneurship. Interestingly, some also cite the railroads as the origin of modern managerial systems given that the expanse of the railroads’ operations required new methods for managing organizations with a distributed geographic footprint.
It’s hard to believe, but prior to 1811 there had been a mere seven companies incorporated in North America. This all changed when New York State permitted incorporation by law upon filing out the proper paperwork which freed the process from bureaucratic legislative acts and politics. As a result, the number of corporations started in the U.S. increased dramatically, and the state of Pennsylvania alone incorporated more than 2,000 businesses between 1800 and 1860. Consequently, the American dream of being in business for oneself expanded to include small merchants and independent craftsmen.
During the latter part of the 19th century, further Westward expansion and government incentives for industries such as the railroads, banking, and land acquisition led to tremendous opportunities for profit, which allowed entrepreneurship to flourish. During this period, entrepreneurship can also be credited with propagating capitalists, innovators, prospectors, financiers, and businessmen who created and expanded existing businesses. It was this period that gave rise to big business and many household name companies within oil, steel, tobacco, shipping, railroads and banking. These industries were largely unregulated, though, which led in some cases to monopolistic power and the inevitable ensuing regulation to establish a more stable business environment for companies of all sizes.
Continuing a trend that began in the latter part of the 19th century, the 20th century ushered in a dramatic increase to the scale and complexity of business in the U.S. In many industries, small enterprises had trouble raising capital and operating at a scale large enough to efficiently produce goods for an increasingly sophisticated and affluent population. In this environment, the modern corporation, often employing hundreds or even thousands of workers, further rose in prominence. This period was responsible for the formation and success of such businesses as Ford Motor Company (1903), Hewlett Packard (1939), McDonald’s (1940), Wal-Mart (1945), Southwest Airlines (1967), Microsoft (1975) and Apple (1976).
Fueled by the internet, the 21st century has been marked by lower barriers to business formation and the creation of a new array of tech-enabled manufacturing and service-based companies both large and small. We’ve come a long way from the pioneering ventures of early settlers and those who sought better fortunes in other parts of the U.S. While the look, feel and focus of American entrepreneurs has changed over the years, the drive to undertake and build profitable businesses has endured paving the way for the successful family businesses of today so frequently sought after by private equity investors.
The Benefits of Investing in a Founder or Family Owned Business
Finally, and without further ado, here are some of the main reasons why lower middle market private equity funds like investing in founder or family-owned businesses:
- There are a lot of them. One estimate is that there are 28.8 million small- and medium-sized businesses (SMBs) in the U.S. and that 19% of them are family owned. So, 28.8M x 19% = ~5.5M family-owned businesses into which private equity can flow.
- Aging Baby Boomer business owners are seeking liquidity. Of the ~5.5 million family-owned businesses in the U.S., nearly 4 million, or ~75% are controlled by Baby Boomers. And, given that Baby Boomers are defined as those born between 1946-1964, that means that the Boomers are now aged between 55-73. To that point, 47% of family business owners now report that they intend to retire within the next five years. So, we are amidst a wave of estate planning-driven business sale activity that is buoying the population of target companies eligible for PE funds.
- Most family-owned businesses do not survive generational transitions. Sad but true – only 30% of family businesses survive the transition from first to second generation ownership. Even worse is that only 12% survive the handoff from the 2nd to 3rd It’s like the old saying, “Shirtsleeves to shirtsleeves in three generations.” Most business owners are all-too familiar with these statistics and related adages, so they are looking for a safe set of hands to usher their life’s work into the future while creating a lasting home for their employees to continue their careers. In many cases, private equity funds are the perfect acquiror insofar as they manage companies by profession and will increase the odds of a successful change in ownership.
- Ability to develop a rapport with the founder and/or owners of the business. When you acquire a business from a corporate entity or institutional investor, the discussion is largely around price as the chief determining factor in whether the seller will transact. However, deal discussions with a founder or family are much more nuanced. Founders, rightfully so, want to know that what they’ve bled, sweat and cried for is going to endure into the future. So, this creates an opportunity to build a meaningful relationship with the founder to ensure that there is a shared vision and a strong working chemistry insofar as they will continue to be involved after the deal closes.
- The founder or family will often retain some ownership. I don’t know about you, but the notion of buying 100% of a company from a founder who has no intention of remaining involved with a company post-closing is scary to me. This would be like someone throwing the keys at you after purchasing a car, wishing you well and then screeching off into the distance never to be seen again. Not a good sign. The best transactions are where the prior founder or family retains a meaningful amount of equity in the company and is aligned to help continue building the company with you. After all, these are the people who architected the vision, strategy and culture to get the company to the point where a PE fund would want to invest in the first place.
- Tangible growth opportunities. Once a company starts to generate substantial cash flow, the incentives to grow it can be at odds with the perceived risks of disrupting a comfortable lifestyle that a business owner has come to enjoy. Said another way, if an owner is generating $5 million in EBITDA and is making more money than they ever dreamed they would, why undertake the investment and risk associated with growing the bottom line? This dynamic is prevalent with many founder and family-owned businesses and creates the opportunity for a PE fund to execute on numerous “low hanging fruit” growth initiatives that have not yet been pursued.
How Private Equity Helps Founder and Family Owned Businesses
|1. Wealth Diversification||For many entrepreneurs, their business represents their largest single financial asset. This concentration of wealth created by the business creates an inherent risk to their net worth should something happen to adversely affect its valuation. Therefore, a transaction with a private equity fund helps to diversify a business owner’s net worth by generating liquidity (i.e. cash) for the founder or family owner.|
|2. Team Development||While many family or founder-owned businesses can generate strong growth and profitability for a time, they will ultimately stagnate if they haven’t invested in a team that can manage a larger organization with its new assortment and complexity of challenges. And, we routinely see certain departments that have been under- or undeveloped such as Finance or Sales. The good news is that private equity funds are in the common practice of helping companies supplement their teams with high quality talent who can help the business get to the next level.|
|3. Business Building||Beyond team development, many founder and family-owned businesses have not fully embraced best practices regarding systems or process. In order for small companies to become big companies, they need to be built upon a framework that will support the transition to a larger organization. This applies to things like data capture & analysis, workflow management, compliance, and financial controls. Given that private equity funds invest across a portfolio of companies, they have an excellent vantage point to identify and help implement the necessary systems and/or processes to help management teams drive their business forward.|
|4. Financial Sophistication||Private equity funds have earned a reputation for taking an analytical eye to the businesses in which they invest. Frequently, a founder or family-owned company’s prior reporting processes will evolve under new ownership to become both more strategic and granular. Business owners will get a flavor of this during the due diligence process when an investor begins analyzing the business to better understand it. A test of whether a fund is focused on the right things is if an owner gains new and valuable insight about their company that they had not previously considered. The end goal is for a company’s investors and management team to know precisely where the key drivers of value exist and focus on the areas that really move the needle.|
|5. Capital For Growth||Don’t forget that private equity funds often reserve capital to support the growth of their partner companies beyond what it takes to close the deal. For many businesses, growth via the acquisition of smaller businesses in the same industry can be an excellent way to increase scale and profitability. So, if you aspire to acquire smaller businesses and fold them into your organization, make sure to ask any investors with whom you are speaking about their ability to fund future deals.|
|6. “Two Bites of the Apple”||In many cases, a private equity fund will want the founder or family shareholders to retain some ownership following a transaction. The helps ensure that the person or people that drove a company’s prior successes are aligned with the new investor’s goal of supporting future growth. The amount of retained ownership varies for each deal but generally ranges from 10-30%. By holding onto some of the equity in the business, owners stand to benefit from the next exit if the business increases in value. In some cases, we’ve seen the proceeds from an owner’s second transaction, or the “second bite of the apple” exceed proceeds from the initial transaction.|
We hope this sheds some light on why private equity funds like investing in founder and family-owned businesses. As always, we’re here to help, so give us a call to start a conversation.
About ClearLight Partners
ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.
Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.
Demand for central London office space sinks as thousands of staff work from home
Demand for office space in central London sank in the third quarter as staff at major occupiers such as banks, insurers and asset managers continued to work from home as a result of the coronavirus pandemic.
A survey from the Royal Institution of Chartered Surveyors showed that 77% of surveyors reported a drop in demand for London office space.
The survey comes as banks such as HSBC confirm they are looking at a hybrid model of remote working and office working that could lead to a steep drop in the amount of prime office space needed by financial-services firms.
Availability for London’s office space grew for the eighteenth successive quarter, the survey showed, with availability growing at the strongest pace since 2009.
Over the next year, prime office rents in the capital are expected to fall by 6.8% as demand shrinks.
Tarrant Parsons, RICS economist, said: “Occupier demand across the office sector remains in decline and may continue to come under pressure going forward as businesses reassess their office-space requirements following the increased prevalence of remote working.”
Deutsche Bank and HSBC are among lenders that have announced that they will embrace the model of workers who opt to spend some days in the office and some days out.
The announcements come as a Morgan Stanley survey found that some 63% of office workers said they believe their employers will allow one or two days working from home in the future.
About one in five, or 18%, in the bank’s survey said they think their bosses will allow even more days than that. More than 90% of London office workers have been working from home during the pandemic — the most of any major European city.
Surveyors who commented on the RICS survey predicted that the coronavirus pandemic could lead to long-lasting changes in the way that companies use offices.
David Apperly of Apperly Estates said: “The biggest impact of coronavirus will probably be long term for office demand; rental growth is likely to be subdued for 10+ years.”
Gregory McGonigal of Ashdown Phillips said: “We are highly unlikely to return to anything like we were all experiencing in 2019 for at least five years and certain sectors will be changed permanently. The pandemic has caused, and will continue to create, a seismic shift in the UK property sector.”
Simon Wood of Downing Intervention simply said: “Winter is coming.”
To contact the author of this story with feedback or news, email James Booth
BlackRock wants global standards for sustainability reporting
Previous demand for firms to follow with existing standards led to a 400% increase in compliance
BlackRock, the world’s largest asset manager, has called for the creation of a single global sustainability standard, claiming existing frameworks are making it difficult to compare companies and leading to confusion for investors.
“BlackRock is calling for convergence of the different private-sector reporting frameworks and standards to establish a globally recognised and adopted approach to sustainability reporting,” the $7.8tn New York-headquartered group said on 29 October.
BlackRock claimed the proliferation of existing disclosure initiatives, many of which are overlapping, has meant companies are reporting the same information more than once and that there is a lack of consistent and comparable data.
“We believe that this could be resolved by aligning and converging to establish a globally recognised sustainability reporting framework and set of standards,” BlackRock said.
“Ideally, these would be developed by those with domain expertise in the private sector and supported by public policymakers as they move to require more comprehensive corporate reporting.”
The call from BlackRock comes after it asked companies in January to publish their climate-related disclosures in line with the Sustainability Accounting Standards Board standards and the Task Force on Climate-related Financial Disclosures framework — two of the world’s major reporting standards.
BlackRock said it would consider voting against company management where sufficient progress had not been made.
Companies appear to have heeded BlackRock’s warning. According to a report by the fund manager’s investment stewardship team, by the end of September, there had been a 400% increase in companies reporting under the SASB standards.
“The uptick is encouraging,” BlackRock said. “However, one of the top challenges to greater adoption we hear from the directors and leadership teams is the confusion caused by the various frameworks or standards.”
Efforts are already under way to develop a common approach for sustainability disclosure.
The IFRS Foundation published a consultation in September to assess demand for global sustainability standards. The IFRS said it would assess to what extent it could help develop such standards if demand proved strong.
Also in September, a group of five sustainability-reporting organisations — the SASB, the Global Reporting Initiative, the International Integrated Reporting Council, the CDP and the Carbon Disclosure Standards Board — said they planned to work together to develop “a comprehensive global corporate reporting system”.
BlackRock has singled out an approach proposed by the IFRS Foundation as the “most practicable and likely to succeed”.
“Progress may take some time,” it said. “BlackRock will continue to advocate for TCFD and SASB-aligned reporting until a global standard is established.”
To contact the author of this story with feedback or news, email David Ricketts
Comment: Don’t overestimate the coronavirus recovery
At this point in the Covid-19 crisis, governments have only one good option: further aggressive fiscal stimulus complemented by coherent virus-containment strategies
The world economy has risen from the depths of the initial Covid-19 plunge. But the recovery has been tepid, uneven and fragile – and is likely to remain so for the foreseeable future.
Start with the good news. World merchandise trade has rebounded strongly, consistent with indications of a revival in household demand for goods in many economies, even as public-health restrictions and consumer concerns continue to hobble demand for services.
Moreover, financial markets have held up surprisingly well, with stock markets in many countries regaining or even exceeding pre-pandemic levels. Despite near-zero interest rates, banking and financial systems seem largely stable. And consumer and industrial demand has buoyed commodity prices, with even oil prices having recovered somewhat.
But as the latest Brookings-Financial Times Tracking Indexes for the Global Economic Recovery update shows, many economies are experiencing essentially no growth, or are even contracting. With private sector confidence depleted, and the struggle to contain the virus far from over, the risks of substantial and long-lasting economic scarring are on the rise.
This is true even in the economies that have returned to growth, such as the United States. In some ways, the US seems to have turned the corner. Industrial activity and the labour market have regained some lost ground. The unemployment rate is falling, and employment levels are up.
But unemployment remains significantly higher, and employment significantly lower, than before the pandemic. The increase in long-term unemployment, together with ongoing service sector disruptions, portends a difficult path to a more robust and sustained recovery.
It doesn’t help that fiscal stimulus measures have largely lapsed, and negotiations on a new relief package have repeatedly broken down. As household disposable income has declined, private consumption growth has weakened. Similarly, business investment continues to contract – a trend that does not augur well for sustained growth.
Even stock markets, which experienced a sharp rebound earlier in the year, seem to be taking a breather. This may reflect concerns about the virus-containment strategy (or lack of) being pursued by US president Donald Trump’s administration. In any case, as next month’s presidential election approaches, heightened political and policy uncertainty is likely to keep consumer and business confidence muted.
The eurozone is in even worse shape. Not only has the pandemic decimated short-term growth; deflation is now setting in, raising the risk of a deep and prolonged contraction. While manufacturing in Germany and elsewhere has rebounded, the positive effects are more than offset by the enduring services slump, reinforced by ongoing public health restrictions.
The United Kingdom’s services sector, by contrast, has experienced a revival. Yet the combination of erratic lockdown policies and far-reaching uncertainties surrounding Brexit are contributing to a continued economic contraction. Meanwhile, on the other side of the world, Japan is also in serious economic peril, though it has so far avoided sliding back into deflation.
Most emerging market economies have not fared well, either. India is experiencing a sharp slowdown in economic activity, which could be exacerbated by a devastating acceleration in Covid-19 cases, fuelled by the easing of lockdown measures. The government has pushed through some agricultural and labour market reforms, but a banking system hobbled by bad loans remains a powerful constraint on growth.
Brazil and Russia have fared little better. Both have experienced substantial economic contractions, and have few policy levers available to revive growth.
The one country experiencing a strong recovery is China, where, thanks largely to the country’s apparent success in bringing the virus under control, both industrial production and services have rebounded. Retail sales and manufacturing sector investment have also bounced back. By many indicators, the country’s economic performance is now even stronger than it was before the pandemic.
Yet, unlike in the wake of the 2008 global financial crisis, China’s strong performance is not likely to do much to buttress the rest of the world economy, not least because of the growing push towards deglobalisation. China’s recently unveiled “dual-circulation strategy” – whereby the country will increasingly depend on the domestic cycle of production, distribution, and consumption for its long-term development – will reinforce this trend.
Making matters worse, central banks now have far less firepower than they did after the 2008 crisis. To be sure, the major central banks have pulled out all the policy stops since the Covid-19 crisis began, pursuing unprecedented monetary expansion in order to support economic activity and, in some cases, to fend off deflation. Some – most notably, the US Federal Reserve – have even adjusted their policy frameworks to signal tolerance of higher inflation. The central banks of some smaller advanced economies, such as Australia and New Zealand, and emerging economies, such as India, have also resorted to unconventional measures.
But the limits of monetary policy for boosting growth are becoming increasingly apparent. Meanwhile, large-scale purchases of corporate and government bonds, together with the direct financing of firms, are generating serious risks – not least to central-bank independence.
Against this background, governments have only one good option: further aggressive fiscal stimulus, ideally in the form of well-targeted government expenditure that could spur private investment. Whatever risks the increase in public debt may generate, they do not compare – especially in today’s low-interest-rate environment – to the long-term economic pain that countries will face without such stimulus.
To be effective, however, fiscal measures must be complemented by coherent virus containment strategies, which credibly enable safe economic reopening. Without such strategies, demand and confidence will remain subdued, and global growth will continue to falter well into the future.
Eswar Prasad is a professor of trade policy at Cornell University’s Dyson School of Applied Economics and Management and a senior fellow at the Brookings Institution. Darren Chang and Ethan Wu, undergraduate students at Cornell, assisted in the writing of this commentary.
Copyright: Project Syndicate
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