Best Practices for Navigating M&A With Family-Owned Businesses From An Insider
In the latest edition of the Intralinks Deal Flow Predictor, we spoke to Frank A. McGrew IV, a managing partner at merchant bank McNally Capital, about doing deals with family-owned businesses.
19 December 2018
McGrew is a managing partner at McNally Capital, a leading merchant bank formed by the McNally family, owner and operator of Rand McNally & Company. McNally Capital provides private capital and delivers advisory services to operating companies and family office investors. McGrew has nearly 30 years of experience as both a private investor and adviser to closely held and family-oriented businesses.
Philip Whitchelo: Family-owned businesses are important providers of employment, growth and exports in successful economies such as Germany (e.g., the Mittelstand) and Japan. How does this compare to the U.S.?
Frank A. McGrew IV: Family-owned businesses play a similarly important role in the U.S., even more so as the universe of public companies is shrinking fast. To put it in numbers, in 1996 there were 7,439 public companies, by the end of 2017 that number had fallen to 3,616, a 51 percent decline. Meanwhile, there are over 20,000 private businesses to consider for investment – “private equity” – most of which offer a very different value proposition: a focus on family ownership; a greater emphasis on leaving a legacy — the longer the business has been in the family, the keener the current generation is to keep it that way; and a sense of generosity and social attachment to the community it operates in. These are values that we tend to consistently see in family-owned businesses.
What are some of the key characteristics and dynamics of family-owned businesses which makes them different from other businesses?
In my mind there are three key characteristics: One, family-owned businesses tend to work with and think in longer time frames. They are not driven by weekly or quarterly targets; instead they think in years, even generations. Leaving a legacy is a key feature that factors into this approach. Second, they maintain more flexibility and are not rigidly bound by a public company’s operating structure, nor do they need to actively communicate with investors. Third, they are financially much more conservative and are unlikely to maximize their credit lines. As a result, if something bad happens, like a product recall or a general drop in the market, they find it much easier to ride out the storm and/or invest in their companies.
Succession planning is often cited as an important challenge for family-owned business. How can they address this?
I feel it boils down to a framework of four Ps: Planning – setting goals and having a clear understanding of the overall objective; Professionals – making sure you have the right team of professionals working with you, i.e., accountants, lawyers, bankers and advisers, all before you even start thinking about doing a deal; Processing – physically playing through the event and having all the necessary documentation in place; and, finally, Profiting – this does not simply mean making the most money out of a deal, but making sure you consider issues such as: Do we have the most tax-efficient structure? what jurisdiction should the sale take place in; what needs to be in place? Basically, how can the business be staged to ensure the maximum “net proceeds” valuation?
"I think buyers of family-owned businesses should spend some time working out what kind of relationship they would like to have with the family and the previous owners and managers when the deal is done. Do they want them to stick around? Be part of the board? Retain a small shareholding in the business? These considerations could well have an impact on the success of the deal." —Frank A. McGrew IV, McNally Capital
What are some of the challenges that present themselves when doing M&A transactions with family-owned businesses?
Personalities and culture! The business end of the transaction tends to be fairly straightforward – arriving at the right valuation is in fact not as challenging as it can initially seem; but understanding the social issues – that is often the real challenge and determines outcomes for a transaction. Also, appreciating that, for the seller, this is a highly unusual and maybe a once in a lifetime process, one which they will not have experienced before; and so if you compare this with a private equity fund, which is well versed in doing deals, there is great potential for a culture clash. Any prospective buyer must appreciate that a fair bit of patience and courtship is required, and that not every interaction will lead to a transaction.
What is the financing environment like for family-owned businesses? How do their needs for, and access to, financing compare to other types of businesses?
In today’s market, with its abundance of money (debt and equity), access to capital is not a concern for family-owned businesses. In fact, usually their established commercial banks are pushing them to borrow more money than they want! However, they tend to have much lower leverage than public companies and are generally not as aggressive when it comes to utilizing debt in their capital structure. That said, I would say that family-owned businesses should do more to monitor the capital markets as interest rates rise, and credit might be harder to find in the future if economic conditions weaken at some point. As we all know, the best time to raise money is when you don’t need it, so business owners should be proactive and vigilant about knowing what is out there for them on the capital markets, talk to people, and build and maintain relationships. When it comes to what that money is used for, it is less likely to be liquidity financing that they need, and much more likely to be to buy out a retiring family member or expanding facilities.
Frank A. McGrew is a managing partner at McNally Capital, a leading merchant bank formed by the McNally family, owner and operator of Rand McNally & Company. McNally Capital provides private capital and delivers advisory services to operating companies and family o ce investors. McGrew has nearly 30 years of experience as both a private investor and adviser to closely held and family-oriented businesses.
What do you think makes family-owned businesses so attractive to both strategic and financial investors?
On a high level, it’s a big universe of prospective targets and an aging group of business owners without a succession plan. The perception is that many of these family-owned businesses are run inefficiently and possible are victims of digital disrupters, which is also making some owners anxious about the future of their businesses. Growth potential plays a key role for both strategic and financial investors looking at family-owned businesses as acquisition targets. Strategic buyers see them as a source of growth via economies of scale in a market where organic growth is almost impossible, while financial buyers see the potential to achieve increased revenues via streamlined operations and geographic expansion. After all, size matters when the time comes to exit, and bigger firms typically command a higher multiple when sold!
What are some of the sensitivities that family-owned businesses may have in doing an M&A deal, and what tactics should potential acquirers employ to maximize their chances of doing a successful deal with a family-owned business?
I feel there are three things to consider: First, be sensitive to their culture and how they approach the family dynamic/ownership overall. Second, have a strong understanding and knowledge of the company and the industry it operates in, meaning you can make a credible and informed approach versus just calling companies blindly without a thesis. Third, have a differentiated value proposition and demonstrate what is unique about your offer in a potentially crowded field of suitors. Alignment on these three issues is often far more important than offering the highest price. All business owners have a high regard for their business and see their peers receiving top dollar for their companies, so they too have a desire to realize the same if not even higher values. I would also add that we are seeing an increasing number of family-owned businesses seeking out how to engage with family offices as a funding source alongside or often in lieu of private equity. Family offices are becoming very sophisticated in pursuing direct investments and are a desirable capital source as they share many of the attributes a seller is seeking, such as a long or indeterminate holding horizon, reduced leverage, more flexibility, a shared sense of culture and values beyond just maximizing profits, etc.
How can acquirers of family-owned businesses bridge any valuation gap issues with the sellers?
As I mentioned before, alignment on three key areas can overcome valuation concerns. Earnouts based on future revenue streams, such as via a new product launch, are another option I have seen work very well in the past. However, it is important to be very careful with earnouts as they can create conflict down the road and defer problems until after closing.
What other liquidity options are available for family-owned businesses other than an outright sale?
The option of selling less than 100 percent is always there. This approach would allow the family to dip their toes into the water and go slowly while developing a relationship with a prospective buyer. An example would be to create a joint venture with an investor to expand into a new region. This would allow the family to benefit from the investor’s time, resources and knowledge. The key to such a deal being successful is to have a clear understanding of the overall objective and post-closing goals. And again, any partner should understand that a family-owned business will be playing the long game and may not have much experience in doing such a deal. By initially selling less than 100 percent, the seller might also be able to receive proceeds in several steps, enabling them to participate in the future growth of the business. This “majority” or “minority” recapitalization facilitates the “second bite of the apple” as financial sponsors like to highlight for sellers and usually enables the sellers and management to phase out their involvement over time.
Thank you very much, Frank, for your insights. Do you have any final thoughts you would like to share with us?
Yes, I think buyers of family-owned businesses should spend some time working out what kind of relationship they would like to have with the family and the previous owners and managers when the deal is done. Do they want them to stick around? Be part of the board? Retain a small shareholding in the business? These considerations could well have an impact on the success of the deal. I would also remind everyone that hiring the right team of professionals is the best advice for family-held businesses considering a sale or transaction.
Thank you very much for taking the time to talk to us.
It has been my pleasure.
This feature also appears in the Q1 2019 Intralinks Deal Flow Predictor available here.