Entrepreneurial Finance*Week 5

Family Business and Financing Family Firms

Dr. Yong Wang

Family Business Dynasties*TOYOTA, FORD, HONDA, FIAT

WOOLWORTH, MORISSONS, WAL MART, SAINSBURYS

LOREAL, ESTEE LAUDER

IKEA

AMAZON

MARS, REMY COINTREAU

HOSHI HOTELS OF Japan: 718AD, 46th Generation

Role of the family business sector *

UK estimates: 60-75% of all enterprises

EU: 85%; Italy: 95% +

Sweden: 1970s 15 families ruled 20% of GDP

Proportion of OECD Firms That are Family-Controlled in Percentage- Upton and Petty (2000)Over 85% of EU/US businesses are family run

*degree of ownership and management by family members

e.g. A company in which more than 50 percent of the voting shares are controlled by one family, and/or a single family group effectively controls the firm, and/or a significant proportion of the firms senior management is members from the same family - Leach et al. (1990)

inter-dependent subsystems

e.g. The sub-systems in the family firm system include (i) the business as an entity, (ii) the family as an entity, (iii) the founder as an entity, and (iv) such linking organisations as the board of directors - Beckhard and Dyer (1983)

What is family business?

*generational transfer

e.g. A business that will be passed on for the familys next generation to manage and control. - Ward (1987)

multiple conditions (a combination of three former dimensions)

e.g. Family ownership of more than 50% of the business in private firms or more than 10% of the stock in public companies; more than one family member works in the business or the owner anticipates passing the business to the next generation of family members or the owner identifies the firm as a family business - Astrachan and Kolenko (1994)

What is family business?

The Family and the Business *Strengths of the family business Shorter lines of communication Shorter response times Strength of family relationsGreater financial flexibilityLess dependent on external sources of knowledge Individual involvement greater sense of identityAbility to cope with difficulties

The Family and the Business *Difficulties -Complex interaction of personal and business aspects-Not all family members will be good at the job (benevolent paternalism)-Business existing for owners rather than customers-Intro-vision - Age hierarchies

FamilyManagementOwnership

The businessThe familyBusiness family:

The predominant system is the business. A family will emerge and family considerations evolve, although not necessarily predominant Birley (2000)

The familyThe businessFamily business:

The predominant system is the family. Key issues: children should be involved in the business at an early age and successors should be chosen from the family Birley (2000)

The business The familyThe family and the business:

Be concerned to arrive at an appropriate balance between family and business issues Birley (2000)

*EmotionsInward-lookingFamily patternsDynastic controlInertia TasksOutward-lookingBusiness patternsGrowth and profitsChange Family Concerns Business ConcernsPressure FrictionConflict

Differences between Family Business and Non-family Business - Morris et al. (1997)*

Family BusinessNon-family businessFamily members in managerial positions have lifetime and personal stake in firm.Managers interest in firm is limited to specifics of employment contract.

Failure of the business has dramatic personal and career implications for family members, especially those in senior management positions.Failure of the business has relatively less personal impact on the manager.

Likelihood of family member in managerial position being terminated is low.Likelihood (or perception of likelihood) of a manager being terminated or his/her position eliminated is greater.Personal gain results from a sense of pride in organisations growth, success, job creation, and family wealth creation.Personal gain results from advancement, promotion and increased compensation.Organisational performance tends to be correlated with managerial compensation.Organisational performance tends to be less directly correlated with what a particular manager earns.

Differences between Family Business and Non-family Business

*

Family BusinessNon-family businessDecision making tends to be more centralised, although this may lessen across generations.Decision making is often more participative and team-based.Internal control systems tend to be more informal.Internal control systems tend to be more formalised.Non-family employees may perceive real limits to their upward mobility and personal opportunities within the firm.Employees are apt to have a greater sense of equal opportunity in terms of advancement and participation in decision making; this may produce more internal competition.Family affairs can directly affect business affairs and vice versa.While the personal lives of employees affect their job performance, the impact is likely to be more on the individual than the firm.

Family Business Succession *In European countries, less than 30% of founders successfully transfer the ownership of the family business to the second generation; only about 10% make it to the third generation

-Leach (1994); -Poutziouris and Chittenden (1997) - Wang (2003)

Family Business Succession *Managerial succession in a family businessThe quality of available family leadership talent determines the extent to which competent outside managers are neededSuccession is a long-term process starting early in the successors lifeThe succession process begins with the pre-business stage and includes part-time jobs and full-time managerial workTension often arises between the founder and the potential successor as the latter gains experienceTransfer of ownership involves issues of fairness, taxes and management control.Planning and discussing the transfer of ownership is sometimes difficult but usually desirable

Business Survival Ward (1987) Manufacturers 2001924-1984 80% failures 33%: 0-29 years35% 30-59 years 32% 60+ years Survival 20%5% sold-out2% flotation13% familiar 7% -declining3% - stable3% - growing

Why failure to transfer to the young generation? *Lack of a clear, well-defined succession plan

Failure to address the issue of who will run the businessOwner-manager unwilling to relinquish Reluctance of offspring to take over Non-family managers unwilling to assist successors

Succession Options Sell part of the businessSell the entire businessDo nothingLiquidate the businessAppoint a family member

Family Business Succession the likely routesSandAire 2001 Survey - MBS

To pass on to the next generation within the family51.5%To partially exit, realise wealth and become less active 44.9%To sell the business (trade sale)44.1%To float the business and realise wealth15.3%To liquidate the business 3.8%

*Financing Family Business Capital Structure (i.e. debt-equity ratio) Modigliani and Millers (1958) theory on effect of capital structure on company value forms the foundation

Assumptions: Companies are involved in perfect markets and face perfect competition where companies operate without taxes or transaction costs and where all relevant information is available and free of charge.

Propositions:1. Under this circumstance, variations of a companys capital structure will not change the companys value or shareholders wealth. 2. A companys capital structure will only determine how the stream of net operating cash flow will be divided by different investors. - Romano et al. (2000)

*Financing Family Business Capital Structure (i.e. debt-equity ratio) Propositions:

3. Financial leverage is not related to shareholder wealth

4. Shareholders expected rates of return are directly related to levels of gearing (i.e. debt-equity ratio)

5. Expected increases in returns are negatively related to risk.

The above propositions only are valuable when the assumptions are true. When assumptions are relaxed, factors such as taxes, agency costs, costs of financial distress, and information asymmetry can all influence capital structure. - Romano et al. (2000)

*Financing Family Business Capital Structure (i.e. debt-equity ratio) Pecking Order Theory

Modigliani and Millers (1995) propositions appear to be more relevant to public corporations rather than to family firms.

Propositions: Because of information asymmetry, internally generated funds will be favoured by owner-managers (e.g. retention of profits). This is particularly true when owner-managers are risk averse. Following this, family businesses source capital via short-term bank finance (e.g. overdraft being the main source of external funding; and then external equity finance. Many family controlled firms have an antipathy towards institutional equity finance (venture capital, flotation etc). - Romano et al. (2000) Poutziouris and Wang (2002)

*Financing Family Business Capital Structure (i.e. debt-equity ratio)

Matthew et al. (1994) and Barton and Matthews (1989) argue that a firms capital structure is affected by managements goals. Dreux (1990) recognise conflicting objectives of businesses ad shareholders (e.g. the growth of a business vs. the retirement of an owner)

Matthews et al. (1994) claim that capital structure is influenced by owners attitude towards the utility of debt as a form of funding as moderated by external environmental conditions, as well as owners need to be in control, risk propensity, experience, social norms and personal net worth. - Romano et al.(2000)

*The Finance GapThe problematic flow of development debt financing (costly, insufficient, short-term);

The persistence of an equity gap;

The short-termist approach to strategic financial management

- Poutziouris (2000)

*The Response from the Government The promotion of the business angel network;

The establishment (since 1995) of the Alternative Investment Market (AIM), a secondary market designed primarily for smaller companies;

The promotion of tax efficient Share Ownership Schemes to broaden equity share ownership

- Poutziouris (2000)

*Supply of Private Equity Finance Most of the venture capital invested in MBO/MBI rather than entrepreneurs at the start-up or growth stages

Equity gap exists as early stage, younger and smaller companies experience problems in accessing finance between 50k and 200k- Poutziouris (2000)

Funding Structure of Private SMEs-Poutziouris (2000)

Sources of Finance Family Businesses% of % of externalall funding funding Non- Family Businesses% of % of externalall funding fundingRetained profits51.5--42.8--Bank overdraft17.952.415.537.5Owners equity14.4--15.7--External loans6.218.28.520.4HP/Finance leasing4.713.810.926.3Factoring2.67.63.89.2External equity.82.31.33.1Other1.95.61.53.5

*Funding Structure of Private SMEsThe importance of retained profits as the overriding source of capital

The external financing of private firms is heavily biased towards short-term fund

An aversion towards institutional finance and in particular an antipathy towards external equity

Perceived Problems and Issues in Venture Capital Dealings-Poutziouris (2000)

Problematic IssuesFamily Businesses(%)Non- Family Businesses (%)Dilution/loss of control71.659.2Loss of management freedom63.059.2Pressure from 3rd parties to meet profit targets60.048.9Pressure to change the management team40.532.4Lack of knowledge about rules of the game43.226.8Financing costs49.546.5

Attitudes towards ESOPs and PLC Options-Poutziouris (2000)

Family Businesses(%)Non- Family Businesses (%)Flotation Plans18.232.4Employee Share Ownership Schemes6.459.0

Performance of Private SMEs-Poutziouris (2000)

MeasurementsFamily BusinessesNon- Family BusinessesGrowth rates Sales growth Employment growth Asset growth8.346.149.0714.9014.6414.59Profitability ratios Return on total asset Return on total equity Return on capital employed Profit margin.0929.1023.554.33.0930.1324.492.99Gearing ratios Short-term debt Long-term debt Total debt30.8011.5341.3234.8815.1649.41

Performance of Family Business*

Family companies exhibit weaker growth rates

Family firms appear to neither outperform nor under-perform non-family counterparts in profitability ratios

Family firms have no intensions to maximise profitability to impress internal or external stakeholders

Family firms are inclined to have lower gearing and they have aversion to large-scaled loans.

Homework *Reading Material: Chapter 9: Carter, S. and Jones-Evans, D. (2006) Enterprise and Small Business: Principles, Practice and Policy. 2nd ed., Harlow: Financial Times Prentice Hall.

Gallo M.A. And Vilaseca A. (2004) Finance in family business, Family Business Review, ??

Romano C.A., Tanewski G.A. and Smyrnios K.X. (2000) Capital structure decision making: a model for family business. Journal of Business Venturing, 16, pp.285-310.

Wang Y., Watkins D., Harris N. and Spicer K. (2004) The relationship between succession issues and business performance: evidence from UK family SMEs. International Journal of Entrepreneurial Behaviour andResearch, 10(1-2), pp.59-84.

Winborg J. and Landstrom H. (2000) Financial bootstrapping in small businesses: examining small business managers resource acquisition behaviours. Journal of Business Venturing, 16, pp. 235-254.

Question:Q1: With respect of using debt and equity finance, will family businesses controlled by different generations have different views?

*******Strength: family members willing to contribute; **************************