Cultivating the Family Tree

As the capital gains tax hike approaches, mid-market deal pros are anticipating that a corollary of that will be increased deal flow originating from family owned businesses. It's a theme many in the deal market are well versed on these days. But while many pros are likely eager to get back to doing deals, there is a caveat: working with family-run corporations can be as frustrating as a New Years at the in laws.

The primary challenge, deal pros say, is getting the business owners to adopt a for-profit mindset. It's not that family executives are making decisions that are intentionally destructive to value, but it's hard to get owners to put their short-term self interests aside.

As self-evident as this sounds, the modern reality of dual allegiances and the torn loyalties that family business owners face makes this fundamental component quite complex in practice.

Everett Cook, co-founder and managing director of Pouschine Cook Capital Management LLC notes that sometimes this means owners have to face some hard truths. That may even mean in some cases that siblings or other family members get overlooked.

"The problem is recognizing the human capital deficiencies," Cook says. "That is really the differentiating capital in almost every business over a long period of time. It's a challenge to motivate a family-owned business to take this next step as a business, even if it's not in their best interest to do so."

Often established family businesses can "coast" for a period on previous successes. Eventually, innovations in the marketplace necessitate bringing in an "A-player" to lead the organization to the next stage of growth. It's not unlike a startup that may have been launched in a college setting. The idea and the product may work, but it's unlikely that the random makeup of the dorm room's floor magically assembled the best team to take the business to the next level. Why would it be any different for a collection of siblings or cousins?

As an investor, the correct decision is typically quite clear. But when an executive is a controlling shareholder, a well-compensated executive of the business, and shared a bathroom for 18 years with the rest of the executive team, every decision becomes more agonizing, especially when the choices involve a possible sale.

Pouschine Cook worked with a Midwest furniture retailer that was run by two brothers who each owned 49% of the business. The owners were in conflict, as one brother desired a steady dividend, and the other wanted to achieve maximum growth through expansion of the business. Pouschine Cook's solution was to acquire the shares from the brother who was seeking a dividend, as well as a two-percent stake that the mother owned, then worked to develop the business.

It is precisely this type of family conflict that can present the greatest opportunity to deal pros willing to wade into the marketplace. It takes an unbiased and detached perspective to lead negotiations and suggest a solution that will be beneficial to both sides of a dueling family. Once consensus is reached in such family conflicts, a dealmaker can achieve outstanding results.

"If we are coming in as a control shareholder, we can affect a large amount of change," said George L. Cole, a managing director at private equity firm Veronis Suhler Stevenson.

With that said, deals involving family owned businesses are rarely this easy, especially once investors begin to encounter multigenerational shareholders, which makes a consensus all the more difficult of a destination. Deal pros, in this case, need to operate in equal parts family mediators and deal adviser.

"You need to understand the family dynamic every bit as much as you understand the organizational dynamic," Cole said.

Family dynamics play an enormous role not only in dealmaking, but also in the operational capacity of family-owned businesses. In such cases, a thorough due diligence process should map out the management structure and how initiatives are implemented. Although reluctant to blame family dynamics, Cole said issues involving multigenerational families can certainly create operational dysfunction.