Can you revive your distressed family business?
Family businesses have been the backbone of the American economy for years. Entrepreneurs entered industries with low barriers and grew prosperous enterprises through ambition and perseverance. But the start of the 21st century saw the sale of many family-owned businesses as second- and third-generation owners chose to monetize their investments. The family companies that remained found themselves competing against companies where sales growth and EBITDA, rather than family values and long-term profitability, were the overriding goals.
Many family business owners’ reaction to the recession and mismanagement of finances hurt their profits and viability. Growth opportunities and wealth quickly vanished. However, by making some important changes to their strategic business plans and improving communication with business partners, these companies can again become prosperous.
A case study
Family-owned distribution companies illustrate the problems faced by many family businesses in various industries throughout the years. One company I worked with was founded after World War II, as men returned from battle to an expanding economy with vast opportunities. The founders built the company on personal relationships and strong customer service and passed it to their children in the 1980s. This was the business their children had learned around the dinner table, and the prospering company was able to support two families. As other siblings joined the business, the company expanded through organic growth and acquisition. By the 21st century, sales exceeded $50 million, though margins were squeezed owing to competition.
As the company expanded into new locations, the family purchased real estate for the business to rent, as an investment strategy. As in many cases, during the boom years the real estate equity was greater than the equity of the business. This seemed like a good investment until the recession hit, exposing the flaws of the distribution business model. Among them were losses generated by one family member’s special projects, excessive salaries paid to family members, buyouts paid to the senior generation as the next generation took over, drained resources through the paying of acquisition earn-outs, depreciation of real estate, and stale inventory that had lost considerable value.
Adding to the mess, while the rest of the economy grew in 2007, the distribution industry started to feel the downturn, and eroding sales further exposed the dynamics of the family business. Up to this point the new generation of owners had experienced only growth, and they believed the downturn would not last. They were slow to reduce expenses and streamline the corporate structure. Even as sales declined by 33%, and then 50%, the owners did not cut costs because they believed expansion was just around the corner.
The owners, like many others in similar situations, “reinvested” in the business, inadvertently damaging the company’s equity with poor choices regarding where to reinvest. They sold to questionable customers, continued to purchase inventory based on historical sales, purchased through vendor “new item” buying programs and invested in equity or debt to cover their losses.
By the end of 2009, liquidity was tight and the company’s banking partner was not willing to expand its risk. In fact, it was actually scrutinizing the collateral of the company’s asset-based loans. As a result, the bank reduced the company’s accounts receivable and inventory borrowing rates, tightened eligibility requirements and squeezed availability of additional funding sources. The bank also reviewed inventory value as the liquidation market became more saturated owing to numerous bankruptcies and business closures. Liquidity continued to tighten, vendors were extended and the company’s loans were not renewed.
The business found that the only way to survive was to pledge all family assets (including real estate) and provide personal guarantees as collateral for its current and new loans. The owners rationalized this strategy by telling themselves that economic turnaround was imminent; they could not afford to miss a new expansion opportunity; losing the family business would end the family’s main income source; and they had a moral obligation to their employees, investors and vendors.
Unfortunately, sales did not improve and the business had not reduced costs to operate profitably at its current sales level. The losses continued to mount as vendors were paid down, liquidity was squeezed and the company was told to find a new lender. The business was failing; what’s more, the real estate market was collapsing and the family’s real estate equity was no longer available to borrow against to cover losses.
Many family businesses like this one were sold to strategic buyers at little more than liquidation value. If the owners had made strategic changes when the business’s liquidity first began to be squeezed, they could have had a happier ending.
Saving the business
Family-owned businesses can survive, even if they hit tough times. Arguably, the most important step in saving a distressed family business is assessing its cost structure. Often as businesses grow, the staffing levels also grow. Once a downturn hits, rightsizing the workforce is a move that family owners do not want to make. There is no question that rightsizing the staff is difficult. But it’s important for the business owner to take a step back and see where overhead can be reduced and what the appropriate staffing level is for the business’s size. In a restructuring, decisions must be based on needs and costs rather than emotions and loyalties.
Another area that typically needs improvement during tough economic times is vendor communication. Often by this point vendors have stopped selling inventory to the troubled business and want to be paid immediately, but the liquidity is not available to satisfy these debts. The best way to resolve this issue is with proactive communication. If vendors are informed of the situation, they are often amenable to working with the company. Vendors that had refused to provide product often agree to resume doing so through COD payments for at least six months, allowing the company time to reestablish profitability and refinance its loans. The vendors agree to this arrangement because they can earn profits with no increased exposure. This maintains the relationship, restores the vendors’ confidence and enables the family business to satisfy its customers’ needs.
Once overhead cuts have been made, product has been secured and the business is starting to see profits again, it is time to begin the process of securing attractive refinancing options. Typically, families running their companies believe in the business and feel that the real estate value will be the magic elixir they need to secure additional loans. In reality, the business will need to show profits for four to six months, while having equity, in order to qualify for refinancing. For companies in severe distress, refinancing can take six to nine months while a turnaround takes hold. It’s important to initiate the needed changes to provide the stability required to qualify for refinancing.
The first step is to determine whether the business can be cash flow positive at the current sales level or at lower levels, if sales continue to decline. A review of historical trends will reveal whether the company is viable at the current sales and gross margin levels.
In addition to controlling costs through overhead and workforce reductions, the sales mix may need to be adjusted. This might decrease incremental profit dollars but improve overall profitability and liquidity. If these steps cannot be completed, it’s time to look at options for selling the company.
Although many family business owners are hesitant to ask for help outside the family or let an outsider into their inner circle, an outside consultant may be needed to take an unbiased look at the business. Many times the combination of restructuring, improving vendor relationships and securing refinancing will be enough to save the company.
Steven F. Agran is a managing director in the New York office of turnaround firm MorrisAnderson (email@example.com).
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