Financing Sources and Solutions for Family Business Growth Capital Needs

By David Guin, Clyde Tinnen

This is the first in a series of three articles.  Future articles will consider the challenges faced by family businesses when seeking owner liquidity options and managing through a change of control.  This article supplements an Expert Briefing on the same topic at Transitions West 2017. (Sponsored Content)

Family businesses, like all businesses, must grow in order to survive and thrive.  As the saying goes, business is like a foot race on a road made of live crocodiles. If you keep moving, they will bite at your heels. If you stop moving, they can swallow you whole!
 
What is Growth Capital?
Growth capital is the money required for a business to fund its long-term strategic growth objectives. Examples of strategic growth objectives include acquisitions, joint ventures, major facility renovation and product-line, production and geographic expansion. Growth capital is contrasted with working capital (money for ordinary operating expenses, such as payroll, rent and inventory costs), maintenance capital (money for repairs and maintenance) or recapitalization capital (money for redeeming stock, special dividends or refinancing outstanding debt). Growth capital is typically larger in scale, more speculative in nature and more burdensome on businesses than other forms of capital. The substantial resources that are required to fund strategic growth objectives reflect the risk and rewards of the goals that are sought. 
 
What Types of Growth Capital Exist?
Growth capital comes in various forms with disparate terms and considerations.
Operating cash flow/retained earnings – Ideally, the cash generated from operations would be sufficient to fund expansion and growth. 
 
Debt – Borrowed funds, typically from an investor or bank. Advantages of debt financing include the wide array of commercial terms that are available (e.g., short term vs long term, secured vs unsecured, guarantees, mezzanine, multi-tranche, special purpose vehicle borrowing, etc.), potentially higher returns on equity, the deductibility of interest expense for tax purposes and no dilution to family ownership. Disadvantages include tighter lending standards (especially on speculative new lines of business or acquisitions), restrictive covenants, burdens on prospective cash flow and insolvency risk.
 
Equity capital – Sale of equity entitling investors to "ownership" rights, including a portion of earnings. The company's organizational documents and state law govern the specific rights of equity holders.  Depending on the form of organization, there could be significant flexibility to negotiate the voting and economic rights of equity holders, and those rights may differ between family and non-family owners.  Frequently, investors have some preferred economic rights and limited voting rights, and they may also be entitled to special protections. 
 
Hybrid instruments – Instruments incorporating features of both equity and debt, for example, convertible preferred stock, warrants or convertible debt.
 
Royalties – Accepting a capital infusion in exchange for royalty rights based on a percentage of sales or other metrics, sometimes paid in perpetuity or paid until the royalty holder has received some pre-determined multiple of its initial capital provided. 
 
Sale leasebacks – The sale of property to a third party for cash today followed by a lease of the same property on a long-term basis.
 
What Types of Growth Capital do Family Businesses Most Often Utilize?
In a recent PricewaterhouseCoopers LLP global survey of 2,802 key decision makers in family businesses with a sales of $5 million to over $1 billion, respondents were asked how they plan to finance future growth capital needs. 76% of the respondents said they would be relying on their own capital, at least in part, to fund growth capital. 78% of the respondents said they would rely on external financing. 63% of respondents said that they would rely on bank loans. 35% of respondents plan to seek equity financing. 31% of respondents plan to incur debt financing other than a bank loan.
 
What are the Keys to Successfully Finding the Best Sources of Capital?
In a family business, careful consideration must be given to the impact of various financing options on family as well as business objectives.  For example, equity financing may be unattractive if non-family members would obtain significant influence over important strategic decisions.  Alternatively, if equity financing is available from sources that would not seek significant control rights, this might be more attractive than debt financing that could impact the ability to provide liquidity to family members on an ongoing basis.  The objectives and concerns of each family will be different, but all families should start the process by weighing financing alternatives against family objectives.
 
Once you have determined which financing options are consistent with family objectives, it is critical to build a credible business case for strategic growth objectives.  No matter who the potential source of capital may be, it is important that management diligently and honestly assess the opportunity at hand in light of the anticipated long-term and short-term benefits.  The business case should consider industry and business risks, management’s and the organization’s ability to execute the strategy, transaction costs and anticipated timing. All of these factors will inform the company’s detailed analysis of the anticipated return on investment to all stakeholders (meaning the investors funding the growth capital as well as existing stakeholders of the business), which is at the core of the decision to participate in the funding. The detailed analysis should be summarized in a heavily-scrutinized, concise, informative, written presentation for approaching investors. 
 
Next, the business needs to identify potential investors and solicit their interest in deal. Typically, the company ought to tap into its existing network first. Banks with a relationship with the company, existing investors, attorneys, accountants, employees, friends, family and suppliers should be considered first. Their knowledge of the business and those involved can quickly bridge an information and trust gap that takes longer to develop with new investors. However, it is important to identify competitive offers, so the search should not stop with existing networks. There are a growing number of non-traditional sources of capital that are willing to provide capital on favorable terms with investment criteria that is better aligned with needs of family businesses. For example, family offices and high net worth individuals are increasingly a preferred source of family business finance.
 
Finally, the business needs to carefully evaluate the terms of capital offered and secure capital commitments. It is important to weigh all of the terms in the context of the strategic objectives. For example, a higher interest debt instrument that does not require personal guarantees or collateral may be more advantageous than a similar debt instrument that does with more onerous covenants that restrict the ability of the business to grow. It is best to engage knowledgeable counsel to negotiate and prepare the requisite documentation.
 
David Guin and Clyde TInnen are partners at Withers Bergman LLP.  This article provides background for their expert briefing at Transitions West 2017.
(Sponsored Content)
 

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