Heeding early warning signs can transform business risk into success

By Sheon Karol

The decline of a family business can be heartbreaking. Often the extended family loses much of its fortune and the financial security of future generations is at risk. Why does this happen, and, if you are a family member who is not running the business, how do you prevent the decline? Minority family shareholders as well as controlling owners can learn to identify early warning signs and take steps to implement solutions that will transform risk of decline into success.

Powerlessness and fear
A family business is subject to the same fluctuations as any other business. Today, especially, the pressures are intense because change happens faster. But an additional element is found in many family businesses: A single dominant figure often exercises effective control. Business problems are exacerbated when the controlling figure is an aging patriarch/matriarch or a successor who struggles to meet current challenges. Other family members, even if they have an economic stake, often lack visibility into the family business and feel powerless to do anything but worry.

Recognize hints of business decline
Fortunately, you can prevent the decline of the family business even if you do not control it. Here is the key: Your ability to sway the controlling family member improves considerably if you understand the dangers that are facing the business. To do this, you must watch for hints of business decline. These hints occur well before business distress.

While the onset of distress results in significant loss of value, there are earlier hints of business downturn. Unlike signs of distress, these hints are apparent at first only to business owners, who tend to ignore them. Some owners do not realize the implications. Others delude themselves that external factors will come to the rescue. On the other hand, if the company acts quickly, you can avoid a loss of value.

Among these earlier hints are financial warning signs:
• Appearance of new competitors
• Shift in buying or sale trends
• Increased importance of payment timing
• Deferral of capital expenditures
• Lack of innovation in products or methodologies
• Overreliance on an officer, supplier, customer, channel or trend

You may think you are too far removed from the business to be aware of such hints. Do not despair: You are not powerless. There are non-financial hints that you can discern, such as:
• No new blood in management
• Family or health demands prevent the controlling family member from focusing on the business
• No enthusiasm for finding new deals or strategies
• Lack of desire or resources to take the company to the next level

Persuade the controlling family member
After you have identified warning signs, how do you persuade the controlling family member to act? It is not easy to convince anyone to change course. To persuade a person in control is even harder. Hardest still is to convince a person in control who may have overcome obstacles that would have deterred others.

The heads of family businesses are often lone — in some ways heroic — figures. They are responsible for their families’ key asset. Their stubbornness and determination are their strength, but these qualities can also be a weakness if they fail to recognize and respond to business problems. The Romans understood that heroes should be honored but also cautioned. A slave would whisper to a Roman conqueror, “memento homo” — remember you are mortal (only a man). Somehow you need to caution the leader: “Every business is mortal. There are warning signs. You are not alone. We need to respond.”

So how do you do this? The etymology of “persuade” is instructive. The Latin word “suadare” means to “advise,” while “per” means “through, to completion.” To persuade, you need to advise — knowledgeably explain the danger signs and then offer a solution.

You have a great advantage: If the family business responds soon enough, there are a myriad of solutions in today’s economy. The options include:
• Addition or substitution of fresh management
• Introduction of new technology
• Adoption of a new pricing model
• Divestiture of a division
• Sale of the company
• Acquisition of a competitor
• Entry into new markets
• Vertical integration
• Modification of debt structure

To demonstrate the wide range of solutions, let us consider two of these options more closely. You could choose to advocate sale of the company as the ultimate way out. This is a valid solution if, for example, the family wants to monetize its assets or if a buyer has the resources to take the business to the next level. Owners who sell before business downturn becomes apparent to third parties reap the benefits of responding to the aforementioned early hints.

At the other extreme was an operationally profitable business with an unwieldy debt structure (a warning sign). I served as chief restructuring officer at this company. Management was motivated but was confronted with a debt burden that was too onerous for the fundamentally sound business. Instead of allowing the company to slide eventually into a bankruptcy, we engaged the lenders in rigorous negotiations. The separate liquidation analyses prepared by the lenders’ adviser and my team accorded and conclusively demonstrated that it was more advantageous for the banks to take a “haircut” than to drive the borrower into a liquidation. Heeding the warning signs led us to a solution — we renegotiated the debt structure and today the company is thriving. In these types of situations, you can transform risk into success by advocating for a balance sheet fix.

I want to stress a key point. The solutions I have provided are efficacious because they provide positive options to the controlling person. Author and physician Jerome Groopman writes in The Anatomy of Hope that “hope is one of our central emotions.” You can change the controlling person’s mindset by offering hope predicated on concrete ideas.

Based on the lives of his patients, Groopman distinguishes between optimism and hope:

“Many of us confuse hope with optimism, a prevailing attitude that ‘things turn out for the best.’ But hope differs from optimism. Hope does not arise from being told to ‘think positively,’ or from hearing an overly rosy forecast. . . .

"Hope is the elevating feeling we experience when we see — in the mind’s eye — a path to a better future. Hope acknowledges the significant obstacles and deep pitfalls along that path. True hope has no room for delusion.”

To persuade the controlling person, provide hope by offering compelling options grounded in reality.
Now that you have identified the hints of decline and found a solution, you need a procedure to bring about the desired result. Consider whether you are more likely to be successful in one-on-one discussion or if you need a formal mechanism to achieve your goal.

If you opt for a formal mechanism, the best vehicles for conflict resolution are those set up in advance of any problem. You can approach the board of directors. An established family council might provide a non-threatening forum for you to raise your concerns and seek resolution. A shareholder agreement could afford protections for minority or non-controlling shareholders. You may be able to force the issue if there is a buy-sell agreement in place. If there are no mechanisms in place, you can convene a formal family meeting or set up a family council. The last resort should be litigation. Litigation is always expensive and protracted — it is even worse in the context of family conflict.

Build family alliances
If you use the family council, family meeting or board of directors mechanisms, you will probably need support from other family members. You can build alliances by finding a financial solution that addresses the goals of the various family interest groups. This is not easy. You will have to approach the problem both methodically and creatively. First, determine what each person (or family interest group) really wants. Then try to develop scenarios that would satisfy these goals.

This may sound theoretical, so let me provide a “real life” example from which you can extract principles. A family inherited from its founder a real estate empire. Most of the children were in favor of selling the business because they wanted immediate distribution of funds. Opposing them were family members who were concerned about losing their employment in the family business. The next generation, the grandchildren, wanted a steady future income stream.

In a certain respect, the solution was complex. We designed a model that provided for a staged sale of the real estate holdings structured to ensure the following critical goals: Current employment continued for family members, the children received funds in the short term, and the youngest family members had a trust that provided for income over a long period. The sale cadence was extremely sophisticated: Properties could be sold only if they did not cannibalize revenues from locations retained for a longer period, positive cash flow had to be maintained throughout, and distributions were timed to meet the interests of the various parties. However, in another respect, the solution was simple. We identified and addressed the desires of each family interest group.

Transform risk into success
The good news is that, even if you do not have a control position, you can save the day. Recognize the warning signs, caution the controlling family member in an effective manner, offer hope by providing a business solution, implement (if necessary) conflict resolution mechanisms, and, if you seek family support, develop financial solutions that address the needs of each family interest group. Controlling and non-controlling family members alike can convert danger of decline into transgenerational growth and renewal.      

Sheon Karol is a managing director and management committee member of The DAK Group, an investment bank serving the middle market (www.dakgroup.com).

Copyright 2019 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permission from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.                                                            

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March/April 2019

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