As the world’s economic woes continue, the axiom “Cash is king,” which may have seemed quaint when quoted by senior-generation relatives a few years ago, is again being heralded as the gospel truth in many family businesses. “Suddenly, the old man who was considered stodgy and overly conservative is looking pretty damn smart,” says family business consultant James E. Barrett of Cresheim Inc. in Philadelphia.
The good thing about cash is that it’s quantifiably certain —either it’s there or it’s not. There is a lot to be said for verifiable assets in a business climate where supposedly rock-solid resources (and even landmark financial institutions) disappear overnight.
“Relationships are great, but cashflow is even better,” Jacob Wallenberg, a fifth-generation member of the family that controls Swedish bank Skandinaviska Enskilda Banken (SEB) and giant holding company Investor AB, recently told The Economist (Jan. 24-30, 2009). The publication noted that both SEB and Investor are holding their own in the current economic crisis. Investor’s more than 80 holdings include interests in industrial banking systems manufacturer ABB, drug firm AstraZeneca, and manufacturing and construction equipment firm Atlas Copco. “The main reason for Investor’s resilience,” The Economist reported, “is that it entered the downturn flush with cash, giving it the means to support struggling subsidiaries and buy distressed assets at knock-down prices.”
But, like most aphorisms, “cash is king” can’t be followed slavishly in all situations. “If you are talking short-term, it’s absolutely true,” Barrett points out. “If you’re talking the longer term, thinking is king—cash helps.”
Another point to keep in mind, according to many advisers, is that while running a business—family-owned or otherwise—on a strictly cash basis may seem like the safest way to operate, it’s not necessarily going to result in a company that’s stronger or more enduring than one that makes judicious use of debt. And it may not even be possible! Even the most conservative managers would be hard-pressed to operate without at least some use of other people’s money, be it vendor terms for merchandise, a mortgage that unlocks the value of the company’s real estate, or a bank credit line to help with seasonal variations in the operating cash flow.
All debt is not created equal
“We use the term ‘debt’ as if all debts were equal,” says Fort Worth, Texas-based family business consultant Sam Lane of the Aspen Family Business Group. “That’s simply not true. There is debt used to cover losses, but it’s not the same as debt that simply levels out bubbles in demand or debt that’s used to finance equipment. Those are very different kinds of things.”
And what about growth? Few businesses generate enough free cash to fully finance the acquisition of a competitor, build a new plant or upgrade a manufacturing facility without using some sort of long-term debt. They may not go to the bank or Wall Street, but seller financing, borrowing against an insurance policy and factoring receivables are forms of leverage also.
During the buyout boom, the Wallenbergs’ Investor AB, the largest industrial holding company in the Nordic region, was criticized for being slow to make deals and for sitting on too much cash, The Economist noted. But the company’s family-controlled status enabled Investor to stick to its strategy. Investor “could resist pressure from outside investors, because it is almost impossible to take over,” the article said.
Yet despite family firms’ advantages in a climate where Wall Street investors are incessantly calling for quarterly profits, family business leaders face some challenges that CEOs of non-family companies don’t have to worry about. David Thompson, president and CEO of Laminators Inc. in Hatfield, Pa., points to one of the most common in explaining a major shift on his balance sheet that occurred last year: “We had a very substantial cushion, but it was built up for a cash-out event for my father. Two of my brothers and I used the equity to take out a loan to buy the business.” It was the first significant debt the company had incurred in more than 40 years.
Watch your leverage; curb your lifestyle
Barrett summarizes the most widely held view of the regal status of cash when he says, “The better approach is not so much having cash as not getting too highly leveraged.”
Jack Mitchell knows about that firsthand. He says his family’s company narrowly averted disaster in the 1989-91 recession and took steps to make sure it never happened again. The second-generation owner and CEO of Mitchells/Richards, a high-end fashion retailer in Connecticut, tells a grim tale: “We had debt as the recession started. We had to do warehouse sales to raise cash. It was totally contrary to our brand, but we needed the cash.” He says the family found themselves in that position because they had just finished expanding their original store in Westport, Conn., and acquired some property next door for another expansion when the recession started. “Thankfully, our advisory board said we absolutely shouldn’t take on any more debt and, in fact, we should be cutting back on what we had and building our cash reserves,” Mitchell recalls. “For a while, I didn’t like that answer, but I’m sure glad we followed it.”
Today, Mitchell proclaims, “We believe in three Cs: customers, community and cash.”
It’s worth noting that the company has some real estate debt and works with its vendors for the most favorable terms possible, but it generally depends on its own cash flow to finance operations. While Mitchell won’t discuss the details of the company’s 2005 acquisition of Marsh’s, a retailer on Long Island, he says no significant debt was added to the balance sheet by the transaction.
Mitchell also points out that his company avoids one can of worms commonly opened by other family businesses: excess cash distributions. Even though seven family members (including Jack’s brother, Bill, and his wife, Linda, as well as four next-generation members) work in the company, “We try to preserve the cash we have as a backup,” Jack Mitchell says. That practice has proved very sound in recent months, since many of the stores’ customers are Wall Streeters, who these days are as careful with their purchases as Main Street denizens are. “They don’t wake up every morning feeling compelled to go buy a cashmere sweater,” Mitchell laments.
In many multigenerational business families, “There is a strong dynamic that money left in the business is money that the owner can’t put in his pocket,” notes consultant Sam Lane. They’re stingy about company spending, too, he says: “You’ll find many family businesses with run-down equipment and things like that.”
But Sean Smith, who in 1995 founded Coalition America, an Atlanta health care resource management company, with his twin brother, Scott, says too many family business owners are using their businesses as personal piggybanks. “I see a lot of family businesses that are really lifestyle businesses for the owners,” Smith says. “They’ll put cars, houses, retreats and a lot of personal things on their company that don’t really add value to the company. What it does is give them ways to improve their lifestyles.”
Though the Smith twins were just 26 years old when they founded Coalition America, which helps clients manage health care costs (see FB, Winter 2002), “We’ve always run this as a business,” Sean Smith says. “We don’t even have cars on the company.”
In that respect, a non-family business may hold an edge over a family firm, notes Lane. “In a non-family business, management can’t do that [extract money from the company]. They get their salary and their bonus and that’s it. They can’t take money out otherwise.” Those who attempt to do so end up with a damaged reputation, as former Merrill Lynch CEO John Thain learned when reports of his $1.2 million office renovation became public.
Smith says he and his brother learned the value of cash at their mother’s knee. “It’s rare that my mom will buy anything unless it’s on sale,” he says. “I can remember having a savings account from the time I was three or four. I remember going to the bank to deposit 35 cents over the counter and watch my passbook balance go from $1.60 to $1.95.”
While they don’t use the company’s funds to finance their lifestyle, the Smith brothers haven’t found it necessary to retain excess cash flow in the business, Sean Smith says. Instead, they’ve chosen to pay bonuses and make distributions over the years. “My brother and I and some of the employees who are also shareholders own 100% of the business,” Smith says, “and we’ve been able to pull out enough capital over the last 14 years to diversify our portfolios.” Their personal finances are sound because of the company, but not dependent on it, Smith says. “If the company were to disappear tomorrow, I would be stressed,” he says, “but I could still maintain the lifestyle I want.”
Smith uses a gambling analogy to explain his philosophy. “We could leave cash in the company to compound, but it’s kind of like going to Vegas,” he says. “If you’re ahead, do you let it all ride, or do you take some of the winnings off the table? If you sit at the table long enough, you’ll probably wish you’d put a few of those chips in your pocket.”
It should be noted, however, that the Smiths’ company isn’t capital-intensive. They must meet payroll for about 100 employees and keep up their investment in IT, but unlike many firms, they don’t have heavy equipment, inventories or other cash traps.
Smith and his brother may have strong feelings about cash, but they didn’t hesitate last year to take a plunge into the debt markets to finance their $25 million acquisition of National Preferred Provider Network, a major strategic move that Sean Smith says has paid off already. “That has ended up being a very good acquisition,” he reflects. “It increased our client base and gave us a large base of contracted providers to give to our clients. It gave us a lift in revenue and EBITDA as well as adding to our service platform.”
They chose to make the acquisition with a five-year note from GE Capital so they wouldn’t have to dilute their equity by issuing additional stock, Sean Smith says. “We’ve been able to pay that down in the first year by almost a third,” he adds. “We’re well ahead of schedule.”
Fiscal discipline
The Smith brothers’ experience may be the exception that proves the rule, according to Lane. “You’ve got to have a real race horse to operate at the edges of leverage,” the consultant says. “You need to be in an industry or run a company with an extremely high growth rate to outrun the debt service. Most family businesses just aren’t like that.” He adds, “I’ve seen family businesses that are leveraged to the hilt, and most of them just aren’t that high-performing.”
Barrett urges caution, too, especially today. “If you look at the companies in difficulty now, most of them could do fine on an operating basis, but they got themselves so highly leveraged that they have big payments coming due [and] they cannot muster the amount necessary. They also can’t roll them over because the banks are being so fussy or they don’t have the collateral.”
That’s the scenario that weighs heavily on Thompson’s mind after last year’s buyout of his father. “We’re starting to feel the pinch like the rest of the world,” he says.
His company, Laminators Inc., serves two markets. It bonds plastics and metal into sheet panels for outdoor signs, like those used by real estate agents, that are sold around the Western Hemisphere through a distributor network. Laminators also manufactures composite panels used in commercial construction for decorative wall systems—usually around the entrance of a building, often surrounding a glass storefront. Revenue is split equally between the two lines of business. Both have been affected by the current economic downturn.
“We laid off some folks, cut everybody’s hours back to 32, and my office staff is taking a 10% pay cut,” Thompson explains. “It’s not fun, but if you do it right and do it early, you can keep yourself from ending up in a great big hole.” In the summer, Thompson says, the company typically employs about 90 people. Business is slower in the winter, and the firm sheds seasonal help as the weather cools. In recent months, Laminators has had had two layoffs, cutting the staff to about 75.
The company’s debt could crimp future growth, too, particularly the expansion of some product lines that Thompson has in his sights for when the economy turns around. In the meantime, it will definitely limit the owners’ ability to pay dividends. “We have covenants in our loan that include cash flow recapture,” Thompson says. “Until our ratios are above a certain trigger point, we as owners are precluded from taking distributions beyond what it takes to pay the taxes. Anything above the trigger, the bank gets 25% that goes toward principal reduction.”
The economy is pushing more companies into cash-centric strategies like Thompson’s. “People do everything they can to conserve cash,” Barrett points out. “They cut the inventory, reduce people, fiddle with pricing and credit. On the customer side, you can either shut credit down or extend it to keep customers alive. Inbound, [business owners] work with their own suppliers to improve their terms and work with their banks to maintain their financial ratios within the covenants of their loans.”
On a more sophisticated level, Barrett adds, “Losses, and tax refunds on the basis of them, are a source of cash. There is room to play in those areas, and the accountants know about it.”
It sometimes takes a little fancy footwork and more than a modicum of discipline, but there are definite advantages for family businesses that put cash back on the throne. “Probably a third of my clients have no debt whatsoever, aside from a small line of credit,” Lane observes. “They sleep well at night.”
“There’s a new reality out there, and we have to adjust to it,” says clothier Jack Mitchell. “That’s how we’ll have a business to pass on to the fourth generation.”
Dave Donelson is a business journalist in West Harrison, N.Y.