How to plan for your future capital needs

As in other business activities, a little foresight—no crystal ball needed—can protect your business.

By Chester A. Gougis

Almost every company on the New York Stock Exchange was at one time a family business. In most cases, the companies ceased to be family businesses when the need for capital to achieve corporate or family goals made it necessary to sell a majority of stock to outside investors. The biggest challenge in preserving a family business has always been how to maintain ownership and control and still obtain the capital needed to operate the business and provide for the family’s personal needs.

While these issues have always been critical, several factors make the management of capital especially important today. The need for capital has never been greater. Increasing global competition and the rapid pace of technological change in most industries have put pressure on U.S. companies, large and small, to accelerate their investment in new plants and research and development.

Making the capital management problem worse is the fact that the availability of capital has actually decreased in recent years. As a reaction to the excesses of the 1980s, banks and other lending sources have been far more cautious about providing financing. And while public equity markets have recently been favorable for new offerings, this is still recognized as a very expensive method for raising capital and out of the range of reasonable options for many family companies.

Another change that has increased the capital needs of family businesses is the ongoing evolution of the owner-manager structure to a family-shareholder structure. Traditionally, a family business was one that was not only owned by family members but had a significant number of them involved as managers and employees. Increasingly, however, family businesses are those in which family members are involved principally as shareholders who have broad oversight but are not actively involved in daily management.

This can create additional liquidity needs for the business. No longer can these family members realize economic returns from their ownership solely through their compensation as employees. Instead, they must look to other kinds of returns—dividends, stock repurchases, and the like. At the same time, the company must adequately compensate the nonfamily professional managers who are responsible for running it. The need for personal liquidity along with the growing need for reinvested capital, at a time when capital availability is low, creates one of the biggest challenges for family businesses in the 1990s.

FAMILY CAPITAL PLANNING

What can families do? The first step is to develop a “capital plan” for the corporation. This refers to a joint effort by the company and the key family members to estimate the capital needs for reinvestment and for shareholder liquidity over the next 5 to 10 years. Coupled with this effort should be a forecast of what the company’s business will be like over the same period. Once the magnitude of the capital needs have been determined, various solutions can then be examined.

Of course, to many companies, planning is anathema. In the 1980s, long-term plans were often abused by those seeking to justify everything from investments in junk bonds to making aggressive acquisitions at twice their value. Furthermore, with the fast pace of change, a plan is often obsolete by the time it leaves the word processor.

Nonetheless, I believe the planning process can be a valuable tool for helping companies come to grips with capital and liquidity problems. The most valuable part of this exercise is not the specific forecast that may result but the process of systematically thinking through the various needs and alternatives.

When does the principal owner want to retire? At that point, how much money does he want to live on? What kind of financial burden will that place on the company? Is the company morally obligated to buy back the shares of certain non-active family members upon their death, so the heirs can pay estate taxes? When will the company need to replace major assets? Does the company have a strategic need to make acquisitions in Europe to expand its markets? These are the kinds of questions that surface during the planning process and must be addressed.

ESTIMATING FREE CASH FLOW

The capital plan should start with a forecast of the ongoing “free-cash” generating ability of the company. By free cash, we mean money that is really above and beyond what is needed to keep the basic business of the company going—that is, cash that can be used to pay dividends, repurchase stock, or make acquisitions or fund expansions.

Knowing the company’s net income as reported on its audited financial statements is only a start in this process. Net income usually does not represent the actual free-cash flow that the company generates. To measure free-cash flow, one must add back to net income all the non-cash charges, such as depreciation, amortization of good will, or deferred taxes. This represents what might be termed the “gross cash” generated by the business. From this amount, you then have to deduct ongoing increases in working capital (inventory, receivables, and so on) which will be needed to support the growth expected during the forecast period. In addition, capital expenditures necessary to maintain and renew the company’s physical plant are also a net use of cash which must be considered.

Once the free-cash flow of the business has been estimated, then more extraordinary capital needs should be examined. For example, capital for expansion into new areas or related markets may be strategically important to the company’s future. Some of these needs may be financed through divestiture of other business lines or assets that are no longer producing income; the rest will have to be financed out of free-cash flow or outside capital.

CORPORATE VS. FAMILY NEEDS

Once the capital needs of the company have been determined, the capital needs of large family shareholders must be addressed. The most apparent capital needs of many family businesses are related to estate planning. The company must estimate when it is likely to have a significant need for capital to buy back shares from the estate of a large family shareholder or to pay taxes.

The income needs and expectations of inactive family members must also be estimated. As pointed out, when family members become less involved in the business they often require a higher return on their investment. Because the worth of the business is a key to many issues that arise, the valuation problem must be addressed as an integral part of planning. For example, when the time comes for stock buybacks, how will the business be valued and by whom?

A family business capital plan should not try to predict the future precisely, but rather should develop contingency plans for alternative scenarios of what the future may bring. Too often, families are forced to sell the business because of events they might have anticipated and prepared for. Sometimes a little foresight—no crystal ball required—is enough to forestall this type of unfortunate circumstance and allow the family business to grow and thrive.

Chester A. Gougis is president of Chicago-based Duff & Phelps Financial Consulting Co., which specializes in a range of business and financial planning projects, including corporate valuations, employee stock ownership plans, venture capital financing, and taxation issues.