A capital idea?

Our cover subjects for this issue are the Schwab family, who instituted an Employee Stock Ownership Plan (ESOP) in their company, Harrisburg, Pa.-based D&H Distributing Co. The ESOP not only funded the buyout of some family owners but also has motivated D&H's employees, leading to exponential revenue increases since 1998, when the plan was put in place, the Schwabs say.

Other funding strategies a family company can implement when bank loans are hard to come by include going public, licensing out a technology or product, selling royalties, executing a recapitalization and partnering with venture capital or private equity investors. These mechanisms were discussed at the Private Company Governance Summit 2016, held in May in Washington, D.C., and presented by Family Business along with our sister publications, Private Company Director and Directors & Boards.

PCGS 2016 speakers pointed out that each of these strategies has its drawbacks. Companies that institute an ESOP must judiciously manage the repurchase obligation (which can be sizeable if management decides to restructure or outsource, resulting in many employee departures) and must thoroughly educate employees on what an ownership stake entails. (For more information on ESOPs, see the cover story.)

An initial public offering isn't an acceptable option for families who want to keep financial information private. And few business models are well suited to licensing or royalty agreements.

A preferred stock recapitalization can be used to resolve intergenerational wealth issues or family disagreements (although it is not a good option if the family dissidents want to sell the company). The family members exchange their common stock for a newly created class of preferred stock; they receive a preferred dividend, and often their voting rights are reduced or eliminated. Preferred stock is treated like debt, although it is junior to bank debt. This transaction is unwise for a business likely to face near-term competitive risks, because the dividend requirement drains cash that the business might need. In addition, potential estate tax implications must be carefully assessed.

Private equity companies can provide liquidity to meet minority shareholders' needs or to cash out exiting owners. But families who want to preserve their business for the long term must be aware that most private equity firms have a five- to seven-year time horizon. Will the business be able to buy out the private equity firm in seven years? What will happen if your private equity partners don't like the way you're managing the business?

As was pointed out at the PCGS 2016 session entitled "Capitalization, Liquidity and Shareholder Return," these strategies work well when the value of the company is increasing—and not so much when the business is losing value. Is it possible to free up the needed cash simply by improving operating margins—by reducing overhead or easing up on the "owner benefit"?

Know the downsides before you enter into any of these arrangements—and make sure that all family owners are on board with accepting these risks. This is an area where an independent board can be an invaluable strategic asset.

Copyright 2016 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.