Financing the Family Business: When Growth and Succession are at Issue

Financing the Family Business: Northeastern University
When Growth and Succession are at Issue

Family Business Quarterly
by Thomas M. O’Reilly

The following is a true story. The names and certain details, however, have been changed to ensure confidentiality.

In 1957, Stanley decided to go into business. With $10,000 of his own and another $10,000 from his brother Fred, he started a small parts supply company.

By 1994, Stanley’s company had become a thriving $33 million business with 15% annual growth. Fred, who still owned 50%, was not seriously active within it. He used the company as a place to launch various less-than-successful enterprises. He relied on the 50% split of company profits that Stanley had always given him to live on and to fuel his various undertakings.

The success of the supply business had largely been the result of Stanley’s efforts and that of his two sons, Tim and Rory. The sons had been significantly involved since 1982, and Stanley believed that their hard work, combined with his understanding of the industry, had resulted in the company’s growth.

Ownership Challenge

The problem was that Fred was never willing to recognize Tim and Rory’s roles and prohibited them from having titles and pay that reflected their contributions. In 1994, this all came to a head, and Tim and Rory gave Stanley an ultimatum. “Either we get titles and an opportunity to own this business or we are out of here,” they said.

Stanley decided to approach his brother. First, he would solicit Fred’s interest in being bought out. If that didn’t work, he would invoke his rights to buy his brother out under a long existing “buy-sell” agreement that they had. But Fred was not interested and a long and bitter negotiation followed.

What were the key issues? First, Fred counted on the income he got from the business each year. Second, the agreed upon price gave him 50% of the book value of the company, and that was insufficient for his way of life.

From Stanley’s perspective, everything was fair. Fred had never really involved himself in the business; yet, he had been paid millions in salary over the years. Besides, the “buy-sell” agreement gave both Stanley and Fred the right to offer each other a price for the company; and if Fred didn’t like the price, he could buy Stanley out.

Much to Stanley’s surprise, Fred opted to try to buy Stanley out. He hired a top-notch attorney and investment banker and set about developing a counter proposal.

Financing Dilemma

One thing led to the next–eventually resulting in a pricing war that drove up the purchase price to about $9.5 million, or roughly three times what was called for in the original “buy-sell” agreement. The problem now was that neither side could afford the purchase price on its own, and the company was going to need up to $5 million in working capital availability to support its continuing growth. That would mean that this historically virtually debt-free company would not only have to borrow from a bank, but would also likely have to take in outside equity to provide all the financing.

Five bankers and three venture capitalists later, Stanley and his sons were getting a pretty good picture of the future, and Stanley wasn’t sure he was going to like it. It seemed obvious that it was going to take bank debt and venture capital money to get what he needed, almost $15 million dollars worth.

With only $9 million in assets, he didn’t think a bank would extend him the additional financing he needed. The venture capitalists wanted a lot for their money. They needed about a 30% return, significantly more than the prime plus 1 or 2% that he expected the bank to charge. To meet the venture capitalist’s expectations, he would have to give up 10-40% of the business in outright stock or warrants.

That was not what Stanley wanted. After all, he didn’t want to buy out his brother just to take on an unknown partner who would probably need to see the company grow even more rapidly to achieve the return that the venture capitalists expected. The decision created a lot of anxiety as his sons began to see the venture capital route as a better deal.

Bank Approaches the Family

One banker seemed particularly persistent in talking to Stanley about the whole situation, however. He not only asked questions about the company’s financials, but asked to meet with Tim and Rory. He also asked about the effects that the negotiation was having on the entire family. He told Stanley that he had already gotten to know the company’s attorney and accountant because he had been interested in the business for a long time.

Eventually, the banker asked if he could bring out the three key people who would decide whether or not to lend the business money. Stanley agreed to the meeting and was pleasantly surprised by its outcome. The bankers came in and reviewed the financials. They toured the plant briefly and met with selected staff. Finally, they returned to Stanley’s office and, with Tim and Rory present, asked if there was anything management could do to strengthen the company.

It was as if the flood gates opened. Stanley, Tim and Rory told the bankers what they would do if they were running the business for themselves. An hour or so later, the bankers offered to revise their original proposal. If Stanley, Tim and Rory were willing to commit their ideas to a written business plan, cap their salaries at an agreed upon level, limit distributions to cover taxes and provide a limited personal guarantee of the debt, then the bank would provide an all bank deal. No venture capital money required.

Reasons for Success

How could this be? According to the bank, the financials told only one story–past history. The people told another story-the future. And the bank believed in Stanley, Tim and Rory. It believed they had the skills to grow the business, given the right incentive.

The bank had done its homework. Its account officer was experienced. He had met and gotten to know the company’s professional advisers. His tenure at the bank was recognized and gave him credibility. He had effectively created a relationship with both the company and the key people within the bank. And based on the understanding that relationship created, if ownership was willing to share the risk and put its reputation on the line, the bank was willing to do the entire deal.

From the banker’s perspective, the deal worked because Stanley, Tim and Rory were who they said they were. They gave the banker a chance to know them and to establish an honest rapport with them. They gave him the information he needed to be able to accurately present the company’s case to the other key decision makers at the bank, and he believed that there was more to the business than just the numbers in the financials. Finally, despite not being wealthy people, the owners agreed to share in the risk that the bank was willing to shoulder.

From Stanley, Tim and Rory’s view, the deal worked because they were working with a seasoned banker who was interested in more than just the company’s financials. He was also interested in them as a family and in their goal to keep the business a family one. Plus, he delivered the deal he promised.

In the end, all the banks weren’t the same and all the bankers weren’t, either.

Thomas M. O’Reilly is a Vice President of State Street Bank and Trust Company, specializing in providing banking services to family businesses. In 1995, he received the bank’s highest award for lending performance, the Chairman’s Award.