Happiness is Stock Liquidity
with Inactive Shareholders in Later-Generation Companies.
Here’s how you can Track Stock Value on a Continuing Basis and set up a Stock Redemption Program
by François M. de Visscher
The lack of liquidity options is the most frequently cited source of unhappiness among passive family shareholders. The demands of these shareholders frequently escalate in later generations at just about the time when larger family businesses have opportunities to expand or a need to diversify and require infusions of capital. At precisely the time when third- and fourth-generation shareholders are coalescing as a force to be reckoned with, management is resisting their demands for liquidity, setting the stage for family conflict. Under the emotional strain of being badgered for liquidity and constantly second-guessed, the managing shareholders often throw in the towel and sell the company, more out of frustration than rational choice. The collision of interests often damages family relationships irreparably.
All shareholders in family companies want a clear idea of what their investment is worth, how it compares with other, alternative investments, and how it can be liquefied, if necessary. Succeeding generations are increasingly well educated and financially savvy. Aided by easy-to-use personal computers and portfolio-management software, they are likely to become more rather than less demanding of a competitive return on risk capital. Family businesses need a formal mechanism for valuing and liquefying privately held stock on a continuing basis, and intelligently factoring in the capital needs of the business so that conflicting claims for finite amounts of cash are minimized. The managers can also reap substantial benefits by establishing ongoing liquidity programs for stockholders who want to diversify their investments or get their hands on cash for personal uses.
Two types of programs can be used to provide ongoing liquidity: the annual redemption fund and the company-sponsored loan program. The most common of the two is the annual redemption fund, which allows shareholders to periodically sell their stock to other family members or, if they cannot find such buyers, to the company at a fixed, formula price. Under these programs, the company creates a pool of funds out of available cash flow in order to buy back stock during a predetermined period every year.
Funds for a company-sponsored loan program are provided by a different mechanism. The company arranges for a bank to loan money to its shareholders against their stock, usually at higher ratios of loan to stock value than a bank would normally offer borrowers. Under this arrangement, a company puts its credit behind that of its shareholders, in effect promising to make good on any loan in the event of a default-in which case it can reclaim the stock which is the collateral. The company-sponsored loan program is often used in combination with the annual redemption fund. The loan approach is particularly attractive to younger stockholders starting out in life, who may desire liquidity to fund new ventures or career education and yet may not want to sell stock in the family company for emotional reasons. The annual redemption fund is targeted more to the needs of older shareholders, who may want to diversify their investments or achieve liquidity for retirement.
Creative use of the redemption fund
A Midwestern family company faced a liquidity dilemma three years ago and solved it with an annual redemption fund. Founded in 1925, the company grew rapidly to become one of the largest auto parts distributors in its region. The company was led by four second-generation family members who were active in management and a nine-person board that included highly respected outsiders. Although the company distributed established, brand-name parts and was reasonably profitable, it paid only modest and irregular dividends. Management was thus under increasing pressure to provide more liquidity from third-generation stockholders, members of the Baby Boom generation who were unhappy with their return.
To increase the long-term value of its stock, the company had diversified by investing in distribution outlets downstream and in real estate. But for many shareholders, the long holding periods common in real estate development were creating unacceptable risk-and-return tradeoffs. A small but increasingly vocal group became convinced that the real estate values were in excess of the earnings value of the business and were clamoring for a sale of the business assets. In contrast, the active shareholders believed that the business was getting stronger through its captive distribution network. They also felt that the real estate assets had not yet matured to their full value. Management was therefore vehemently opposed to a sale.
To satisfy the dissidents, the company set up an annual redemption program tailored to the family’s specific needs. The program approved by the board consisted of three parts. First, it set up a liquidity pool funded with annual contributions of 20 percent of cash flow. This pool is used to redeem shares of family members every year provided certain financial tests are met-for example, so long as the total book value of the company, as determined by the board, does not sink below a certain level and debt-to-capital ratios do not exceed a reasonably safe limit. Second, a formula was established to determine the price at which stock would be sold. The formula consisted of four measures: 1) pre-tax income, 2) earnings before depreciation, interest, and taxes (EBDIT), 3) book value of the company, and 4) after-tax market equity. Third, all transactions would have to take place within a limited time frame-45 days following the date that notices go out to shareholders. And, fourth, the price would be updated annually according to the formula.
Over a period of a few years, shareholders who sold their stock have received cash for personal use and for diversifying their investments, while buyers have increased their ownership in their preferred investment vehicle-the family business. By scheduling a fixed time period for such transactions, the company has maximized the opportunities to match buyers with sellers and thereby minimized the need to dip into the redemption fund. Meanwhile, management has been able to pursue longer-term projects as well as take advantage of short-term opportunities that might have been stymied by the dissidents. The recently developed distribution outlets, which had been opposed by some of the dissidents, have become large contributors to revenues and profits. The recovery in real estate values has enabled the company to complete a long-term mortgage financing. The company has thus realized some of the rewards of “patient capital.”
There were also unexpected benefits from the program. The process of tracking stockholder value-by means of the annual formula price-provided shareholders with a better understanding of the macroeconomic and competitive pressures that influence stock values. Psychologically, the process helped to bind the loyalty of inactive shareholders to the family managers who were on the firing line. A new spirit of camaraderie developed between the “ins” and the “outs.” In fact, when provided with a liquidity alternative and an unemotional framework for understanding value, many previously dissatisfied shareholders opted to retain their shares. The process drove home the point that they retain more wealth when the appreciation in value on the stock is unrealized than when they receive taxable cash dividends.
Management also learned some valuable lessons from the program. The emphasis on value exposed the inherent weakness in the cyclical auto parts business and persuaded the managers to invest in product and geographic diversification as well as in acquiring its own stores downstream. At the same time, board members became more conscious of the importance of maximizing shareholder value, which served to improve the company’s strategic planning as well as its relations with shareholders.
Finally, the process of setting up the redemption fund improved communication with all shareholders and eased family tensions. The dissatisfied group felt that their concerns were finally being recognized and acted upon by management. By shifting more ownership to the shareholders who were most interested in the growth of the family business and preserving its heritage, moreover, the leaders also increased the prospect of a successful transfer of the company to the next generation.
Designing a redemption fund
The most critical step in designing an annual redemption fund program is to select a valuation methodology and funding mechanism that is tailored to the particular company and the dynamics of its industry. It is usually wise to engage experienced advisors to design the formula and reassure all shareholders of its objectivity and fairness.
The annual formula price is typically derived from standard valuation criteria, including income approaches, comparisons with values of comparable public firms, and data from previous arms-length sales. The formula differs slightly from standard valuation criteria, however, in its emphasis on available cash flow and borrowing capacity-since these are the primary sources of funds for stock redemptions.
The formula price and buyback fund must be responsive to changes in the operating business and the industry. For slower-growth, highly capital intensive industries, the most appropriate yardstick is often free cash flow, adjusted for annual capital investment. For high-growth industries, in contrast, after-tax earnings is frequently emphasized. Cash flow as measured by earnings before depreciation, interest, and taxes (EBDIT) is the most appropriate measure for industries such as broadcasting, communications, and food processing. Because of the operating leverage in their franchises or brand names, companies in these industries are often driven and valued by cash flow, for which EBDIT is an approximation.
The formula price allowed the managers of the auto parts supplier to demonstrate the degree to which their efforts had benefited shareholders. It became a benchmarking tool with which to project stock values that might be achievable under a business plan with certain assumptions. Pursuing a particular investment opportunity might temporarily lower the price, for example, but management could show how much value the investment would add over the long term. Thus inactive shareholders had a more reasonable basis for making an informed decision on whether to hold on to their stock or sell some of it.
The formula also focused their attention on the factors that determine value in the business. For example, one of the components of the formula took into account real estate values, which shareholders thought fluctuated less than the earnings component. By following the trend in the formula price, shareholders learned that real estate values were not always constant, particularly in a recessionary economy or when interest rates are rising. The inclusion of supply-and-demand considerations, as well as tax costs, lessened the shareholders’ desires to liquidate their portfolio.
Balancing capital needs and shareholder liquidity
Much has been written about why founders and second-generation owners do not do a good job of managing shareholder relations. The entrepreneurial management style is often secretive and does not evolve naturally in the third or fourth “coalition” generations into the more open style of communication that is necessary to deal with growing numbers of inactive shareholders.
During these later stages, the psychic and other intangible benefits of ownership that normally bind shareholders to the family company in earlier stages tend to weaken. Managers do not benefit as much from “the family effect”-the strong loyalty to and identification with the business that is characteristic of founding families. As a result, shareholders will evaluate their stock according to the same criteria they apply to other investments. When tensions arise, business owners have tended to consider only two conventional solutions to liquidity issues: sell the company or go public. Both of the traditional options have well-known disadvantages.
Selling a family company is, of course, usually painful for both present and future generations, because of emotional attachments to the family legacy. It also results in large capital gains taxes for the owners and unemployment for both family members and loyal employees, as well as economic losses to the community. As for an IPO, it is a risky game at best. Even if a public offering is a possibility for a rapidly growing family business, the vagaries of the cyclical IPO market makes going public something of a gamble. Besides the added costs of record-keeping, a public company faces all of the risks and constraints involved in having to regularly disclose financial information that may benefit competitors.
If implemented and communicated properly, ongoing liquidity programs reconcile the capital needs of the business with the liquidity needs of the shareholders throughout the evolution of a family business, so a crisis level is never reached. These programs preserve the pride of family ownership and still allow inactive shareholders to diversify investments and get needed cash.
An established share price that is regularly updated also facilitates estate planning. It enables shareholders to plan for potential estate tax burdens. When the formula share price is high, for example, shareholders may be interested in cashing in some stock or gifting shares to charities. If the price drops, they might transfer shares to family members.
Recent demographic projections indicate that we will see a multi-trillion dollar transfer of wealth to the Baby Boom generation in the next 10 years. Much of this wealth will be in the form of stock in family businesses. The proliferation of shareholders with different needs and loyalties will likely result in growing pressure on managements to provide liquidity. Responsible family managers will react proactively with creative solutions. If family ownership is to be preserved for future generations, they must have the vision to see the liquidity trends in later-generation businesses and respond to them before the problems become acute and the options limited.
By permission of the publisher from Family Business (Spring, 1995). Family Business Publishing Company, http://www.familybusinessmagazine.com.