Neil Patel

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M&A in family-owned businesses involves unique dynamics specific to the unusual structure of such companies, regardless of their scale. Typically, family firms have objectives, cultures, and ownership frameworks that are distinct from other companies.

As expert M&A advisors note, family firms maintain complete control over their operations and focus on long-term investments. While they are averse to taking major risks, they are also open to taking advantage of short-term opportunities.

These contradictory thought processes make M&A transactions all the more challenging and need customized strategies to execute effectively.

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    Family-Owned Companies Are the Key Drivers of the American Economy

    Interestingly, family firms are the key drivers of the American economy, with families owning more than 90% of all businesses. These companies range from small, local mom-and-pop stores to MNCs like Marriott, Berkshire Hathaway, Exor, Schwarz Group, and Walmart.

    Together, they account for close to 50% of the GDP, paying out almost 50% of the total wages in the country. However, less than 30% of successful enterprises are run by second generations, and just 12% retain third-generation ownership.

    As a result, exit strategies and succession issues are crucial in M&A in family-owned businesses. Companies come into the market for sale by their founders or subsequent generations. Many aspects come into play here, including their expected returns from the sale and firm valuation methods.

    The family’s emotional attachment to the company, its culture, mission, and estate planning for the owners are crucial considerations. Even so, the economic downturn over the past three years has led to more family enterprises coming up for sale.

    Dealmakers are recognizing the need for unusual strategies to ensure successful M&As and efficient integration and synergies. Read ahead for detailed information about how these acquisitions work.

    Culture is the Main Differentiating Factor

    Family firms offer buyers a valuable asset that is missing from conventional acquisitions–their culture and goodwill. These assets don’t feature in financial statements or other valuation methods, but acquirers should work on how to preserve them.

    Maintaining the underlying aspects of the family firm should be an important consideration of M&A in family-owned businesses. The founding family has likely lived and worked over an extensive period in its community. Their close one-on-one relationship with customers is integral to the firm’s success.

    When estimating synergies, buyers must factor in cultural aspects and how to maximize advantage from them.

    In conventional M&A transactions, dealmakers focus on the financial and physical assets. They’ll also factor in Intellectual Property (IP) and intangible assets, including the brand name, logo, goodwill, and dedicated customer base. Acquiring a family firm offers all these assets along with a USP–root strategic assets.

    Root strategic assets form the establishment’s cornerstone and core aspects that dictate long-term success. The firm’s community ties, culture, history, commitment to social issues, and ongoing influence and leadership are other undeniable aspects.

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    Achieving Cultural Synergy Can be Challenging

    Mergers and acquisitions among traditional companies miss out on these assets that can influence long-term scalability and survival. The business’s ownership changes can impact its ideology and practices for operating and interacting with the community and customer base.

    During M&A valuation, sellers will want to factor in the root strategic assets in the final pricing. On their part, buyers will want to assess if they can preserve that culture and maintain synergies. And if they can successfully sustain and leverage the location-centric knowledge-based assets and talents the seller has acquired.

    Identifying culture and leveraging it effectively is more challenging for new managers. That’s because identifying and describing an organization’s culture is virtually impossible. The company culture is an outward manifestation of underlying family values and history and is hard to replicate by third parties.

    Root strategic assets like disciplines, beliefs, and other traits that create a local market presence and connection cannot be quantified. Nor can dealmakers place monetary values in M&A in family-owned businesses.

    Emotional Intelligence Quotient is Undeniable

    The emotional intelligence of the company’s workforce influences integration and getting stakeholder buy-ins in a big way. Family-owned businesses typically employ local people who have close ties with the community. Or people who have positions because of special favors and allowances.

    Further, these companies often hire family members as employees on the basis of their relationships instead of qualifications and capabilities. Issues like these can cause problems during integration when the sellers would prefer the new owners to maintain their workforce.

    The owners themselves have an emotional connection with the company, considering their name is on the door. They are likely to screen potential acquirers carefully after assessing their suitability and sensitivity to the local social structure.

    The buying entity may have to answer questions about how they hope to integrate the acquisition with their own company. Their future vision, expected synergies, and prospects of the seller’s workforce within the acquirer’s organization are other causes of concern.

    M&A advisors often talk about how senior-level integration is crucial for the deal’s successful closing. Acquirers may also have to factor in the costs of special training for undesirable employees to develop necessary skills. Or even create positions and projects for the sole purpose of hiring them.

    The inability to restructure the surviving company to include these hires can lead to dissatisfaction and mistrust among the employees. This situation is not just detrimental for the acquirer internally but can also have fallouts among the community. Losing customers is just one of the many risks.

    Remember that storytelling is everything, whether in fundraising, mergers, or acquisitions. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

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    Complex Shareholder Structure

    Family-owned firms typically have complex ownership and shareholder structures. Shares and owner stakes pass down over generations and may include active and non-active family participants. M&A deals can only progress after these complexities have been unraveled.

    Before the transaction closes, dealmakers may have to work out the historical, current, and future tax implications of ownership. That’s because family businesses have different members working in roles like board members, employees, partners, and advisors.

    Some of them may hold stock but may not have any decision-making powers. Then again, the salary structures, compensations, and pension plans may also be undefined or unfairly allocated. Or they might have legacy programs to secure the future of the subsequent generations whose parents are working in the company.

    Lack of clearly defined roles and wages leads to conflicts, especially when personal rivalries and disagreements spill into business operations. M&A in family-owned businesses becomes all the more complicated when advisors and buyers must navigate these issues.

    Unclear ownership and decision-making rights make M&A in family-owner businesses complicated. Especially when the company represents a significant part of its owner’s net worth.

    Examining Financial Statements and QofE Reports

    An essential aspect of M&A due diligence is examining the financial statements and analyzing them. With family firms, owners tend to co-mingle personal and business expenses. They may also use the company’s revenues to cover payroll for non-active members.

    Diverting company profits to vacations combined with business trips and payments for personal cars, phones, and other charges complicates statements. Factoring these costs and separating them from the owner’s financials is crucial for determining the company’s value.

    A practical solution is to invite third-party accountants to add back the charges and balance financial statements. M&A advisors typically direct sellers to conduct Quality of Earnings (QofE) before sale.

    Conventional audits of a company’s financial statements provide insights into its historical profits, losses, and revenues. The metrics indicate the company’s performance and whether it is compliant with the Generally Accepted Accounting Principles (GAAP).

    However, a QofE report not only focuses on the historical performance but also determines the firm’s potential earnings. The report identifies and records non-recurring and pro-forma adjustments that normalize the accounts as needed.

    Determining sustainable earnings with QofE reports helps in the firm’s valuation process while estimating projected financials for the coming years. Sellers can have a fair overview of the asking price before they put the company up for sale in the open market.

    This is why QofE reports are quickly becoming an essential part of the due diligence process during M&A in family-owned businesses.

    Knowing how to navigate due diligence is a crucial skill founders should have for every stage of their company. Not sure how to do that? Check out this video I have created explaining it in detail.

    Estate Planning for Family-Owned Enterprises

    From the seller’s perspective, the company sale represents a significant liquidity event for the multiple generations of the family. Bringing in expert advisors to manage estate planning and its taxation repercussions is crucial to secure the family’s financial future.

    Sellers must work out how to handle the estate planning when the company ownership transfers to third parties. Taking the right steps is essential as soon as the family-owned business starts raking in revenues and becomes profitable.

    Traditionally, when owners pass on, their estate passes on to the heirs, who must pay high tax rates. Retaining the services of a business consultant, tax planner, insurance agent, lawyer, and accountant can help minimize this tax burden.

    To minimize taxes, owners freeze the company’s value by creating preferred stock, which does not appreciate in value. Since the stock cannot be appreciated, it will not attract substantial taxes. Though, recipients of these shares must pay gift taxes when owners transfer the stock to them.

    However, when owners of family firms are ready to sell their company, buyers may have to navigate the preferred stock. They may also have to work around any other tax-saving strategies the owners may have adopted.

    That includes living trusts, marital deduction trusts, dynamic trusts, unified credit or exemption trusts, and annual exclusion gifts. The owners may have also set up payment structures for the stability of the members working in the company and their families. Buyers must factor in these payments also.

    Avoiding Ownership Dilution

    Family businesses typically prefer to secure their ownership in the company and maintain control by avoiding dilution. When they need to raise capital for the company, they prefer non-diluting securities and options like cash, debt, and recapitalization.

    Owners may not want to bring in equity if that means bringing in external investors. This tendency often results in cash flow issues. For this reason, family-owned firms prefer to engage in cross-sector acquisitions that allow them to diversify their product portfolios.

    This strategy helps them expand quickly by integrating other verticals while retaining control over the business. As a rule, family firm owners focus on the scalability of their ventures, adopting a long-term perspective for sustainability.

    While they are open to taking short-term risks, they are also open to leveraging their brand name and goodwill. They use these assets for growth and expansion, especially when they can improve the brand value and reputation.

    At the same time, they undertake detailed planning before making decisions that have a long-term impact on their legacy. Factors like these are understandable when a significant portion of the family’s wealth is locked into the business.

    This risk aversion and tendency to invest only in viable opportunities is a huge benefit for acquirers. They could be looking to purchase a business that has a robust foundation and structure with great projected metrics.

    Benefits of M&A in Family-Owned Businesses

    Acquirers assessing a family-owned enterprise as a target for purchase can leverage several pros that ensure long-term sustainability. Buying a known brand with an established and dedicated customer base is a huge advantage.

    Getting funding to acquire a reputable brand is much easier since investors are aware that the firm is generating profits. Above all, buyers get instant access to decades worth of learning and know-how the family has developed.

    Intangible assets like community relationships, leadership, and positive influence are indispensable for long-term growth and maintaining a market presence.

    M&A in family-owned businesses comes with its own set of challenges. However, the upsides far supersede the downsides, with buyers acquiring established and reputable brands with a market standing that can take years to develop.

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    Neil Patel

    I hope you enjoy reading this blog post.

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