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Money is Plentiful: What Easy Credit Means to Family Firms

Why are stock prices so high? Why are interest rates so low? Why are so many merger and acquisition deals being done? Why are you getting more phone calls from people wanting to buy, sell, merge, consolidate, leverage, strategically ally, take public or otherwise financially manipulate your family business?

All of those questions have the same answer ..."The Baby Boomers." Finally facing the reality of retirement, 76 million big spenders have become big investors and poured oceans of funds into the capital markets. The tide has spilled over into the middle market, with investors accepting high risks in search of returns. Financial intermediaries are accommodating the market by finding users for all this capital. Family businesses and those who have financial ideas relating to family businesses would seem to be ideal consumers of the boomers' monetary bumper crop.

What does all of this mean? According to Loan Pricing Corporation, the cost of private equity capital and mezzanine funding for medium-sized companies decreased by as much as 30% between 1996 and 1997. Fees to close financial transactions were halved in the same period.

The same trends have caused the prices being paid for middle-sized companies to rise. Measured by the ratio of EBIT (earnings before interest and taxes) to sale price, multiples have steadily increased for nearly five years. For financial buyers (those looking primarily for investment return) the ratio has increased from 5.4 to 7.1 (up 31.5%) and for strategic buyers (those who want your business because it fits with their business's strategy), the ratio has moved from 6.1 to 9 (up 47.5%), between 1993 and 1997.

Add those increases in price to any earnings growth you've experienced of late and the 1997 reduction in capital gains tax from 28% to 20%, and you might be happily surprised at what the sale of your business might net. If you doubled your earnings before interest and taxes over the past five years, you may have increased the after tax gain on the sale of your business by 333%.

But now to the most important question: "So what?" If you sell your business (which is what everybody wants) you will have money (which is what everybody has). You go from holding the prize to joining the chase. If you have funds, you must invest them and the question becomes, where could you find a better place to invest than in your own business. Our advice remains unchanged-don't let purely financial considerations tempt you to sell.

However, the current financial environment offers numerous opportunities for family businesses committed to multi-generational success:

  • Make sure you are borrowing in the most advantageous ways, at the most competitive rates. Ask not what you can do for your banker. Ask what your banker can do for you. Plenty of people want to loan you money today. Let them compete for the opportunity.
  • Strategic planning, decisions and action are more important than ever before. Your competitors may use low cost capital or borrowing to become more aggressive. We've increasingly seen margins eroding, new and stronger competition, investments in increased manufacturing and distribution efficiencies, spending on new, improved or broadened product lines, and other competitive improvements. In some industries, strategy may require that you "buy or be bought." More often, that is not true (it is the hype of the financial folks stirring the pot). What is true, however, is that you cannot sit strategically still.
  • If you have a "no debt" philosophy, you may want to think again. Because debt is relatively cheap, you may want to consider adding some debt or substituting some debt for equity to fund growth, improvements, or new strategies, or to provide funds to retiring family members. This could be a good time to create a liquidity program that gives shareholders an opportunity to sell stock back to the company.
  • Keep some powder dry. Some of the wise, old family businesses we know are waiting for this cycle of soaring values to play out. Even though many now say "cash is trash," they are accepting lower interest rates and patiently preparing themselves for the time that prices fall. Some family businesses were among the original and bravest contrarians.
  • Don't die. Higher multiples drive up market valuations of closely-held companies. Your estate tax may be higher than you think. Review estate tax plans in light of the current higher valuations and consider strategies for transferring family business ownership to the next generation, even if the kids go into (cheap) debt to buy aggressively discounted minority interests from the older generation.
  • Update your market intelligence. Review who owns and manages your competitors, and how they are financed. Take time to try to parse out their strategies. Do not be complacent about what's going on in your industry. Ownership transitions, whether within families or to new entities, can have a great impact on your competitors' creating strategic threats and opportunities.

The economic environment is terrific now, but taking advantage of that fact demands that family businesses hone their strategy and financial management skills. As always, some family businesses will survey the competition and drop out of the race. Other family businesses will renew themselves (again) for the ever changing realities of business, and live to fight for another generation.

 

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