Business Exit Strategy for a Family-Owned Business
Companies like Walmart in the US and Reliance in India are some really successful examples of family-owned businesses. However, family and business are two parallel worlds that should ideally never meet. Operating a family business comes with its own challenges and results in friction in family relations. This friction then translates to failure of the business.
In order to run a business successfully, it is important to keep all emotions aside, a family business, however, goes against that basic principle. In situations where a family relation turns sour due to business conflict or any other such reason that compels a party to make a decision to part ways with the business, there arises a need for an exit strategy.
In the Middle East, a family-owned business is a popular business model that is being passed on from generations. However, recognizing the challenges that come along with conducting a family business, a Family Business Council- Gulf (FBCG) was incorporated to promote family businesses in the Gulf. This FBCG aims to facilitate the growth of family businesses across generations and create an environment of trust, openness and confidentiality in the region.
Issues that may have an effect on the exit of a member from a family-owned business can be enumerated broadly under as follows;
The most common consideration that compels a family member to exit the company is succession. There is always an underlying expectation of every family member to be the next face of the business, especially if they have contributed to the growth of the business greatly.
Further, a career change may also play a role in influencing this decision. There may arise a need for professional and personal fulfilment outside the realm of the family business.
Another reason may be that of disagreement in terms of strategies and ownership structure. Further, poor decisions accompanied by issues in transparency in the business model may compel a shareholder to leave the company.
In order to deal with this issue, during incorporation of the company itself, the shareholders/ family members must lay down certain terms and protocols according to which, a shareholder could easily exit the business.
In any business model, be it a company or a partnership, on an occasion that a member or a partner decides to leave, there is an asset valuation that is done so that the departing member can get a fair share of what he deserves. Further, this asset valuation also facilitates in projecting the future ratio in which the profits are to be divided among the continuing shareholders.
Famous cases of conflicts in the family business
Reliance Industries and Anil Dhirubhai Ambani Group
Anil Ambani and Mukesh Ambani, India’s richest siblings got into a conflict post the death of their father Dhuribhai Ambani over the business, following which they pursued a non-compete agreement that would basically bar each one of them from entering into a competing business for a stipulated period of time. The agreement barred Reliance Industries from entering into gas-based power projects until 2022. The non-compete agreement further incorporates the right of first refusal in case any of the groups decide to sell off the business.
This case went on to be heard in the Supreme Court of India wherein the dispute was decided in favor of Reliance Industries which allowed them to sell gas to RNRL owned by Anil Ambani at prices that were set by the government.
This scrapping of the non-compete agreement proved beneficial to the siblings in terms of their business interest.
The Gucci Family business
The conflict herein arose when Paolo Gucci instituted a suit against his father and other members of the family who were also engaged in business. The business got into several financial scandals that resulted in a lot of negative publicity over the years.
Palo wanted to use the Gucci name and sell leather goods, which would adversely influence competition in the market. Therefore, the defendants herein filed countersuits in that respect in order to prevent Paolo from using the Gucci name. The suits were dismissed in favor of the defendants in 1980.
This feud did not end here; conflicts continued between the family that led to financial issues in the business, which finally pushed family members to come to the decision to sell nearly 50 percent stake of Guccio Gucci to an investment banking firm based in Bahrain.
It is imperative to note that every family business faces the issue of succession. Exit strategies, therefore, plays a major role, not just in getting out of the business but also in deciding the future of the business.
In case such a situation arises where the next natural heir would not take over the business, the business can go into:
- A decision can be taken to sell the business to a third-party investor
- Further, a business can also be sold to a promising employee or management
An exit strategy must be adapted based on the business considerations like competition in the industry, new opportunities and the projections of the company with respect to its financial future.
An owner of a business may want to go into winding up because of a wide range of factors, both internal and external. The external factors may be, the fact that the competition in the market is getting too stiff, or that innovation in the products and marketing strategies are leading it into redundancy or even profit margins that are not able to sustain the existing business model.
Internal factors may also be considered in making this decision; they may be, passion for continuing the business, realization of the mission of the business etc.
Further, the decision to sell the business to a competitor or the management may be a way to protect the existing employees in the company and basically give them a new home. The decision to sell a business to a competitor is a great strategy since it ensures higher valuation and ease in negotiation.
Moreover, it is important to conduct a prior or annual valuation of the business. This practice is especially important to keep a check on the cash flow and the future of the company. It allows business owners to know exactly how to strategize in terms of growing the business and knowing when it’s time to throw in the towel and sell the business.
The exit plan of any company must be based on the goals of the business owner. It becomes important to know exactly how much they expect to realize out of the business so as to have a steady income once it concludes.
Further, this valuation of a business allows owners to fill all the gaps in terms of financials which further maximizes the value of the company and makes it more desirable to prospective buyers.
Family Business Exit in UAE
Keeping in mind the predominance of family businesses in the Middle East. The Family Business Council – Gulf has, in association with PwC, launched a comprehensive guide to navigate exit strategies of shareholders.
This step seeks to promote harmony in the family business and seeks to avoid any major feud that may result from an exit decision. Further, this step is even more important since the majority of businesses in the Middle East are family-run, and exits in such businesses may threaten the sustainability thereof.
Valuation of a business
There is a difference between public and private companies in terms of valuation. The value of a company is easier to determine since it allows transparency in operations; however, in the case of the private company, a discount can be applied in order to evaluate the value of the business.
A valuation discount basically estimates the value of a company in contrast with the competitors in the market. Such a discount helps in determining the marketability and liquidity of the firm.
The requisites as laid down by the FBCG for determining valuation discount are as follows:
- The extent of marketability and liquidity of the company due to low profits, growth and high volatility of the shares of the company in the concerned sector.
- In case of a minority shareholder’s exit, for instance, there may be a lack of control over an incoming shareholder.
- Ineffectiveness of the management team in the company or lack of governance
- Unreliability of financial information
- Insufficiency of goal alignment of majority shareholders
On the contrary, the buyer or incoming shareholder may carry out a value estimation which refers to the excess value as compared to its competitors in the concerned industry. This type of valuation is known as valuation premium.
The key consideration in determining the valuation premium of the company are:
- The performance of the company in terms of growth and profitability
- The incoming shareholder’s goal with respect to the goals of the company
- Benefits of acquiring another business to merge with the prospects of the company
- Control over decision making and strategy
- Competitive advantage as compared to competitors in the market
- Barriers that prevent external investors
In terms of a privately owned company, the main considerations under this heading are that of marketability and control over minority shareholders.
The FBCG has laid down potential exit routes that can influence the exit decision of a shareholder. These are as follows:
The business may choose to sell its entirety of a business to an existing shareholder through a private sale. This may benefit the company since it ensures that the business will remain in safe hands, i.e. a family member itself. Moreover, it is a less complicated process than offering shares for sale to external buyers. It further ensures that the operation of the business continues smoothly without any disruptions.
Another exit route can be offering for sale, the business through an IPO process. This serves as advantageous in terms of gaining capital for growth. It also allows shareholders to exit the company with a comparatively larger stake. However, the IPO process may not be the most cost-effective way of exiting the business in terms of documentation and corporate governance.
A trade sale is another means to exit the business. This type of transaction is based on value creation and identifying opportunities such as market expansion, diversification, operational collaboration etc. this method ensures that there is a value premium.
The business owner may also take the decision to sell off the company to the existing management. This is also a less disruptive method of exiting the business and allows stability in the company and operation of the business. However, in this case, the family status of the business is subject to dilution.
Selling the business to a financial investor that could be a financial institution or a private equity firm. This sale, however, may be difficult due to the standards of the financial institution that need to be adhered to, in terms of returns. This sale may cause the company to go into restructuring in order to match the profit-maximization goal of the incoming shareholder.
There are certain family protocols that are followed by family businesses. These protocols, however, are not binding in nature. Legally, the process of exit requires that the shareholder offers the shares of the company for sale to the existing shareholders, failing which, these shares can then be offered to third party investors. However, if the family chooses, during the time of incorporation of the company itself, they may contractually agree to keep the shares within the family to a certain extent.
The FBCG lays down certain documents that can be designed in order to regulate exit strategies. These are as follows:
- Family Protocols
This document is non-binding in nature and only contains guidelines for the shareholders in the family business in case of an exit.
- Memorandum of Association (MOA)
This document is binding in nature that governs a myriad of matters related to a business, like business objectives, capital, liability etc. it further also contains matters related to the SHA and protocols.
- Shareholder’s Agreement (SHA)
This document is also binding in nature and governs matters related to the shareholder, including the protocols related to exit.
In case of an exit, the law provides for the sale of shares to the existing shareholders, failing which shares can be offered to a third party unless except a third-party offer is restricted as per contractual obligations. The shareholder can declare dividends in case there is a shortage of funds to buy the shares offered.
They can further contractually agree to minimize the offer of shares to external shareholders and maintain that majority of shares are to be offered to family members only. As an alternative, they can assign shares in the name of children or heirs that may be able to take over the family business upon reaching the age of majority.
Another option can be buying back shares of the company from existing shareholders. This practice is prohibited under UAE law, in which case, dividends may be declared, which may then facilitate the purchase of shares.
The company should, therefore, at the time of incorporation itself, lay down exit strategies as a contingent. This will disable any conflict in the future and ensure that the business runs smoothly without disruption.
It is imperative to have a code of governance within the company framework to ensure smooth operations of the company after exit is initiated. This code should contain all the necessary and comprehensive requisites that facilitate exit like, method of valuation, investment options etc.
Further, the exit strategy must be synergized with the mission and vision of the business owners once the process is concluded.