Welcome to the second article in our Build Back Better series. A question regularly asked is how businesses, which have originated and developed under family ownership can make the step to replacing friends and family with external investors, what the principal reasons might be for doing so and how the dynamic of your business might change as a result.

Following on from the first article in this series on the use of debt and/or equity when looking to grow your business, we asked Seneca Corporate finance director Ian Dawson to provide his take on the subject.

The usual story…

For generations, private family-owned businesses have been the backbone of the UK economy, probably more so than in many other parts of the world. In fact, many of the stellar businesses in the UK began with humble origins and it’s fascinating to read many books charting the journeys of our most eminent entrepreneurs that started with seed funding from friends and family.

Even Jeff Bezos started Amazon with seed capital from friends and family including his parents. Not every business owner wants or needs to grow the next Amazon or become the “next big thing”; however, over time, many replace or dilute friends and family shareholders with external investors, particularly as they enter the scale up phase of growth.

So, what might be the principal drivers behind replacing friends and family shareholders with external investors?

What is driving the decision?

Often, it is the case that significant capital is required to fulfil growth ambitions which existing family and friend shareholders are either unable or unwilling to fund. Or it may be the case that long-standing family and friends have reached a natural break and are looking to cash out and enjoy some reward for their time as investors in the business. Similarly, there might be a skills or knowledge gaps which external investors can help bridge to take the business through the next phase of growth. These are not negatives but are real life, day to day dilemmas that many family boards continually wrestle with.

The next phase

Reconciling the objectives of several family members is not always an easy task. Agreeing valuations, overcoming the notion that this is still “our business” and all being in agreement that any incoming investor is the right partner, bringing value over and above simple investment capital, are all valid considerations.

Family-owned businesses are popular investments for private investors as there is often plenty of opportunity to develop the business, professionalise and drive value creation. Quite often decision-making rests with a founder or a close-knit group of family shareholders and bringing in an external investor can help improve corporate governance by providing independent thinking and checks and balances.

Existing shareholders usually target the highest valuation they can achieve, especially in a cash-out scenario. However, it’s important to focus on the additional attributes an investor can bring to the business in addition to capital – be it financial acumen, a network in commercial or financial circles, or simply acting as a sounding board offering guidance and best practice gained from experience.

Consideration should be given to prevent losing the tight networks and strong company culture present in many family businesses; nevertheless, an external investor can often be a catalyst for positive change and help drive the next phase of growth.

Reaching agreement

There are multiple sources of equity capital available to good businesses, both young and old, and often it will be the relationship with the investor and the terms of the incoming investment that determine whether a deal can be struck. Having good advisers at your side to navigate the legalities and commercial conditions of the investment agreement is crucial, not least as a first step in avoiding disputes further down the line. Voting rights, seats on the board, drag and tag rights, swamping rights and dividend policy are just some of the vital elements that need to be properly addressed.

The circumstances behind each investment vary enormously but with investments structured to cash out exiting shareholders, any incoming investor will want to understand what might be “lost” from the business. Often, this might lead to a structure where the headline deal is legally contracted but where full payment is deferred and depends on future business performance and achieving milestones. A common theme is the requirement for key personnel to be retained for a fixed period of time post completion of the deal to ensure a smooth handover and minimum disruption to the business.

Any equity investment entails forward planning, often months or even years in advance. In a positive sense this should enable working towards a target valuation for the business in the time leading up to the deal being concluded and it is also soundly advised to plan the corporate and personal tax consequences in advance.

If the reason for obtaining fresh capital is more about facilitating growth over a cash event for friends and family shareholders, then this is usually a much quicker process and valuation and the extent of dilution will likely be the overriding factors.

Capital availability and access

Growth capital has multiple access points and many of which are conferred with tax advantages under specific scheme rules designed for this purpose. Venture Capital Trusts (VCTs) and the Enterprise Investment Scheme (EIS) are the most prominent with providers of both always seeking out the best companies in which to invest their capital. There are strict qualifying criteria in both cases not least relating to sector, age and size of the business concerned. Both are small private equity type schemes for SMEs. Where transaction sizes are larger and perhaps more specialist, it is a good idea to appoint advisers to help source capital from more targeted sources e.g. private equity funds or even trade partners.

Not all equity providers are willing to invest simply for money to be taken off the table by exiting investors – indeed schemes such as those referred to above actively prohibit it. For this reason, given the complex equity funding ecosystem and terms required by external investors, talking to advisers as early in the process as possible will help you present your case in the most favourable manner and obtain the best value deal.

Our next article in the Build Back Better series will be on selling your business. Looking at how to prepare, where to seek advice and what shape the business needs to be in.

Ian Dawson is a director in the corporate finance and advisory division of Seneca Partners