A family-held manufacturing company with $300 million in sales has 75 shareholders in the third and fourth generations. Only ten of those shareholders currently work in the company. The major issue for them is how the business can fairly accommodate the majority of family shareholders who do not work for the firm, and how all shareholders can participate in the risks and rewards of their activities.
The family decided a family bank would best serve their diverse needs. The first thing they did was set aside $50 million from the company's retained earnings, which would be used to invest an average of $1 million to $5 million in certain ventures shareholders might want to buy or launch. The second step was to create specific selection criteria for the kinds of investments the family bank would underwrite. For them these criteria included: leverage (they decided on a maximum debt-equity ratio of 50-50); projected rate of return (it must be well above 22 percent, a rate money managers could reasonably be expected to achieve); and the portion of equity in a given venture that the family bank will fund.
Who will make the final decision? In this case, the family was careful to make sure that each branch was represented on what is called a commitment committee, which votes on all projects that meet the basic criteria. If there is a tie, the chairman of the company would use his extra vote to break it. The family also decided to include a couple of outside professionals on the commitment committee. Conveniently, two outsiders who serve on the firm's board and are already familiar with the family and the business, agreed to join the committee.
Although final details have yet to be worked out, inactive shareholders are already lining up with business proposals in hand. One family member is eager to buy an interesting little battery business; another wants to team up with an inventor who just patented a water filtration process he wants to market. A family bank can be set up with as little as $5 million, but because the cost of setting up and managing a family bank is high, anything less would not make sense. A company with less than $50 million in sales would probably not be able to scrape together the capital required.
There are several ways to structure the new ventures. They can become a family partnership, or a corporation owned by the family bank, acting as a holding company. The family should have a substantial interest in the entity, and some kind of control. That doesn't necessarily mean the family must hold a majority position, but some family bank members should sit on the board.
The family bank presents several parallels to venture capitalism, and some important differences. The similarities include the decision-making process. The commitment committee should be as objective as a venture capitalist. The shareholder seeking funds should prepare a sophisticated business plan for the committee. Committee members should review the plan diligently. They need to check out the health and future prospects of the business. And they should make sure projections are reasonable by running them past the family business CFO or an outside, independent accountant.
Two weeks or so after the business plan is circulated, the shareholder should make a presentation before the committee, prepared to answer rigorous questions. Finally, the shareholder retires from the room, the committee debates the project and takes a vote.
A rejection of the business plan could create resentment between family members. To prevent that, any committee members who are especially close with the inactive shareholder should abstain from the vote. All decisions should be based on the merit of the investment for the family in the long run.
The long-term orientation is the principal area in which the family bank differs from a venture capital group. The latter group looks for 40 to 50 percent returns on investments. Family bankers should be content with more modest results, and over a longer period of time. Proceeds of the investment, when there are any, can be distributed in a number of ways. A certain amount should be retained by the venture, to help it grow. Some should be distributed among the family members. But the family bank should consider its investments as long term, not like venture capitalists who look to get money out in three to five years. You should not consider liquifying the investment by going public, selling the venture or a chunk of it or distributing major dividends for at least seven to ten years.
The family bank offers other benefits: It helps spread wealth among family members in a tax advantaged way; provides an opportunity to diversify the family's assets; and builds new wealth.
The family bank is not for everyone. Indeed, it is so new that not many are around, although many family businesses are considering starting one. Other ways to reach similar goals include a repurchase program. Employee stock option programs (ESOPs) are another route. Or consider a co-sponsored loan program, in which the business negotiates favorable lending rates with its commercial bank for loans to inactive shareholders, using their stock in the family business as collateral.
The family bank will not replace these mechanisms, but it is a way to create immediate liquidity for an extended group of shareholders with diverse business interests and talents, without having to sell or pledge their stock. Best of all, this can be accomplished in a way that all family shareholders win.