When shareholders lose their patience

For the past generation or so, Dow Jones and Co. has enjoyed a Jekyll-Hyde reputation as (a) the publisher of a great newspaper-the Wall Street Journal-and (b) a company with mediocre stock returns. Both identities sprang from a single source: the hands-off approach of the controlling Bancroft family-the heirs of publisher Clarence W. Barron-who left the company's management to good journalists and demanded little return on their investment

That policy of benign neglect began to change three years ago when one of Barron's 26 great-great-grandchildren, Elizabeth Goth, discovered that at age 32 she owned 700,000 shares of Dow Jones stock worth about $23 million and started wondering whether her stake was worth keeping. As one of her confidants put it, "She woke up and said, 'I care. This is my fortune. This is my asset. Now what do I do?'" Since then, Dow Jones managers have been scrambling to boost their stock price to the level of their journalism.

Like Dow Jones, family firms have long recognized that one of their main competitive advantages is the stability of their "patient capital." Family business shareholders used to be willing to wait a long time-in some cases, like that of the Bancrofts, almost forever-before they received the dollar benefits of their investment or inheritance. Unlike publicly traded companies, family firms don't have to dazzle their shareholders with next-quarter earnings.

Or so the theory goes. Unfortunately for family businesses today, the stability of "patient capital" is often being shaken at its roots-among the family shareholders themselves.

As a result of the unprecedented wealth build-up of the last ten years, many shareholders in family businesses have accumulated wealth outside the family business. What's more, the passage of generations as well as today's desire for short-term rewards have reduced what's known as "the Family Effect": the combined value of a family firm's ownership, heritage and stewardship. "What have you done for me lately?" is becoming the most commonly heard question at family business shareholder meetings.

But all is not lost. You can regenerate or even enhance the "patience" in patient capital by focusing on one very simple concept: increasing shareholder value.

In a publicly traded company, shareholder value is easily measured: The higher the stock price, the more money shareholders make when selling their stock.

In a family company, in which a limited market exists for the stock owned by the family, shareholder value is measured in the form of excess cash return-that is, the cash returns generated by the business after cash expenses, taxes and investments above the cost of capital. This excess can be distributed to shareholders, reinvested in the business or put to other uses.

By creating shareholder value, the company assures shareholders that their return expectations are met-and, consequently, they'll be more inclined to keep their investment in the family firm instead of seeking greater returns outside or clamoring for the sale of the company.

The cost of patient capital

Does it come as a surprise that family shareholders harbor expectations for their investment-in other words, that patient capital has a cost? It shouldn't. Yet too many business owners take family money as a given and believe it costs the business nothing. The question is how to define the cost of patient capital. There are several ways to do it.

• The opportunity of cost. This is the rate of return that family shareholders could earn on their money if they took it out of the family company and invested it elsewhere. If they know they can get a 12% annual return by investing it in the stock of comparable publicly traded companies, for example, that's the starting point of their expectations. And if your company is returning 8% or 10%-well, already it's not looking so good by comparison.
• The degree of liquidity. When family members buy publicly traded shares, they can sell them any time they wish. But since most family business investments are not marketable, family shareholders expect a premium to compensate for that lack of liquidity. If the return on an outside investment is 12%, family shareholders might want that plus an extra percentage point or two for keeping their funds in the family firm, putting your cost of capital at 13% or 14% or more. But if your company has a liqidity program and family shareholders can redeem shares with some ease, their expectations will be lower.
• The "family effect." This phrase takes into account the intangible return of being a part owner of a family business, such as the commitment to the family heritage, the stewardship of wealth and its values to one's children, or just the satisfaction of being part of a business-owning family.

When the family effect is strong, family shareholders tend to demand less financial return. The shareholders who were thinking in terms of 13% might now reduce their expectations-as well as your cost of patient capital-to, say, 11%.

Take aggressive steps

When your cost of capital exceeds the cash return generated by the company, you need to manage aggressively on behalf of shareholder value-increasing your cash return above the cost of capital or reducing the cost of capital, or both.

Consider the case of Tops Pet Food (not its real name), a family-owned business with more than 40 family shareholders. Only three of them work as senior executives in the family business. Most of the other shareholders have built significant outside wealth. So the family managers of Tops shouldn't have been surprised when, at last year's annual meeting, several shareholders raised questions about the value of their Tops shares. Some even suggested that they might be better off selling their shares in Tops and investing the proceeds elsewhere.

Confronted with shareholder dissatisfaction, Tops Pet Food's family managers first surveyed their shareholders to determine the strength of the family effect. They also ascertained what returns family members could expect if they put their money into publicly traded companies in the same industry.

This fact-finding showed Tops that its cost of patient capital-what the family shareholders expected returns to be-was about 16%. The business, however, generated only about 11%. The disparity meant there was a high risk that family shareholders sooner or later would say, "We can do much better on the outside, so we want to sell the company."

To head off that possibility, the managers launched liquidity programs for the shareholders and took steps to strengthen the family effect-introducing a family newsletter, a family website and a shareholder education program. As a result, family shareholders lowered their return expectations, thus reducing the company's cost of capital.

To increase the company's cash return, Tops sold off some underperforming divisions, introduced incentives to increase productivity, renegotiated some of its bank credit lines and initiated a major cost-reduction program.

As family shareholders saw management swing into action, they became very supportive. And their faith has been richly rewarded: The company's cost of capital is now down to about 10.5%, while the company's cash return has risen to more than 16%. Needless to add, the shareholders are thrilled.

But increasing shareholder value produces more than shareholder happiness and loyalty. As the Tops example shows, it strengthens the family and the business to survive the demands of the present and the challenges of the future.

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