When it comes to maintaining long-term liquidity in a family business, just going with the flow is not an option. You need a solid wealth extraction strategy, says Richard Brass
Wealth extraction sounds painful, like tooth extraction. Indeed, many who contemplate the process of extracting wealth from a family business view it as a similarly unpalatable experience.
The process of extracting wealth can be an emotional and drawn-out process, and with today’s economic background it is doubly so. The current state of the global economy leaves it very difficult to make economic predictions and undoubtedly makes finance more difficult and expensive to obtain.
Let us consider the following scenario. The owners of a well-managed, family-run company wish to extract wealth from their business without losing control of it. If, as is often the case, the owners are made up of a group of individuals, perhaps spanning many generations, it is likely that they will each have different wealth requirements and varying degrees of involvement with the family business.
Having a ‘liquidity strategy’ in place, an agreed means by which income and capital are distributed to the owners, will remove uncertainty over future income. It can help avoid confusion and disharmony among key shareholders and in turn ensure that the family business continues to make strategic decisions with a long-term perspective. This is a distinct competitive advantage to be preserved.
So the desire to extract wealth cannot be considered in isolation from the fundamental needs of the business itself. A successful liquidity strategy aligns the interests of the business with the interests of the owners.
Several important questions follow from this. What are the owners’ wealth objectives (emotional investment versus financial return)? How will a liquidity strategy affect the business’s prospects and values? What are the viable sources of finance? Is outsider influence wanted or needed? How do we address the owners’ wealth-planning requirements?
When putting a liquidity strategy in context, there are two key considerations to bear in mind. First is business succession and planning — the impact of the chosen liquidity strategy on the long-term prospects of the business. Second is wealth preservation — the ability of the chosen liquidity strategy to maximise value for the owners.
More specifically, some questions may be posed to assess how a liquidity strategy may be optimised. How will a liquidity strategy affect the ongoing health of the business and its stakeholders? What level of outside involvement is acceptable to incumbent owners and business management? Why is wealth required, and is the chosen method of extraction tax-efficient?
Posing these ‘How, What and Why’ questions can help a family navigate their journey through the business issues, opportunities and challenges that inevitably arise.
Preparing a business or strategy plan is a helpful discipline, whether it is merely jotting down ideas or preparing a detailed analysis in a more formal manner. A business plan will enable owners to assess their potential investment return from different funding strategies. It will provide a basis (or at least a starting point) for discussions among owners. This may present a major commitment in terms of time
and resources, but it should prove to be a worthwhile investment over time.
Sources of finance
Finance will come from either the business or an external party, and there are a wide range of options. The business can increase compensation, pay dividends, squeeze working capital and set up an internal equity-trading market to enable shareholders to buy and sell shares between each other. Such internal sources of finance have the advantage of being relatively flexible.
External finance may be sourced in the form of debt, equity (from private equity and public markets) or a hybrid of the two. It can be received directly by the shareholders or channelled via the business. This outsider involvement may be unappealing at first glance but it can bring relevant industry expertise and know-how, and professional management skills and experience. There is also the possibility of seeking alternative, more ‘strategic’ forms of finance, such as selling non-core operations or creating strategic alliances.
The credit crunch has made fund-raising extremely challenging. As the economic environment improves, however, family businesses are well positioned to benefit. Investment opportunities will be scarcer and investors will be attracted to well-run businesses where there is a real opportunity to share in the future value of the business. Cultural heritage and long-term ownership, both staples of family businesses, provide the backdrop for identifying any alluring investment opportunity.
A liquidity programme may be rendered fundamentally inefficient if inadequate consideration is given to maximising value after tax deductions and identifying how the wealth will be deployed. After all, wealth planning is an evolving process that needs to adjust to changes in legislation, personal circumstances and, in the case of family business, the business’s financial performance.
What exactly constitutes wealth planning, some may ask? Essentially, it combines three elements: tax advice, structuring, and investments. Domestic, international and personal taxation are becoming ever more complex and, whereas many business owners are often well advised with respect to their corporate tax needs, focusing on the personal tax consequences of a liquidity strategy, or indeed a disposal, may require fresh thinking.
Often, taking time to deal with structuring considerations can deliver significant financial results. For example, the wide current differential between rates of income tax and the capital gains tax rate will have a significant impact on planning for the extraction of wealth from a business.
One should not underestimate the time necessary to build a plan for investing extracted wealth. Early identification and an understanding of the risks and returns of different classes of investment help to benchmark against the merits of a liquidity strategy.
For example, if the liquidity strategy creates an annuity income from salaries and dividends, would the owners consider investing wealth in higher risk/return opportunities? If a lump sum is realised, how is the investment exposure spread to meet short- and long-term obligations and to preserve wealth in real terms?
How, what and why?
No two family businesses will agree on the same liquidity strategy, so in an effort to offer some general messages…
How will a liquidity strategy affect the ongoing health of the business and its stakeholders? Arranging access to and distribution of wealth is a highly emotional affair and must be sensitively managed. An effective liquidity strategy will meet owners’ wealth objectives and assist long-term business planning. It will match the business’s capital requirements with the source of finance (in particular bearing in mind the exit requirement for external finance).
It will ensure that a family business’s inherent competitive advantage is not threatened. Do not neglect to consult all family members, as being included in the process will make them feel more comfortable about it and will help to identify any issues promptly.
What level of outside involvement is acceptable to incumbent owners and business management? Internal finance retains control and offers the greatest flexibility, but it may weaken the business’s trading prospects and its capacity to raise finance later on. External finance brings outsider involvement, particularly for equity investments.
Any concern with such outsider involvement needs to be weighed against the professional qualities and experience an outside investor brings. The business needs to be well-prepared with a clear strategic plan, proper financial records and a realistic assessment of its strengths and weaknesses.
Why is wealth required, and is the chosen method of extraction tax-efficient? Owners need to make a self-assessment of their personal situation and desire to realise wealth. Do they want a lump sum or annuity income, and which will be most tax-efficient? Wealth planning will maximise value received by the owners and help them to assess the merits of a liquidity strategy.
Establishing an appropriate timeframe to address these questions should allow flexibility to make the optimal decisions for extracting wealth while ensuring the long-term sustainability of the family business.
Using an adviser
No single adviser can cover all the issues, and the careful selection of professionals is important and can take time. Family businesses may wish to explore using advisers who specialise in working with corporate and personal clients. Hiring the right set of advisers who can give constructive and independent advice should benefit the family, but saving on fees can be a false economy.
It will be important to have people alongside who are able to take the same long-term perspective as the family itself. An independent and objective private bank can help, one that measures success by having a family and its successive generations as clients, and also has access to a wide network of experienced business people and advisers.
This article has been extracted and adapted from a chapter in a forthcoming book, Business Families and Family Businesses, published by Globe Law and Business for release in June 2009.
Richard Brass is a client director at Schroders Private Banking.