By: Victor Esquivel and Khalid Daruich

When speaking of Mexican companies, we must begin by pointing out that, according to the economic census, more than 90 percent are family owned. This fact is further substantiated when observing “public” companies that trade on the stock exchange: most of them are controlled by one or several entrepreneurs or by a family.

We mention this to emphasize that family-owned businesses should not be categorized by their size or focus, but simply we refer to companies in which the founder or group of shareholders maintain a strong hold on the decision-making process. This creates dependency on the founding member when establishing strategies and searching for opportunities for growth.

Many family-owned businesses have an area of opportunity in the establishment or strengthening of administrative, financial and accounting policies, as the role of the entrepreneur is more focused on the commercial or operational areas of the business than on its managerial aspects.  This becomes a barrier at the moment when the family business tries to grow: the lack of institutionalization of many of its processes and of management control creates problems when searching for financing alternatives.

Today, Mexican companies face constant changes derived from the globalized economy, the dynamics of the market and competition within a certain industry. The objective of this paper is to describe the general situation in which a Mexican family business finds itself in the framework of today’s economy, as it selects a financing alternative that is compatible with the company’s growth strategy.

Financing Alternatives

One of the major topics on the agenda of family organizations as they consider a growth strategy is how to finance it without incurring high costs and losing the flexibility in decision-making processes and control. Historically, family businesses have relied upon some of the following financing options:

1. If the company has a good operational history, it may obtain and qualify for a bank loan. This financing option is characterized by high interest rates and financial and legal restrictions that, far from stimulating growth and expansion, result in the organization making costly interest payments and allowing little room for flexibility in the operation of the business. In addition, it generally requires available assets for collateral backing the repayment to the financial institution, including personal guarantees by the shareholders.

2. In accordance with the size of its operations, the organization may look to the public debt markets. If economic conditions are favorable, this alternative provides additional resources to the organization without the loss of control.  However, on several occasions family businesses have eventually abandoned this type of financing because of the complexity involved in the compliance and preparation of the information required to be listed on a stock market, making it more costly than the economic benefits obtained.

3. Another alternative for family businesses is to consider sources of non-traditional financing, including:

1. Investment or strategic alliances. In this type of financing, a buyer has a broad time frame in which to obtain a return by means of capitalizing on its investment. The investor is usually interested in obtaining control over the decisions and direction of the organization and does not expect to divest in the short or medium term. In this way, its shares will be capitalized through dividends derived from the operations, by synergies with other existing operations or by the simple appreciation of the company during the period of its participation in the organization. When the participation of the investor is considerable, the family organization incurs the risk of losing control of the decision-making processes, especially when groups that were initially minority, now hold a substantial portion of the company.

2. Financial investment from private equity funds. Here an investor hopes to establish a portfolio through various investment projects with the primary objective of increasing its value. At the end of the investment period (that regularly is less than in the case of strategic investors), they seek a liquidity event to exit its investments. This type of investment seeks to institutionalize the company and increase its value in the short and medium term – through growth of the company – in order to proceed to some type of exit mechanism where the investor will try to obtain a return for the successful sale of its investment.

In this way, private equity funds have emerged as an alternative so that companies can obtain the resources they need to finance their growth. The normal process of financing is carried out through an analysis of the type of investment, which may go from obtaining a minority stake, forming a joint venture, or selling partial or total control of the company. Defining the characteristics of the types of investment that exist is a topic beyond the scope of the present article. Instead we point out some of the benefits and features presented by family businesses that have proven to be attractive in the eyes of private equity investors, among which we stress the following:

• Private organizations regularly are purchased with a discount compared to companies listed on the public stock exchange in the same industry.
• They regularly correspond to business opportunities with the support of an entrepreneurial management.
• When growth in family businesses is limited, an injection of capital for expansion may result in returns above the market average.

Also, we have identified general characteristics that family organizations must take into consideration in analyzing a potential sale or incorporation of an investor, such as:

• Family Culture. In many businesses various problems may emerge within the family that are transferred to the companies themselves. For example, on several occasions family businesses may find themselves to be under-capitalized or underinvested, when resources have been diverted as a result of family issues. Another case might be when members of the family occupy key positions and management instead of handing these positions over to a professional management.
• Succession. When the founder or entrepreneur – due to its age, health or self-interest – decide to leave the company, turning it over to the next generation. This situation is crucial: during the process of bringing in a partner, private equity funds often have different visions or interests than those of the family organization. This situation becomes even more critical when the next generation does not have sufficient skills or interest to manage the business.
• Management style. Entrepreneurs or founding members are often the key people in determining the commercial strategy or operation of the company, and for that reason business decisions are borne by a single person. However, the complexity of adopting a growth strategy through mergers and acquisitions requires a strong management team, experienced in similar transactions and involved and encouraged to pursue the stated strategic objectives.
• From the point of view of the family business, the solution is to clearly state from the beginning what can and should be done by each one of the parties involved in this process. There are also opportunities for the company to advance by incorporating a professional management and a group of independent directors who are experienced in several areas, contributing to the value of the company through strategies and objectives.
• Loss of control. Many entrepreneurs believe that when it comes to a sale of a stake or the incorporation of a partner, they will automatically lose control of their company.  However, this does not necessarily happen. Each party in the transaction must understand what type of investment or funding the target company is looking for and establish from the beginning the control scheme that will be implemented by the organization.

Based on our experience, there is no magic formula to indicate the type of control that should be applied. However, it is advisable to leave management decisions and operation in the hands of a professional manager, and try to balance the participation of an institutional investor through means of joint control. This helps to prevent an internal power struggle within family organizations and in turn gives a perspective of personal value to the founding shareholders (mainly for members of the family who are in charge of the operation of the business post transaction).

In addition, various authors express their agreement in institutionalizing the company formally prior to the closing of a transaction. The logic behind this is that when a family grows, it is common for problems to arise when allocating resources among its members. In the same way, when a company grows, it needs to establish clear rules so that all members continue adding value to the organization, even more so if it is subject to a sales process and the involvement of new shareholders.

Finally, another situation that family businesses face while incorporating an investor is when the entrepreneurs themselves want to actively participate in the transaction. The key recommendation is to try to avert any sentimentality and leave the process in the hands of specialists who can objectively identify the strengths and weaknesses of the company. In this way, it will be in a better position to cope with the process in an unbiased manner.

There are a number of consulting firms that offer comprehensive services from financial, commercial, legal, labor and operational points of view. They contribute to guiding the transaction and the process of incorporation and analysis in an orderly and objective manner.

In a changing market, private equity funds have proven to be an efficient tool so that a family business may acquire the necessary funding to sustain the anticipated growth of the company. Family organizations are exposed to different situations when subjected to these types of processes, but it is necessary to understand that the better prepared they are, fewer errors due to improvisation will be made. The entrepreneur or founder is responsible for outlining the strategy and mission of the business. However, it is very important to consult specialists in these processes, those who are capable of offering objectively the solution to the real needs of the company and the sales process.

Private equity funds offer a solution to the problems of financing and institutionalization by moving into an organization with policies of management and control for the business. They present strategic objectives of growth and added value to the family organization and provide support to management by means of economic resources, human talent, knowledge, and industry contacts in order to achieve these goals.

“Let the person with business knowledge run the business” is the fundamental rule guiding financial schemes via private equity funds. By establishing clear rules and adequate conditions of control resources can be provided to an organization without the disadvantage of losing the strength and vision of the entrepreneur or founder in the operation of the business.

References

Reed Lajoux, Alexandra and Elson, Charles M., (2000) The Art of Due Diligence, Mc Graw Hill,

Pearson, Barrie, (1989) Successful Acquisition of Unquoted Companies (Third Edition), Grower,

Brealey, Richard A. and Myers, Stewart C., (2000) Principles of Corporate Finance (Sixth Edition), Mc Graw Hill.

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