a model of liquidity in family business - geluksfabriek

A Model of Liquidity in Family Business

Combining financial and emotional factors

Research paper� Maurits Bruel email: [email protected] State University, Groningen, NetherlandsAugust 1994

Reprinted (with minor corrections) in 2009

mailto:[email protected]

M. Bruel Family Business Liquidity

CONTENTSAcknowledgements i

Preface 1

PART I: INTRODUCTION 3

Liquidity problems in family businessobjectives; research question

Defining liquidity problemsliquidity flexibility; financial mobility

Defining family businessFamily business in this research

Sub questions for the researchThe Family Business Triangle

Liquidity Needs of the ShareholdersThe Capital Needs of the BusinessControl Needs of the Family

MethodologyKind of researchAssuring validityProcedure

paradigmSources of information, concepts, and theoriesStructure of this Thesis

PART II: ANALYSIS 15

The Goals of Family Businesses

ConclusionGeneral Family Business Theory

The Rational Approachconstitutional overlap

The Founder-Focused ApproachPhase and Stage Approach

the three-dimensional model of family business developmentSystems Approach

dual systems approach Critics of the Systems Approach

field theoryThe Three Circle Model

Financial Matters in Family Business TheoryThe Influence of the Family Business CultureConclusion

Concepts from Finance and EconomicsCapital And Ownership Structure

Static tradeoffPecking orderEmpirical information about corporate financing behavior


Meyers' modified pecking orderFinancial Mobility

Shareholder Relations and ExpectationsAgency TheoryThe Dividend QuestionConclusion

Utility model of a family business shareholder

PART III: SYNTHESIS 41

A Concept of the Liquidity Issue in Family BusinessOn the Nature of Family BusinessLiquidity need and liquidity availability

Shareholder Liquidity Needsimmediate; structural; family effect; Active

Shareholders; Inactive Shareholders; Future Shareholders Implications for the business

returns to shareholder formula Liquidity Flexibility and Business Capital NeedsConclusion

PART IV: MODELING 47

Model Formatcash flow statement ; discretionary cash

Pro Forma Financial Statements'worst case' analysis

Operationalizing the FactorsCompetitive Return

Risk ProfileIlliquidity Premium

The Family EffectFinancial Mobility

liquidity cushionNecessary InputProvided OutputRisk Profile AnalysisStrengths and LimitationsQuestions for Further ResearchUse of the concept

Appendices 57

Bibliography 64


Acknowledgements

Before you lies the result of many months of work, not just my work, but the work of many others who were kind enough to help me wherever they could. I can not thank the whole team at de Visscher & Co. enough for the excellent facilities, research feedback and moral support they gave me: Lorraine Szypula and Elizabeth Kelly, who arranged practically everything for me; Jim Murphy, who was always there when I needed an expert opinion (or a tennis partner); and Fran�ois de Visscher, whose unique vision and drive made everything possible.One of the advantages of working with de Visscher was the access to a network of top-experts that they shared with me. The people whom I had previously known only as names on book covers or topping magazine articles became real and many showed great interest in our project. I especially want to thank Drew Mendoza at the Loyola Family Business Center in Chicago and Ivan Lansberg at Yale University for their great contributions.Being overseas for six months made it difficult to keep in touch with the home front in the Netherlands, but everybody was willing to make an extra effort, and I always felt the support of my friends and professors, all of whom I want to thank very much, especially dr P. Grinwis and drs W. Westerman. Finally I would like to thank Joachim Schwass and Albert Thomassen, executive director and president of FBN, the Family Business Network, for instilling the love for family business in me and welcoming me into their field.

Maurits Bruel

M. Bruel Family Business Liquidity page 1

Preface

In the last decades, academics, practitioners and family businesses have been trying to develop the field of family business into a full-fledged academic and practical field of activity. This has resulted in numerous family business forums, family business professors, and family business networks, especially in the United States. In spite of this burst of activities, it is still difficult to judge the impact and maturity of the field, and just recently one of the most accomplished academics and practitioners, Ivan Lansberg, argued that indeed the potential is present, but much work has yet to be done1.Before L�on Danco popularized the concept of family business in the seventies, and in a sense gave it legitimacy as a distinct form of organization, it was never taken seriously, maybe because it was not associated with professional management and seemed to be just another hurdle on the road towards large public companies. And indeed, family businesses were and are often short-lived, but as a group, they can still outlast most economic cycles and ideas about organizational structure and governance. In fact, they are still omnipresent in most countries all over the world, and in the United States they provide an estimated 60% of employment and 40% of GNP. They come in all shapes and sizes, making up 30-40% of the Fortune 500.Recognizing family businesses as a separate group implies recognizing specific problems and solutions. It also implies the possibility of classifying all businesses as either family business or non-family business. This obvious fact is the first problem area encountered by anyone entering the field. There is no clear definition of family business, and which has a lot to do with the inability of the field to point out the specific problems and solutions concerning family businesses. All too often problems are reduced to make them fit in a contingency or other classical organizational model, a solution for the, then distorted, problem is cooked up and the family is told that they should pretend they are not related when at the office. This strategy will probably never result in a satisfactory theory about family businesses, because it sees the family involvement itself as the source of problems, standing in the way of traditional solutions (that are of course not subject to criticism). During my research I have often encountered (and been tempted by) this kind of approach to the field, but the sort of research that it turned out to be fortunately did not allow me to use these methods, that do not explain the dynamics of family business.The original idea of researching family business liquidity issues emerged in an office in Greenwich, Connecticut, USA, where Fran�ois de Visscher established himself as a financial advisor for family businesses. He and his associates specialize in finding solutions for the capital needs of the business and the liquidity needs of the shareholders. The inability to reconcile those needs has destroyed many businesses and families, at high cost to them and society. The awareness of this danger and the possibilities to avert it, however, is very low. The purpose of the

1 Ivan Lansberg 'Family business: field or fad?', FBN Newsletter, spring 1993


research project presented here was to examine means to increase this awareness, and at the same time market the services that de Visscher & Co. can provide. Taking the first step towards a model that can predict liquidity risks for family businesses seemed to be a good way to go.With that in mind, I started exploring a territory that is always fascinating but never simple, like a fractal, displaying ever more structure upon magnification. Although my job is now done, the work continues, and knowing that may be the most gratifying part of my experience.

Groningen, august 1994

PART I: INTRODUCTION

Liquidity problems in family business

Family businesses encounter specific problems that come along with growing and aging; not just of the business, but also of the shareholder base. Often these are liquidity problems originating from structural or incidental conflict of shareholder and business interests. It may not seem possible to fulfill the capital needs of the business and the liquidity and control needs of the shareholders simultaneously. This may invoke conflict in the family or business area, possibly causing declining family business performance or making the family business fall apart.The causes of family business failure can of course be numerous. They do not have to be connected to any family matters, but they often are. Problems in the family often have their roots in the business: conflicts over strategy, policies, responsibilities or shareholder relations. Business conflicts are extra difficult to deal with because of the family relations between shareholders and management, and among top managers. This research will address problems arising from the allocation of family business resources, especially liquidity. Because family businesses typically like to be financially independent, they retain much of their earnings for reinvestment. This hardly would be a problem for ordinary shareholders, who can create liquidity at will by selling shares. But family business shareholders often do not want to sell their shares to obtain liquidity, and, maybe more importantly, they can not get fair value for their stock, since there is no market for it. Especially smaller, non-active family business shareholders, who usually have little influence, are the victims of this. Thus the combination of company strategy, financial policy and the family ties together can threaten the family business' survival. Cutting the family ties is usually not an option to avoid the problem, because of the wish of the family to preserve the family heritage. Other options have to be found to satisfy the needs of all parties. Those options exist, though they are still very much unknown. Only a few consultants have experience with them, de Visscher being one. The solutions they implement sometimes include sale of (parts of) the company to outsiders, but mostly they consist of programs aimed at solving the shareholders' liquidity needs in other ways, like setting up a redemption fund to buy and sell stock to and from shareholders.Apparently, solutions to liquidity problems are available but not common practice. The reasons for that are that family businesses are very closed and often do not seek outside help until it is too late, and that the alternative solutions are unknown among the professionals. That led to three objectives for this research:

- further de Visscher's knowledge on family business liquidity to stay one of the foremost experts in the field,

- give family businesses a possibility to discover potential danger for liquidity problems early, easily, and inexpensively, and

- give professionals a way to determine the kind of risks a family business runs and see if the preventive solutions can be applied


This is a research objective in the sense of Ackoff (1981): a goal that comes closer during the course of the project and will hopefully be reached sometime after that. The research question for the research at hand is aimed at a more concrete goal, one that could be reached in the limited time available. In order to come closer to our objective, we need a theory, or model, of liquidity issues in family business. Eventually, complete analytical model could help reach the objectives for two reasons: family businesses could be shown if their liquidity position will be jeopardized in the future, thus making it possible to take measures well in time to prevent serious difficulties; and professionals will have a common way of analyzing family businesses, so they can learn more easily from each other's experiences. It seemed impossible to develop a complete analytical model in nine months, but it did seem feasible to take the first step by developing a conceptual framework for family business liquidity and make it operational. That led to the main research question:

Develop a conceptual framework and basic structure for an analytical model to analyze the risk of future liquidity problems in family businesses.

I chose to have risk (in the sense of 'probability of future occurrence') as the dependable variable because the risk can be defined and measured more objectively (statistically) than a family business liquidity problem. In order for a problem to exist, the family must acknowledge it. There are no known ways to (always) discover liquidity problems without asking the family. It is not the model's task to tell a family under what circumstances they have a problem, because that would be a kind of self-referential conclusion (you have a problem when you feel you have one), so risk seems a more appropriate measure. A model is made up of relationships and elements, endogenous and exogenous variables. The main endogenous variable will be the risk of liquidity problems, so what needs to be researched are the exogenous factors and their relationships. The exogenous variables will have to account for both sides of the problem: liquidity need and liquidity availability.

Defining liquidity problemsA problem technically only exists in the minds of people, so I will not try to attach a certain amount of money to it. The definition of a liquidity problem I will use is this:

A liquidity problem in family business is a situation in which:a) one or more family business shareholders, with a significant influence in the family

business, demand the business to change its policy on providing liquidity for shareholders, or

b) the family business is unable to meet 'outside' liquidity demands (like estate taxes) that are necessary to keep the business in the family.


Liquidity in this context is not a measure of a company's financial position, but cash or cash-equivalents. The possibilities for shareholders to obtain cash with the help of the company if they so desire is the liquidity flexibility. The ability of the company to deal with financial emergencies is financial mobility.The kind of liquidity needs that arise (continuous or incidental, triggered by business performance or family affairs) will determine the kind of options that are needed and thus the nature of the problem. There are many possible liquidity options, ranging from stock redemption plans to going public, from raising dividends to company sponsored loan programs. Every option has a different effect on capital and control structure, so the willingness and possibilities to change those structures will determine how easily the problem can be solved.

Defining family businessWendy Handy makes some excellent methodological suggestions in her 1989 article, the first one of which concerns the definition of family business. She mentions the common critique that there still is not one single definition of family business, and lists many different definitions (see appendix A). That need not be a problem, though, because "the field may be better off if different configurations of family firms . . . were studied and compared under the umbrella of family business study. It is through grappling with the study and forms of family business that the ambiguity inherent in the study of the family business will be reduced and its niche in theory and practice better defined." (pp. 262-263)Two definitions for family business in the model will probably arise. One is the definition of the companies we would like the model to be suited for, the second is the definition of the companies it is suitable for (which cannot be determined until the end). Because of the lack of agreement on how to define family business, any prior research has to be interpreted with its specific definitionin mind, making any conclusions for my purposes less valid.My definition of family business will be aimed to suit the specific purposes of this research. I shall therefore include only the features a company must have to be able to run into the liquidityproblems mentioned before.

Family business in this research

1) One of the company's goals must be to provide shareholder wealth and income, and perpetuate the business for the off-spring of the owners;

2) there must be impediments to selling one's shares (emotional and/or legal/financial) for a controlling majority of owners, who have strong mutual ties; and

3) the company must be of considerable size, at least 20 million US$ in sales.

This definition is not one of family business per se (the word family is not even used), but most larger family businesses will comply with it. The reason I do not mention 'family' is that some public, professionally run 'family' companies may not have any restrictions applying to


shareholders or to the sale of stock to outsiders. Other companies may not be run by one family, but by a close group of people with a strong bond, they are likely to run into the same problems as family businesses. The organizations that fit the definition will be called family businesses, family firms, or family companies from now on. The owners that have the ties with each other will be called family.The first aspect of the definition needs little further explanation. If a company were to be viewed purely as a playground for the owners without any intention of making money, liquidity issues would be completely different from the ones addressed here.The second characteristic is necessary because if there were no emotional attachment to the company and its shareholders, and always the option to sell one's ownership rights for fair market value, there could be no liquidity problems as we define them.The last requirement is arbitrary, I want to be sure the results apply to larger companies, and 20 million is the minimum sales figure for (future) clients of de Visscher & Co.


Sub questions for the researchBefore formulating sub questions for the research, a little more background is necessary. A closer look at the structure of the problem will reveal most of the important issues.

The Family Business TriangleThe experience of de Visscher & Co. as financial consultants to family business has led to a framework for liquidity problems called the 'Family Business Triangle' (see figure 1). On the three edges of the triangle are the three forces that shape the problem: the liquidity needs of the shareholders, the capital needs of the business, and the control needs of the family. The capital needs of the business occur in the business system, the liquidity needs of shareholders in the

family system, and the control needs of the family in both. Still, changes in any of the three elements directly affects both others.In order to properly address the liquidity, capital, and control issues, a closer look at the elements of the family business triangle is necessary. This will serve to identify the most important topics to be addressed in the next chapters.

Family Control

Shareholder Liquidity Capital needs

Family forces

Personal constraints

Business tasks

Capital market constraints

Source: de Visscher’s Family Business Optimization Model

Balancing three needs in a family business system

Family Control

Shareholder Liquidity Capital needs

Family forces

Personal constraints

Business tasks

Capital market constraints

Source: de Visscher’s Family Business Optimization Model

Balancing three needs in a family business system

Figure 1


Liquidity Needs of the ShareholdersShareholders (or anybody for that matter) need liquidity and liquidity flexibility for two basic reasons: to finance their expenses, and to feel secure about their future. There are a number of sources to finance expenses: salary and other payments for work done; dividends and other income from financial investments; gifts; and credit. Some of those sources can be found in the family business, depending on the situation for an individual shareholder: whether he or she also works for the business, or is a family member, for example. An important factor for the shareholders' attitude towards for example dividends is how dependent they are of the company. In general, the more they depend on unstable income from the business (like dividends or gifts), the more important liquidity flexibility and dividend yield will be for them. (see figure 2)Another consideration to be made is the general life-style of the shareholders and the kind of expenses they finance with income from the family business: fixed expenses (interest, rent, utilities, taxes, etc.); basic expenses (food, clothes, pension fund, etc.); or luxury expenses (including reinvesting). The more basic the expenses to be covered, the more important the financial arrangements are. In large family businesses, it may be less likely to find such shareholders, but it must be considered.

Vulnerability zone

Shareholders who depend much on (volatile) dividends are very vulnerable to policy and performance changes

all dividend

sort ofdependency

all salary

level ofdependency

100%0%Vulnerability zone

Shareholders who depend much on (volatile) dividends are very vulnerable to policy and performance changes

all dividend

sort ofdependency

all salary

level ofdependency

100%0%

Figure 2


The Capital Needs of the BusinessIn a business, shareholders compete with management convictions about the allocation of available capital. Capital needs of the business, as seen by management, do not only depend on the industry the business is in, but also on growth and investment policies of management. Operational leverage for example, depends much on the choice of investing in fixed or variable assets. Investing in fixed assets can make it more difficult to free cash in case of need.In addition to deciding how to invest funds, management must decide how to fund its investments. It can retain earnings, assume debt, or issue equity2. Choosing one or the other has implications for both he liquidity position of shareholders and the control over the business. Unfortunately, those implications are not always taken into consideration in the decision making process. A final important aspect of the capital needs is how volatile they are, and how well prepared the company is for financial emergencies.

Control Needs of the FamilyThe owning family of a family business often considers the business an integral part of the family's history and heritage, that should be preserved and passed on to future generations. That is why they are often unwilling to give up control to outside investors or lenders, or even professional outside management or outside board members3. The consequence of unwillingness to issue outside equity or debt, is a reduction in financing options, which leads to pressure towards low payouts and a limited or non-existing market for the business's shares. In such a situation, conflict can easily arise in the family, especially if many shareholders are not active in the business, and thus share more of the financial disadvantages than of the emotional advantages.

The above elaboration leads to the first sub questions:

1a What are the values and goals of family businesses?b What financial structure and strategy do family businesses adopt to reach those goals?c How does this affect the businesses ability and willingness to generate liquidity for its

shareholders?

2 What does the demand for liquidity from the family business of family business shareholders depend upon?

2There are of course many specialized financial instruments not mentioned here, they are assumed to belong to one of the general categories.

3See for example Ward (1987 and 1991), Danco (1982 and 1987), Dyer (1986), and Poza (1989)


When those questions have been answered, the next step is to identify the indicators of liquidity problems, benchmarks with which family businesses can be analyzed. Questions in this phase will be:

3a Which indicators should be measured in order to assess the probability of future liquidity problems?

b How could those indicators be measured?

When it becomes possible (theoretically) to measure the probability of liquidity problems, a format has to be chosen to model the problem. This format should be clear to family businesses and consultants alike, and convey all the relevant aspects of the problem. Also, it should be very flexible, capable of going through different scenario's, what-if analysis. The final sub question thus becomes:

4 How should the necessary information be modeled to assure clarity, ease-of-use, and flexibility of an analytical liquidity model of family business?

Methodology

Kind of researchThis research is just one step in a larger process, and that process must lead to an actual, useful model. That model will itself play a part in the change cycle family businesses go through when they hire a consultant like de Visscher & Co. (see figure 3) It will make the analysis cheaper, faster and more reliable. It will be a competitive advantage to have the model, not just because of increased service quality, but also because it can be used as a marketing tool.My approach can be qualified as interpretative theoretical4, a search not for new facts but an attempt to combine existing knowledge on family business with existing knowledge in other fields, and see if it is possible to come to useful 'New Combinations'.

4 see A.D. de Groot, 1981

Methodological framework

Liquidity solution cycle

Empirical cycleStrategic option

analysis

ImplementationEvaluation

Problemdefinition

Diagnosis

Plan(solution)

NewSituation

Methodological framework

Liquidity solution cycle

Empirical cycleStrategic option

analysis

ImplementationEvaluation

Problemdefinition

Diagnosis

Plan(solution)

NewSituation

Figure 3


Assuring validityThe purpose of this research is making the first step towards a family business liquidity model. I viewed a model as does A.D. de Groot (1981): a formal system encompassing the objects, relations and admissible operations to arrive at deductions.The deductions in this specific model however, are not made in order to test them, but to act upon them. Therefore the validity of the findings is very important, important decisions will be made according to the findings of the model. It is not practical to test the model in the normal way of social sciences: with test groups and control groups. It is not likely that large businesses will make certain important decisions just to test a model. But in order for people to use the model, they have to trust it, and it has to be valid. The validity can be tested by selecting family businesses that do or do not have liquidity problems now and evaluate their history. But this can only be done once the whole model is complete, because of the interrelations of its parts. It is also possible to evaluate the model in view of its consistency with the whole body of knowledge of the field of family business. Thus the model is falsifiable in that sense. In order to assure consistency with prior research results and established knowledge on family business, there was continuously consultation with family businesses, family business advisors and professors for review of the current ideas. That has proven to be very useful, not only because it improved the quality and acceptance of the findings, but also because some researchers were willing to do empirical research on elements of the final model, in accordance with the suggestions for further research.

ProcedureBecause of the novelty of this project, there was no other starting point than to brainstorm about everything that could be important. If anything was left out in that phase, it would hopefully show up when researching general categories in more detail. After that, the logical steps are selection and operationalization, and finally lay the basis for a future model.One major problem was the absence of an accepted paradigm for the family firm in any of Kuhn's (1970) definitions. Only certain aspects of family and business have a generally accepted and well-developed framework that gives direction to new research. Family business as a field of interest knows many different approaches. Whenever possible, the hypotheses about liquidity in family business were made after examining all relevant theories about family business and finance. When theories differed, a conscious choice was made. The model framework, based on the hypotheses, was evaluated by again comparing it with different theories and experts' opinions. This procedure can not be qualified as a true empirical cycle5, because the predictions are not tested against new data but against the existing data, plus new judgments by family business owners and experts. Still, the model framework should have validity, as discussed above.

5 As described by De Groot 1981, p. 29. De Groot also acknowledges the problem of testing predictions in non-experimental research situations (p. 32)


Sources of information, concepts, and theoriesApart from consulting with experts on family business I examined several concepts in and around family business literature: systems view of family business, developmental concepts, culture in family business, sociological concept of money and the family, concepts from corporate finance, and the utility concept in microeconomics. I did not use organizational structure theories, motivation theories, or power theories. Their primary focus is beyond the scope of this research. All the concepts used emphasize different aspects of organization. The problem was that it is highly unusual to find research results that can be linked directly to family business, and in reevaluating the results it is easy to overestimate or underestimate the importance to family business. I have always explicitly separated my assumptions and assertions from the ones in the literature, in order not to be misleading.A secondary source of information were family business leaders, all clients of de Visscher & Co. Personal interviews were used as a test of the relevancy of the work and findings for family businesses themselves.

Structure of this ThesisThe second part of this thesis will be a theoretical analysis of issues in and around the family business that put the liquidity problem into its context and display its elements. After all the relevant issues have been dealt with, the implications for the development of a model will be discussed and summarized.In part three, back to the core problem: the difference between liquidity need and liquidity availability. Based on the evidence in the analysis section, I will present a concept of liquidity issues in family business.In section four, the framework and format for an analytical model will be examined, with its possibilities and constraints. The concepts from section three will be operationalized, based on the theories of section two, and suggestions will be done to complete the model by further researching.

PART II: ANALYSIS

The Goals of Family Businesses

The definition of family business and liquidity problems in them assume at least one goal common to all family businesses: the wish to keep the business in the family. This implies that the business must be viable, and the current and future family members must be willing to have and keep it. Thus a family business's goal can be expected to be to motivate family members to become or stay involved with the business, without jeopardizing the business's future viability.Unfortunately, there are few surveys of family business that ask the right questions for this kind of dual purpose. Ward (1987) cites one of his own polls that asked about the reasons to perpetuate the family business. Not surprisingly, 70% of the respondents voted for the following top three answers: Pass on opportunity to children; Perpetuate heritage; Keep family together. Only a fraction answered that generating financial advantages and wealth were their major reasons.Surveys published by Davis and Tagiuri (1992) and Massachusetts Mutual (1993) give a very different impression. Davis and Tagiuri were looking for top company goals in successful (small) family businesses, and although they included family-oriented goals in their questionnaire, they phrased the question mainly from a business point of view (1992:57): "In your opinion, what should your company do?" (italics added) Their ranking of goals is not very discriminatory; their tenth ranked goal only received 4% points fewer 'important' ratings than the number one (92% vs. 88%)6. Only goals 11 and 26 include a family aspect: goal 11 is securing the owner(s)' financial security and growth, goal 26 is achieving financial security for the owner(s)' family in the future. Of the respondents 87% and 76% thought these to be important.Davis and Tagiuri's (1992) factor analysis is more useful than their goal ranking, because it resulted in six independent groups of objectives for family businesses (ranked in decreasing relative contribution to explained variance):

- Have a company where employees can be happy and productive, a company whose image and commitment to excellence make its employees proud;

- Provide the owner(s) with financial security and benefits;- Develop new and quality products;- Have the company be a good corporate citizen;- Have a company that offers job security.

6 Their number one goals were (1992:46): make profits now and achieve excellence in the company's field of work. Their number ten goal was 'provide a source of personal satisfaction for those who work in the company'. This could be related to family feelings, but that is not specified, so it is more probable that the respondents were thinking of their employees in general.


Surprising in this list is that making profits and increasing the value of the company are not present separately7, although they may be necessary to provide (future) owners with financial security, and they may be the result of excellence and developing new and quality products. Several of these objectives can be qualified as family values projected on the company: be a good citizen, make employees happy and proud, offer job security. Whether these goals have helped the companies to become successful is impossible to say from the evidence here. If some of those goals are indeed projections of family values, they could also be reasons for family members to stay involved. A model for liquidity should therefore consider those issues.The 1993 Massachusetts Mutual survey asked for important financial goals, which sheds more light on the liquidity issue itself by ranking it in relation to other financial goals for family business owners (see figure 4) Providing liquidity to shareholders is lowest on the list of priorities. In stead, family businesses focus on the profitability and value of the business.

ConclusionCombining the three survey results, results in the following picture:Family businesses have two major objectives: increasing profitability of the business and passing it on to the next generation. These objectives do not cause shareholder liquidity problems by

7 Nor did any of the groups emerging from the factor analysis include the items make profits now, or achieve a high return on assets. Those goals are apparently subordinate to the ones mentioned here.

28

37

51

64

63

76

89

0 10 20 30 40 50 60 70 80 90 100

Providing liquidity toshareholders

Expanding size of thebusiness

Increasing family's wealthindependent of business

Providing access to capitalfor business

Reducing debt level ofbusiness

Increasing value ofbusiness

Increasing profitabilty ofbusiness

Very important financial goals for family business owners

Figure 4 From: Massachusetts Mutual Survey, 1993


themselves, so the cause of liquidity problems must be sought in the manner in which those objectives are pursued, the treatment of shareholders. When liquidity problems arise, the surveys suggest that it is because the current generation managers wants to sacrifice too much shareholder liquidity now for the benefit of the next generation. This brings us to the dynamics of the family firm. In order to better understand these dynamics, a discussion of general family business theories follows.

General Family Business Theory

Although Danco popularized the idea of family business in the seventies, it was not until the eighties before academics and consultants began giving the subject real attention. Family business chairs were established at universities, more family business consultants from different backgrounds became active. The Family Firm Institute was founded, and several periodicals devoted to family business emerged. In Europe, it was not until 1990 that the Family Business Network, the only major international network, was founded. Until this day, family business has received much more attention in the United States than in Europe, and most concepts were developed in the U.S.According to Hollander and Elman (1988), four approaches to family business have emerged over time. They are the rational, the founder-focused, the stage and phase, and the systems approach. These will be presented, as well as their major exponents and the analytical tools they use when dealing with family businesses.

The Rational ApproachSome of the earliest literature on the family firm reflected high frustration with the seeming intractability of the family aspect of the business. Purpose, function and structural properties of the organization formed the unit of analysis in this approach. The writers who subscribed to the rational approach generally lamented the fact that family businesses were not operated in a more 'business-like' way. The recommended solution was to excise the family. It is a very prescriptive approach of family business, basically prescribing the conversion from family business to non-family business.

"Business and family were treated as polar opposites, in conflict with one another... Often there was an attempt to identify one symptom, such as emotionalism, nepotism, father-son conflicts, or poor management skills, as the major problem and use that symptom as evidence of the disabling effect on the business of the inclusion of the family." (Hollander & Elman, p. 146)

The rational approach is based on the assumption that the family business should be driven purely by profit motives. Despite their limited view of the family business and general condemnation of it, writers who proposed to exclude the family made a significant contribution to the evolution of understanding of family business. They recognized the existence of two parallel and equally powerful components: the family and the firm. This was later symbolized by two circles, one for the family and one for the business, and called constitutional overlap (Lansberg, 1983, see systems approach).The rational approach is in a way still the predominant mind set of many of the people in the family business field, even those who use analytical tools from other approaches. The norm that family business should be rationalized is still very much alive.


The Founder-Focused ApproachConsiderably more thinking has focused on the founder than on any other aspect of the family firm. The founder is viewed as the prime influencer of the destiny of the business. With the development of the business, the personality of the founder can become a hindrance. Examining the personality and style of the founder can help to predict difficulties in the transitions that the business must face. Some of the most colorful explorations of the family business have focused on the motivations and characteristics of the founder as the initiator and vital force of the business. The culture of the business becomes, at least in part, the embodiment of the founding personality; this culture then influences operational style (Dyer, 1986), which in turn affects both the development of the business and its ability to respond to change. The founder is usually not a planner: he is secretive and intuitive, and he does not delegate. In his relations with subordinates, colleagues, and associates, loyalty and trustworthiness are more important than performance. The first generation business is usually a one-man show, mirroring the needs of the founder for centrality. The growing need for planning and delegation can conflictwith the hands-on style that worked so well in the early founding stages. Ward (1987) identifies a number of factors that must be dealt with properly to make it possible for the business to survive beyond the career and life of the founder.Understanding the founder is indeed crucial. However, over-reliance on the personality of the founder as an explanation for the course of developments of a family-owned business system can be limited and reductionistic. It subordinates the system to the individual rather than contextualizing the individual as an element of a complex, dynamic system. Little recognition is given to the interactions and interrelatedness of variables and forces, cyclical behaviors, and "pushes and pulls from other factors internal and external to the business and to the family" (Hollander & Elman, p. 150) This approach runs the risk of creating a one-dimensional caricature, which makes it unproductive. The literature developed from a particular generation of male founders under one set of historic and economic conditions, needs to be tested under different conditions.

Phase and Stage ApproachThe phase and stage approach is based on developmental phases and models of growth. This approach assumes that there is a large similarity in the development of businesses, families, and individuals. Combining two or three of these developments leads to models like Danco's (1975), or Ward's (1987). Danco looks at the entrepreneurs’ development in relation to the firm's growing needs. He distinguishes between the wonder stage, the blunder stage, the thunder stage, and the sunder or plunder stage. In the wonder stage, the entrepreneur deals with uncertainties and unknowns but, committed to his idea, forges ahead; in the blunder stage, a period of rapid growth follows, for which the entrepreneur was unprepared; in the thunder stage, the entrepreneur gets loud, opinionated, and impressed with his own success; finally, in the sunder or plunder stage, the


owner either learns to be a manager, or the business goes under.Ward's model (1987) takes into account all three of the life-cycles: family, individual, and business (see table 1) He observes that the interweaving forces can result in a business that is, for example, highly resistant to change, or in which the income is drained to meet family needs. The maturity of the business then leads to decline rather than renewal.

Stages of Family Business Evolution

Stages

I II III

Timing (in years):Age of Business (or business renewal)

Age of Parents

Age of Children

0 to 5

25 to 35

0 to 10

10 to 20

40 to 50

15 to 25

20 to 30

55 to 70

30 to 45

Challenges:Nature of business Rapidly growing and

demanding of time and money

Maturing Needing strategic 'regeneration' and reinvestment

Character of organization Small, dynamic Larger and more complex Stagnant

Owner-manager motivation

Family financial expectation

Family goals

Committed to business success

Limited to basic needs

Business success

Desires control and stability

More needs, including comfort and education

Growth and development of children

Seeks new interests or is 'semiretired'; next generation seeks growth and change

Larger needs, including security and generosity

Family harmony and unity

Table 1 from Ward (1987)

Currently, Ivan Lansberg, with some colleagues, is working on another developmental model of family business. This model will be called the three-dimensional model of family business development. It has a developmental axis for family cycles, the business cycles, and ownership structure, but none for the individual. It is based on the three circle model (discussed below) and has more possibilities to qualify family businesses because it has no fixed chronological order of development. Family businesses can be developed very far on one axis and not at all on another8

This means that it loses one advantage of the phase and stage approach: it does not offer some predictability over time, like the others do.

8 A book on this model will be published by Harvard Business School Press in the spring of 1995.


Systems ApproachThe seeds for the development of systems thinking in family business can be found in the first three approaches discussed and in the work of Von Bertalanffy (1968), who first applied his notions of systems to biology and subsequently to human systems. The underpinning of the systems theory include the emphasis on the whole as a unit of focus, interrelatedness of parts, hierarchy, openness, and interactiveness.The theme of the family business as a system dominated the Summer 1983 issue of Organizational Dynamics. Davis (1983) proposed the notion of a joint system, which operates according to rules derived from needs of the separate parts that have been adapted to the needs of the whole. Lansberg (1983) described a system characterized by institutional overlap. This dual systems approach idealizes the norms and values in family and business, and looks at the differences between them for sources of conflict as the firm matures. The institutional differences stem from the assumption that family and firm exist in society for fundamentally different reasons.Within the systems approach, there are those that view family processes not as external but as integral part of the family business system, and advocate the use of family systems theory in diagnosis and interventions for family firms (for example Hollander (1984)). Family systems theories understand behavior as functioning in a specific, interrelational context and as adaptive within that system, and offer increased clarity in describing the emotional issues that affect rational functioning. Organizational open-systems theories explain the interaction of business with environment. Both are necessary for a complete picture of family business.Hollander and Elman are reluctant to accept systems theory as the new paradigm for family business because of its focus on differences between the systems. Just as an individual contains within it conflicting sets of messages, the family business may hold within itself conflicting needs and values. The question is whether the family business is really a hybrid of two subsystems or a single entity. In their words: "We need to know whether the family firm is a zebra or a pony with stripes." (p. 162)

Critics of the Systems ApproachWhiteside and Brown (1991) criticize the dual systems approach to family business. Their points of criticism are:

- stereotyping of subsystem functioning;- inconsistent and inadequate analysis of interpersonal dynamics;- exaggerated notions of subsystem boundaries;- and underanalysis of whole system characteristics.

They propose looking at the core organization of the family firm as an alternative. The core organization is a highly interconnected group that comprises both family and non-family


members. These connections can be studied by examining decision-making patterns, information flow, cash flow, operational procedures, interactions around critical events, conflicts, crises, and patterns of ownership. They claim that the core organization has "a distinctive style and structure and is more than just a blending of the constituency subsystems." (p. 392)Riordan and Riordan (1993) suggest a different alternative: field theory9. Field theory in social psychology sees the individual as being part of different groups who exert influence (push and pull). Fields of influence have a certain force (effect) on a person. That effect depends on the strength of a field and its valence (positive or negative). The 'direction' of a person's actions is determined by the resulting force (the sum of the force vectors, to put it in mathematical terms). A person lives in a life space with an unlimited number of dimensions, and individual fields can influence any number of those. This approach divides problems into three sorts of situations:

1) the individual stands between two positive valences of approximately equal strength, and doing one precludes doing the other;

2) the individual stands between two negative valences of approximately equal strength;3) the individual is both attracted and repelled by the same region (for example when pursuing

a career [positive] means having to leave home [negative])

Although Riordan and Riordan's research was done to better understand a business owner's behavior, it deserves attention as a different approach to family business issues as a whole, because it draws less rigid boundaries between family and business, and gives more attention to dynamical factors like power and conflict. Also, it is a better framework for the family business triangle, whose corners can easily be seen as fields, but hardly as systems.

9 They draw mainly on Kurt Lewin's work, several references are made to his writings, the most recent one being Field Theory in Social Science, Harper & Row, New York, 1951


The Three Circle ModelHollander and Elman (1988) omitted one important model in their overview article: a way of looking at family businesses, which is close to the systems approach, but also has some similarities with field theory. In the Summer 1983 issue of organizational dynamics, Davis (1983) and Lansberg (1983) did not just use the dual systems approach, they introduced the most popular concept of family business to date: the family firm viewed as consisting of four basic

constituencies: the family, the owners, the managers, and the people outside the firm10. This was depicted graphically with three overlapping circles (see figure 5). Basically, this separated the business system used in the dual systems approach into two subsystems: the ownership and the management system11 (everyone else in the business was conveniently shoved to the environment).

10 The distinction between owners and the family is not just important in cases where there is an outside investor involved. Even if the family owns 100% of the firm, hardly ever does every family member own stock. Ultimately, there are seven combinations of family and/or owner, and/or manager. People belonging to the same combination group are supposed to have similar views and interests, different from those in other groups.

11 Actually, in terms of systems theory, seven subsystems make up the family business. These subsystems have different priorities and relationships with the other subsystems. From a field theory point of view, there are only three active fields. The strength and valence of the fields are different for everyone, but there are similarities between people in the same 'position'.

The Three Circle Model of Family Business

Family2

Owners3

Management2

4 57

6

1,2,3: three “fields”1-7: subsystems

The Three Circle Model of Family Business

Family2

Owners3

Management2

4 57

6

1,2,3: three “fields”1-7: subsystems

Figure The three circle model from a systems and a field theory point of view


Each segment represents an important constituency of the family business.Each constituency tends to have different goals and expectations (Lansberg, 1983, 1988) For example, family members often view the firm both as an important part of the family's heritage and as a source of financial security that will enable them to satisfy their life-style expectations. This view of the firm is "rooted in their membership in the family and the symbolic representation of the firm as a 'mother' whose function is to provide nurturance and a sense of connectedness among family members" (Lansberg, 1988:122).In contrast, managers see their careers as tied to the firm and tend to regard it as a vehicle for professional development and economic achievement. From their perspective, the purpose of the firm is not to take care of the family but to generate profits and ensure them continued career growth. The owners take yet another stand, viewing the firm predominantly as an investment from which they want to receive a fair return. Their expectations stem from an ownership right that is often difficult to exercise in the context of a family business.It is important to note that an individual can belong to more than one group at the same time. Lansberg therefore argues that it "is possible for the same person to hold conflicting views about the ultimate goals of the firm." (1988:123) This position seems difficult to defend, because although a person may feel that he or she can not 'have it all', it is doubtful that a person does not have priorities, leading to one ultimate goal. Therefore it is better to distinguish seven constituencies, each with their own ultimate goals. Those seven groups then have to negotiate the strategy for the family firm as a whole12. There is a similarity between the family business triangle and the three circle model, in that the corners in the triangle represent needs of different constituencies in the family business, at least for financial and control matters.

12 Based on the resulting priorities, it is possible to distinguish three sorts of family businesses, each with a different priority order for family (F), management (M), and ownership (O) interests: FMO; FOM; MFO; MOF; OFM; OMF.

Financial Matters in Family Business Theory

Most writings on family business financial matters deal with accounting measures or compensation of active family members. The relationship and treatment of shareholders rarely takes up more than a few lines. Exceptions are Gougis (1994) and Lansberg (1994) in the spring issue of Family Business. Gougis observes that the need for capital in businesses has never been greater, but the availability of capital has diminished as a reaction to the excesses of the 1980s. Extra liquidity needs are also generated because of the changing ownership structure of family businesses, who have more inactive owners. This "creates one of the biggest challenges for family business in the 1990s" (p. 60). Gougis suggests doing contingency capital planning, both for business finance and family needs, because "too often, families are forced to sell the business because of events they might have anticipated and prepared for" (p. 61), which is one of the reasons for this research.Lansberg posits that family business stakeholders, especially inactive shareholders, need to be educate themselves on the business, and assume their own responsibilities. But senior management does not go free either:

Too often, family members in senior management positions look upon shareholders as greedy nuisances, and on paying dividends as charity rather than a management obligation. Frequently, male prejudice has something to do with this, since many women who inherit stock end up as non-participating shareholders. (p. 7)

Lansberg argues that shareholders have the right to expect 1) a certain economic return and 2) that the business be run in accord with the fundamental values of the family. Their duties consist of educating themselves about business in general and their business in particular. He anticipates problems if those requirements are not met, touching on the very core of the problem for this thesis.

The Influence of the Family Business CultureValues are very important for a family business's attitude towards the distribution of wealth among shareholders, managers and family members, and so is power distribution. Different cultural configurations tend to lead to different attitudes and power distribution. Two writers who have discussed culture in family business are Ward (1987) and Dyer (1986). Sociologist Millman (1991) discusses the status of money and love in modern families in general in her book Warm Hearts and Cold Cash. In families, many people end up feeling cheated, because there are no explicit conventions or guidelines for dealing with family money: "we still have deep expectations, and when these expectations are disappointed, people are devastated" (p. 1). People learn early that money speaks the truth like nothing else. Spending money is not just a measure of commitment, it is a measure of feeling, even in families. Millman refers to Kenneth Boulding when distinguishing the conditional exchange of the market place from the reciprocity of the


family, where the mutual gifts have no formal relation. But people do count all things gifted and received, material and emotional, and "there is probably more counting in families than in any other close circle." (p. 8) What was supposed to be a reciprocal relationship often turns into a disguised conditional one.She gives an example that perfectly illustrates liquidity problems in a family business: the case of the O'Connor family. (pp.18-20)

The O'Connor case illustrates the problem between active and inactive shareholders in a family business, and how those who do not marry or have children are often viewed as less deserving of money and support. However much parents talk about treating their children equally, children who do not 'give back' to their parents by going into the business or having children often discover that they have to pay their own way.

Case: The O'Connor Brothers

Bob O'Connor nostalgically remembers his father as the much respected 'king' of the family, although the man was a tyrant: autocratic, controlling, and unwilling to allow any individuality in his three sons. Bob had broken away from the family business because of conflicts with his father, and worked in corporate law. The father gradually relinquished control of his business to his sons as he grew older, giving each one an equal share. Because Bob was an outside owner, he did not expect to draw the huge salary his brothers were paid from the business, but he did resent his brothers helping themselves to fringe benefits: cars, restaurant meals, theater tickets, vacations--all charged to the business--which decreased the value of his shares.When Bob expressed concern about his brother’s behavior, one of his sisters-in-law retorted that her husband 'sweat' to build the business while he did nothing. He found it useless to try to explain the rights of shareholders. His sister-in-law also added that he was single, and thus did not need the money as much.

When the business came into some extra cash through the sale of a subsidiary, Bob's brothers offered to buy him out. He agreed because he could only see a deteriorating situation in the future: more expenses charged against the business and the looming threat of his brothers' sons demanding shares of their own. But when the time came to arrange the transfer, he was shocked by what happened. His brothers only offered him only half of the conservatively stated book value of his shares. So Bob turned to his father for help, since he knew his father had always wanted things divided equally among his sons, and still had a dominating influence. To his surprise, his father reversed himself in front of him, saying that what Bob was being given was satisfactory. The father was apparently more concerned about the financial situation of the business than about what Bob deserved.

Bob ultimately agreed to the transaction, deciding that it was worth it to stay on good terms with his family. He now avoids all money conflicts with his family by always paying his share of the bill when going out for dinner with his family, and they use the business card to pay for it.


An observation both Millman (1992) and Ward (1987) make is that in many families with money, it is the norm to only use the interest and leave the principal intact for future generations. The consequence for a family business is that it is the responsibility of the current generation to leave an equal or better company behind than they received.Ward (1987) puts this in a context of family philosophy and its impact on business decisions. Two important assumptions are those concerning equality--arbitrarily unequal, equality of results, equality of opportunity (p. 151)--and whether to put the business before the family (like O'Connor Sr.) or vice versa. Ward posits that the choice between family first or firm first is sometimes clear, sometimes difficult to make (see table 2) For the model, it is interesting to note the expected conflict in large family businesses with 3 to 5 members in the leadership generation.

Table 2 (from Ward, 1987)Family First or Business First?

Error! Bookmark not defined.Health and Magnitude of the Business

Number of Family Members in Leadership Generation

1 to 2 3 to 5 5 or more

Weak and small No debate; business survival first

No debate; business first

No debate; business first

Modest No problem; family first

Conflict; resolution critical


Large (probably partially publicly held) and significant resources

No problem; family first


No problem; business first

Note: The vast majority of family businesses are in the conflict; resolution critical stage due to typical family and business size. Those cases require deliberate planning and effort to develop the family's philosophy and vision.


Dyer (1986), discusses three other important situations that can influence the liquidity issue from a cultural point of view. They are weaknesses that are usually found in first-generation family businesses, but can occur in any generation and be very harmful:

1) Slow reaction to new competitive environment, because of the focus on the original mission, reluctance to experiment and denial of negative signs. This of course can badly damage the company's viability.

2) Feelings of inadequacy and incompetency by family members, who compare themselves with the role model in the business (usually the founder) and feel a lot of pressure to succeed. The danger here is estrangement and resentment, causing them to leave the company.

3) The problem of powerlessness, when power is concentrated in a few individuals. this can also cause resentment and estrangement.

Dyer also presents four major sources of conflict in the family firm. The most important one is the choice of business first or family first Ward (1987) mentions also. The most common issue that triggers family conflict is the distribution of profits, says Dyer (p. 87). Equal treatment among family members is another important source of conflict, that causes "maybe the most serious and bitter schisms" (p. 88). He suggest several ways to deal with conflict, but does not provide specific solutions to any problems.

ConclusionGeneral models of family business as presented in this section help to understand more of the problems that occur from the family point of view. They do not, however, explain much of companies' financial structure or their ability to generate liquidity, at most they deal with it in a very general way. The next section will give closer attention to that other part of the equation: the company's financial situation. The focus will shift from the relationship between family and business to that between shareholders and business.

Concepts from Finance and Economics

In part one, the family business triangle was introduced. This triangle depicts how three forces shape the liquidity issues in the family firm: the control needs of the family, the liquidity needs of the shareholders, and the capital needs of the business. In this chapter we will examine some economic theories that can help explain how those forces may work and interact. Because a large majority of businesses are family businesses, and family businesses have rarely been recognized as a separate group, findings in economic literature should at least to some extent be applicable to family firms.The definition of a liquidity problem has two components: one dealing with external factors (outside of the family), one dealing with internal ones. External factors lead to an immediate problem, usually concerning a large amount of money. Many family businesses know they will be faced by those kinds of problems, but fail to prepare for them. External factors are relatively well-known and well-documented, but very complex, especially tax-related problems. Estate tax matters are difficult in the present, let alone trying to predict them in the future.When dealing with the internal factors, some questions immediately come to mind: why do family members keep stock and work in the family business in the first place? Why are they treated a certain way? What do they expect as owners and/or managers of the firm? If we know that, we have the key to the problem. Here we will see how economics looks at financial structure and strategy in the firm and the relationship between owners and managers. This can shed light on how family business dynamics are different from non-family business dynamics. The nature of the liquidity issue makes it necessary to look at the dynamics of the following areas:

1) Financial strategy, cash flow and liquidity position of the business

2) Shareholder relations and shareholder expectations

The concepts of liquidity and financial strategy are well-known in finance and economics. Financial statement analysis and corporate cash flow models are available in abundance in corporate finance literature. Shareholder/ investor behavior and liquidity have been researched and theorized on for decades, for investor strategy and corporate dividend purposes, but the final word does not seem to have been uttered on either: the dividend question has not been answered satisfactory yet, and neither has the investment portfolio strategy question13. Dividend theory is very relevant in this research, but portfolio strategy is not, because the family business stock is usually not traded on the public market14, and it does not seem plausible that family members

13 Recently, it seems that the Efficient Market Hypothesis is increasingly disproved by the Contrarian Investors, and many academics now embrace 'value investing': investing in stocks with a low P/E, low price-to-book ratio and low price-to-cash flow. See for example Lakonishok, Schleifer and Vishny, Contrarian Investment, extrapolation, and risk, Cambridge MA, 1993 (NBER working paper series). They explain why this strategy actually works; because you can not extrapolate earnings and cash flow with any degree of accuracy. Contrarian investors of course realized this a long time ago (but what if everybody adopted this strategy?).

14 Even those family businesses who are traded on public markets must have other ways of preventing the family from


who hold only their family businesses' stock do so for portfolio reasons. "We rarely find family commitment to business sustained by economic benefits alone" as Aronoff and Ward (1992:45) put it.Potentially useful ideas from economics could come from financing theories, and the utility concept, because that is the economist's way of looking at the motivation behind shareholder and management behavior. I will first look at capital structure and dividend theories, and after that I will make a model of the structural (internal) part of family business liquidity in terms of utility.

selling to outsiders and keep the business in family hands, or they would not be family businesses, at least not for our purposes.

Capital and Ownership Structure

Capital structure has long been a major concern of corporate finance. The first important contribution to the problem was Modigliani & Miller's (1958) Proposition I, stating that the value of a firm is unaffected by its leverage. However, they made many simplifying assumptions. Since then, many theorists have tried to describe and prescribe capital structure policy. I will shortly go over some theories and indicate what their contributions and limitations are concerning family business.

Static tradeoffOne of the main older financial theories trying to explain the capital structure of corporations is the static tradeoff theory. The static tradeoff theory suggests that a firm will borrow until its value is maximized. Extra debt provides an interest tax shield and raises the value of the firm. But high leverage also increases the risk of financial distress, so the optimal leverage would be one where both effects offset each other. If this is correct, and there are no significant costs to altering capital structure, each firm's observed leverage should be its optimal ratio. This sounds like a nice theoretical framework, but in practice it does not seem to work. Stewart C. Myers (1984) argued that the problem with this theory is that actual debt ratios vary widely across apparently similar firms. He concludes that firms either take extended excursions from their targets, or the targets themselves depend on factors not yet recognized or understood. Although static tradeoff can not adequately explain actual debt ratio's of businesses, the concept of weighing pros and cons when determining the capital structure is very useful. The problem may be that similarity between firms was sought on the wrong traits, as Meyers implicitly suggested. When static tradeoff was developed, corporate culture and family business were virtually unknown entities.

Pecking orderThe pecking order theory, unlike the static tradeoff theory, emerged from observing actual financing behavior. It rests on two central ideas: the preference for internal finance, and, the preference for debt over equity if external finance is sought. A theoretical basis for this debt preference, consistent with the "maximize shareholder value" idea, can be found in work on asymmetric information. When management's knowledge suggests that stock is underpriced, issuing extra stock at that lower price will dilute the value of the old shareholders' stock, unless the investment opportunity is profitable enough to offset that effect. This may cause management to pass up worthwhile (positive-NPV) investment opportunities. The way to reduce this problem is to issue the safest possible securities, that is, securities whose future value changes least when the management's inside information is revealed to the public.15 This rationale for the pecking order seems somewhat far-fetched, but there is no better one available.

15 When equity is overpriced, it would seem favorable to issue more of it, in stead of debt. But investors can anticipate that and react accordingly to a new issue, if they see that the debt capacity has not been exhausted.


Empirical information about corporate financing behaviorBased on empirical research16, a few conclusions concerning corporate financial behavior are widely accepted:

Internal vs. External equityAggregate investments are predominantly financed by internally generated funds and debt issues.

Timing of security issuesGiven that firms seek external financing, firms are more likely to issue stock rather than debt after stock prices have risen than after they have fallen.

Borrowing against intangibles and growth opportunitiesFirms holding valuable intangible assets or growth opportunities tend to borrow less than firms holding mostly tangible assets.

Exchange offersStock price rises, on average, when a firm offers to exchange debt for equity, and falls when it offers to exchange equity for debt.

Issue or repurchase of sharesOn average, stock price falls when a firm announces a stock issue and rises when a firm announces a stock repurchase.

Meyers' modified pecking orderBased on the above mentioned empirical evidence and his own observations, Stewart Meyers made the following modified pecking order (1984:590):

1. Firms have good reasons to avoid having to finance real investments by issuing common stock or other risky securities. They do not want to run the risk of falling into the dilemma of either passing by positive-NPV projects or issuing stock at a price they think is too low.

2. They set target dividend ratios so that normal rates of equity investment can be met by internally generated funds.

3. The firm may also plan to cover part of normal investment outlays with new borrowing, but it tries to restrain itself enough to keep the debt safe - that is, reasonably close to default-risk free. It restrains itself for two reasons: first, to avoid any material costs of financial distress; and second, to maintain financial slack in the form of reserve borrowing power. "Reserve borrowing power" means that it can issue safe debt if it needs to.

4. Since target dividend payout ratios are sticky, and investment opportunities fluctuate relative to internal cash flow, the firm will from time to time exhaust its ability to issue safe debt. When this happens, the firm turns to less risky securities first - for example, risky debt or convertibles before common stock.

16 See Myers 1984


Financial MobilityPreventing liquidity problems is not just a question of choosing the right investment opportunities and financing them, but also to be prepared for any financial emergency. Different methods are available to judge a company's financial mobility: its capacity to deal with unexpected liquidity needs. So far, only the overall capital and ownership structure has been looked at. Gordon Donaldson (1962) criticized conventional rules governing debt capacity decisions. He suggested a scenario-analysis to base decisions on, with an irreducible minimum for expenditures that are vital to the company's mid-term and long-term survival. These include things like research, capital assets, and common or preferred dividend. In 1969, Donaldson wrote a book about systematic contingency planning to prevent an unexpected need for funds from turning into a crisis for the company. His strategy of financial mobility has three parts:

- maximizing the resource of time. Most cash flow problems would have been easy to handle if they had been anticipated earlier. To achieve this, 'what if' analysis should be used more in forecasting;

- an inventory of the resources of financial mobility, consisting of those resources that are available to management in covering an unexpected deficit in funds flows, including the time needed to convert them into cash.

- a strategy to employ the resources of mobility when the unexpected occurs. The strategy should be to match as closely as possible any unexpected cash deficit with the resources most comparable in certainty and timing.

Assuming that this is a good way of contingency planning, this could be used to assess how well a (family) business is prepared for unexpected events. Together with an estimate of the risk of unexpected events actually happening, this determines the risk a business has of getting into immediate liquidity problems.

Shareholder Relations and Expectations

Agency TheoryAgency theory, pioneered by Jensen and Meckling17, is probably the largest managerial strand in finance and economics literature. It does not deal with capital structure in the same way thepecking order and static tradeoff theories do. It uses ownership structure rather than capital structure, to emphasize the importance of the amount of ownership held by insiders and outsiders. The link with family business is very direct when looking at the three circle model, which also makes a distinction between active and non-active owners.Agency theory assumes utility-maximizing behavior of all individuals. This is the reason why agency problems occur: the agent (manager) will act to maximize his own utility, not that of his principal (the owner). The principal then incurs two kinds of agency costs: those that are needed to minimize aberrant activities of the agent (like monitoring expenditures), and those that are the result of residual divergence between the decisions of the agent and those that would maximize the principal's utility.Where ownership structure is concerned, Jensen and Meckling argue that three variables are important: inside equity (held by the manager); outside equity; and debt (held by anyone outside the firm). The optimal structure is reached when marginal effects of all three variables cancel out.Jensen and Meckling consider the level of managerial ownership an exogenous factor that influences the value of the firm18. In 1983, Fama and Jensen conjectured that family relationships within the management and ownership structure of a firm reduce agency costs because of the multi-dimensional, long-term nature of the relationships allows improved monitoring of the decision agents.In general, the research on managerial ownership structure finds that managerial ownership level and firm value and performance are related. Furthermore, there is an indication that who the managers are may be important (founders, family members). McConaughy, Walker and Henderson (1994) have conducted research investigating the effect of founding family control upon the value and operating efficiency of 128 of the Business Week (1987) 1000 largest public corporations during the period 1986-1988. Their major findings are:

- Founding Family Controlled Corporations (FFCCs) have lower average agency costs, controlling for managerial ownership levels, size and industry.

17 see their 1976 article Theory of the Firm: managerial behavior, agency costs and ownership structure. Of course they were not the first to notice the problem of misalignment of the interests of the owners and managers of a firm. That has been noted, at the latest, by Adam Smith in 1776 and later by Berle and Means in 1932 (p.6)

18 Contrary to for example Demsetz (1983), who argues that the market for managers determines the total value of managerial compansation, including perks, and that in large firms the diffusion of ownership lowers cost of capital because it is not optimal for an individual investor to hold such a large single investment. He concludes that managerial ownership is thus an endogenous result.


- Descendants of founders seem to manage their operations more efficiently than founders.- Among non-FFCCs, those with high managerial ownership consistently exhibited inferior

operational efficiency and evidenced empire building, suggesting that higher managerial ownership without founding family control leads to entrenchment or at best, makes no difference.

The Dividend QuestionHere again Modigliani and Miller (1961) have explained first why dividend policy does not matter in public companies: shareholders are interested in earnings potential, not earnings or dividend payout. Shareholders can sell their shares if they want liquidity. Even when allowing for taxes and portfolio adjustment costs, dividend policy does not matter, really. A high-payout/high-outside financing strategy will simply attract different shareholders than a low payout/low outside financing strategy, which is no object to non-family businesses. A firm's choice of dividend policy, given its investment policy, is really a choice of financing strategy. The only way dividends 'affect' the value of a public company is by conveying unexpected messages about management's changing expectations concerning earning power, a mere information effect (first put forward in Muth's theory of rational expectations (1960))Gordon Donaldson (1994) puts forward a slightly different view. In his book Corporate Restructuring, he describes how he sees the changes that have taken place in dividend policy in the last decades and puts more emphasis on the role of the investment community in influencing dividend payouts. The increasing mobility and decreasing loyalty of shareholders in the sixties and seventies, and the decreasing mobility of careerholders (because of double careers) made the then common strategies inadequate: "in seeking to insulate the firm from the discipline of the capital market, through financial self-sufficiency, and from the product-markets, through diversification, management's sensitivity to the needs of those two critical constituencies had been weakened or temporarily lost. In many cases, the restructuring of the 1980s was a dramatic reversal of that trend." (p. 211) The investment community demanded a higher portion of earnings to be recycled through the capital markets before reinvestment was confirmed. The had lost their faith in previously adored professional management, management suffered the consequences and had to comply. But the temptations will always be there: the incentive to grow and sacrifice current returns for growth, is an essential part of every dynamic organization and of the job potential of its managers and employees. The tendency to overcapitalize and to minimize negative effect of financial risk is naturally tempting in an uncertain environment when the opportunity presents itself and the critics are silent. "In all aspects of financial policy, there is a predisposition to bury one's corporate financial identity in the averages--not to appear at an extreme and thus to attract attention--to conform to the norm. Hence, there is a pendulum-like secular movement in aggregate behavior." (p. 180) Donaldson expects a renewed dedication to minimizing financial risk, maybe even a new movement towards financial self-sufficiency in the 1990s.


Donaldson does not conclude that a different system of corporate governance is needed, but Porter (1992) does. In Capital Disadvantage: America's Failing Capital Investment System, he states that companies should "seek long-term owners and give them a direct voice in governance. The most basic weakness in the American system is transient ownership" (p. 81). In his discussion of the disadvantages of the American system, he praises family business:

It is important to note that there are companies and owners in the United States who operate differently from the predominant national system - who have overcome the disadvantages of the American system and achieve superior results. Examples of these are companies that have permanent and active family ownership, such as Cargill, Hallmark, Hewlett-Packard, Motorola and others, which seem to enjoy competitive advantages in investing. (p. 73)

ConclusionIt seems that economists have more faith in the ability of families to successfully govern businesses than do family business theorists (who are always family business advisors on the side). When discussing the three circle model, it was noted that owners often have difficulties in exercising their ownership rights. Assuming both observations are correct, being a family business must be both a potential advantage and disadvantage.

Utility model of a family business shareholder

This chapter will deal with the individual motivations that underlie shareholder behavior from a utility point of view.When dealing with liquidity issues, a shareholder in a family business must weigh two things: the utility (value) of getting extra liquidity at the expense of the family business versus the utility of giving up that liquidity in favor of the family business. When a major shareholder decides that his personal interest should prevail over the company's, there is a problem.A shareholder will consider many things when weighing the options:

* How soon does (s)he need the money?* How important is the destination of the money to him/her?* What is his/her general attitude toward the family business? Should it be a competitive

investment or not?* How easily does (s)he think the company could afford to give him/her what (s)he needs?* What are his/her alternatives to obtain the money? Other sources of income, credit lines,

etc.

Each of these could be broken down in several other factors, but that is not important here. The concept can be modeled as follows:For a family business shareholder, the utility of obtaining extra liquidity from the business depends on the urgency of his need for money. Urgency will be measured by the amount of money needed divided by the time left to obtain it. However, similar urgencies do not mean similar utilities. Every shareholder has a different financial situation and a different attitude towards the consequences of not fulfilling a financial obligation or desire. Shareholders will make an effort to find other sources of funds outside the family business. This is the sacrifice they are willing to make for the good of the company. The amount of sacrifice involved can also be seen as a level of utility: the utility of the money for the company (in the shareholder's eyes). That level of utility depends on the financial situation of the company, the amount of money the shareholder is already receiving, and the shareholder's attitude towards the company. If a shareholder is very attached to the company, he or she will be less inclined to take money out of it and lose influence or involvement, which translates into a higher 'utility of sacrifice'. When a shareholder decides that his or her utility is higher than the company's, he or she will demand the company to provide the amount needed.


Over time, two utility pictures emerge:

- shareholders' "company liquidity utility" changes, because of personal financial and attitude changes and changes in the urgency of money needed.

- Shareholders' utility of sacrifice for the company changes, because of the changing financial position of the company and the changing opinion of the family business.

Those two developments could be depicted graphically as two utility curves (see figure 6). As long as the utility of sacrifice exceeds that of extra liquidity, the financial relationship between shareholder and company can remain stable. When the utility of extra liquidity becomes higher for a shareholder than that of sacrifice, there is a liquidity problem. The chances of that happening depend largely on the initial distance between the two utility curves and their volatility. In this context, it is easy to see why liquidity problems can easily arise in family businesses that

do not provide their shareholders with much liquidity or liquidity flexibility. The shareholders are in worse financial shape, thus have relatively higher utility of extra liquidity. At the same time, they may feel that the company treats them unfairly, which lowers the utility of sacrifice.

Utility of sacrifice for the company

Example of two utility curves over time

(one individual)

High

Utility

Low

Time

Utility of extra liquidity Danger zone

Utility of sacrifice for the company

Example of two utility curves over time

(one individual)

High

Utility

Low

Time

Utility of extra liquidity Danger zone

Figure 6


This utility curve concept, abstract as it may be, can be helpful in understanding the changes that occur in family businesses and how those changes structurally or incidentally affect liquidity problems. Measuring utility is always difficult, and to compare the utility of one thing with another can usually not be done beforehand, but only after the resulting choice is known.

PART III: SYNTHESIS

A Concept of the Liquidity Issue in Family Business

On the Nature of Family BusinessA popular misconception about family business is that it would be an inefficient or ineffective form of organization. Economic and family business studies suggest this is not at all the case. McConaughy et al's (1994) research even suggests better performance of family businesses, although it is unclear why this is so. It is possible that a sort of natural selection is at work, families could tend to abandon less profitable businesses, but in that case it is difficult to account for the stronger emotional ties associated with family businesses. It is striking that in corporate finance, family ownership is thought to lower agency costs, and in family business theory, it is almost the opposite, although many scholars/advisors in family business do recognize that family businesses have certain competitive advantages.Ward and Aronoff (1991) for example, posit that family business have the following competitive advantages:

"As a family, here's what you can do well but others have difficulty with: You can make decisions more quickly; you can build businesses based on personal relationships and integrity; and you can provide close, personal supervision.Family firms' other strategic advantage is the opportunity to take the long-term view." (p. 55)

Ward and Aronoff then quote a successful business-owner: "Patience and the long-term view not only make good business sense but also make great family sense." Ward himself made a similar comment (1987:55) "Well-managed businesses and healthy families do share many positive constructive traits." This does away with a related misconception: that the family is a hindrance to business success. Cultural approaches (see pp. 26-30) teach us that certain cultures are better at dealing with the people-problem in family firms, others are better at dealing with the competitive environment. Not every family will have an equally positive effect on its business, but in principle, nothing seems to stand in the way of family businesses becoming at least as successful as their non-family counterparts, without excising the family, as many 'rational' theorists would like. The incompatibility of family and business is a myth. Family businesses have to deal with the same problems as others, but they often choose different solutions than non-family businesses. These different solutions can work out worse, as good, or better than their alternatives. For this research, it is not necessary to search for excellence in family businesses, define what makes them a success in their industry, it is more interesting to find out what holds them together. It is not just the family feeling, nor is it just the economic gains. Those two factors influence each other, and can both cause problems as well as satisfaction. This research is aimed at determining the importance of liquidity issues, under different family and business circumstances. This brings us back to the heart of the problem: liquidity needs versus liquidity availability.


Liquidity need and liquidity availabilityWe are back at the bottom of the family business triangle: shareholder liquidity needs versus business capital needs. If family businesses are not doomed from the beginning, and can become very successful financially, why are liquidity problems still so frequent? A summary and synthesis of the concepts of the previous part could give the answer to that question.

Shareholder Liquidity Needs19

On the shareholder's side, two sorts of liquidity needs can arise:

- an immediate (large) liquidity need, caused by unexpected personal financial needs, or the wish to part from the family business (cash out);

- a structural liquidity need, caused by the feeling that more liquidity and liquidity flexibility should be given to the shareholders.

An unexpected financial problem can hardly be prevented, but the wish cash out can be influenced by matters like influence on the decision making and goal setting process in the business and personal relationship with the family. Thus in order to judge the probability of such 'fatal' conflicts, the strength and flexibility of the family bond has to be analyzed, as well as the strength of the bond between the family and the company.A structural liquidity need, caused by feelings of discontent, usually is a function of the following factors:

- Family business shares, especially minority interests, have a very limited marketability;- Family business shareholders are emotionally attached to their company;- Family business shareholders often hold few other investments (are undiversified);

The first and last factors can be a problem because they restrict shareholders' investment opportunities: they can not influence the risk profile of their investment, unless they are also in influential positions in the company. The difficulty of turning an investment into cash is present in every closely held company. To make up for that disadvantage, the market for those shares expects a higher yield than the public market. The more illiquid the investment is, the higher the yield premium.The emotional attachment to the family business and the family values also influence shareholders' liquidity demands. The analysis of family business in section II suggests that their position in the family, relations with important family members (like the patriarch), the presence

19 This is assuming that the shareholder is a family member. If there are outside shareholders, the problem is a little different. For this research, I chose to see the possibility of having outside shareholders as a form of liquidity flexibility for the family shareholders


of family values in the business, etc., can influence what is considered a fair level of dividend and enough liquidity flexibility. This concept, the influence of family matters on the expected return on investment is the family effect. The family effect is of course very personal, but using 'three circle model' reasoning, it is probable that the biggest differences in family effect occur between groups belonging to different constituencies. Three types of shareholders with different attitudes then emerge: the active shareholder, the inactive shareholder, and the (potential) future shareholder.

Active ShareholdersActive shareholders stand to gain and lose the most. They can be active out of family pride or pressure, financial motives, or power and status motives. They have good reasons not to want to sell their shares. They are themselves responsible for the company's performance and thus for their share of earnings, and it is more difficult for them to secure their position or that of their children without shares.When active shareholders do decide to sell their shares, it is because of a financial emergency or leaving the company. This could happen for example when a designated successor is chosen, and the other candidates are unhappy with the outcome of the decision.

Inactive ShareholdersInactive shareholders can have financial and family reasons to stick with the company. They will be more tempted to 'sell high' than active shareholders. They usually do not have the opportunity to sell high though, because of the lack of marketability of their shares. If the company does not pay high dividends or offers liquidity flexibility, the only thing keeping the inactive shareholder involved is the family effect. If there is no family effect, these shareholders will start behaving like rational investors: they will demand a premium for the fact that their shares are 'illiquid' there is no market for them. They will want to sell their stock for portfolio reasons or because they need liquidity. From the literature it is also known20 that when power is concentrated, it can result in estrangement and resentment, especially if managers and shareholders disagree on fundamental values or the business strategy. Even if there is a family effect, the inactive shareholders who depend heavily on company dividends for their income, demand the dividend payout to be kept relatively stable.

20 see the discussion of the influence of family business culture in section II


Future ShareholdersFuture shareholders are important because of the continuity-goal of family businesses. In order to increase the chances of them entering the family business as manager or shareholder, they have to be instilled with family pride and values, and given the opportunity to get involved in the business. Their attitude is thus related to the family effect. If they are not motivated to take part in the business, chances are that they will look for a career outside of the business and sell out at the first chance they get.

Implications for the business*In order to stay a family business, the business must satisfy the needs of three kinds of shareholders. Their wish is a fair return on their investment. In the public market, a fair return is based on the return on a risk-free investment plus a risk premium, depending on the volatility of a company's stock. Shareholders in family business will expect a compensation on top of that, for illiquidity of their stock. On the other hand, they will feel the family effect, which, when present, is in itself a compensation for lower yields. For the company, this means that their financial returns to shareholder formula looks like this:

RF = the risk free rate of return (government bond yield)b = the company's beta, its volatility relative to the public market MR = average yield of the public market(MR - RF) = the standard market risk premiumIP = the premium for illiquidity of the stockFE = the family effect.

*note MB 2009: during one of the presentations of this model, a business valuator pointed out that the family effect implies a higher value of the firm tot the family than to outsiders. The difference hence could be interpreted as the emotional value of the firm to the family

Minimum necessary yield of family firm stock(increase in value + dividend)

(RF + b(MR - RF))(1 + IP)(1 - FE)


Liquidity Flexibility and Business Capital NeedsOpposing the needs of the shareholders in the family business triangle are the capital needs of the business. Needs is not a very good way to describe them though, because they are usually the result of specific strategic choices. Only part of the capital need is fixed, the rest a function of growth and operating strategies.The fixed part is mostly dependent on the industry the company is in. Some industries require great capital expenditures (like the oil business or high-tech industry) The variable part depends on growth targets and fixed asset investment. The more a company strives for growth and high operating leverage, the higher its capital expenditures. When making decisions about this, and the way to finance the expenses, little attention is often given to the resulting shareholder liquidity. As long as cash flow and profits are expected to be positive, the rest matters little. This attitude in a family business would not cause liquidity problems if shareholders had a way of balancing their cash needs with cash available (liquidity flexibility) Some ways in which a family business can offer liquidity flexibility are:

Company-sponsored loan programs for shareholdersBuy-sell agreements between shareholders or shareholders and the companyAnnual redemption fund purchases

When analyzing the probability of liquidity problems, the presence of these instruments should be taken into consideration. In terms of the return formula presented, the presence of liquidity flexibility will lower IP, the illiquidity premium. Depending on the financial situation of the shareholders, the influence of liquidity flexibility can be high or low.In order to be able to meet immediate shareholder liquidity needs, a family business has to maintain a higher financial mobility than non-family businesses.

ConclusionThis section combined the ideas from family business theories and economics theories into a general concept of family business liquidity issues. To prevent liquidity problems, and perpetuate the family business, boils down to four major factors:

- provide a fair return to shareholders (this requires educating shareholders as well);- provide enough liquidity flexibility to shareholders;- create enough financial mobility to deal with financial emergencies;- keep the family members involved.

The next section will deal with operationalizing these concepts and combine them into a model, with the help of the ideas presented in the Analysis section, and the concept presented here, the shareholder return formula.

PART IV: MODELING

Model Format

Although it is not the purpose of the research to produce a complete analytical model, the concepts of liquidity can be modeled into a base model, that will have to be completed, improved, and tested before it can be used in practice. This model provides a framework for a final model, capable of helping individual family businesses. It is important to note that the model is not meant as a forecast in the sense of 'expected future events'. Rather, it is meant for educational purposes: a warning for family businesses, hopefully prompting them to take preventive action. Many of the features have been added to show what would happen if a certain financial strategy were followed.A model to analyze liquidity issues must be based on the flow of funds in a family business. That flow is reflected in the pro forma cash flow statement, which can be derived from the pro forma balance sheet and income statement. In the cash flow statement, the choices concerning the allocation of liquidity are addressed: how much has been borrowed or repaid, and how much dividend has been paid out. The cash flow statement must reflect the relevance of those two decisions by separating those from the other cash flow lines. This discretionary cash is the amount of cash flow that is available before financing decisions about debt and dividend. If that amount does not suffice to fulfill the liquidity needs of the shareholders, one of three things can be done:

1) (partially) ignore the liquidity needs of the shareholders;2) lower the liquidity needs of the shareholders;3) increase the liquidity available to shareholders.

Option one is the easiest to take in the short run, but a dangerous habit in the long run. It will increase discontent, thus lower the family effect and increase the shareholder return demands. The discrepancy between what shareholders want and what they get can then quickly become intolerable.Lowering the liquidity needs of shareholders is not something a model can calculate or assume will be done, either by increasing the family effect or lowering the illiquidity premium.The model will have to focus on increasing liquidity availability, a variable that can be directly influenced by changing the cash flow. Increasing the liquidity available means either attracting more debt or reducing expenses. Those actions will change the balance sheet and income statement. So it is important to know ho much 'slack' there is. If debt level is already at a maximum and capital expenditures at a minimum, there is little financial mobility and more chance of liquidity problems. By assuming that the business wants to satisfy its shareholders, the model can make adjustments to the financial statements and examine the effect on the company's financial situation. If that situation becomes dangerous, it is probable that liquidity problems will arise, either because the shareholders do not get what they want, or because the business becomes vulnerable to any extra financial burdens.


Pro Forma Financial StatementsThere are two possibilities to obtain pro forma financial statements from family businesses: have the model make predictions, or use the company's forecasts. The advantage of having the model make the projections is that the quality of those projections will be constant. It would however be far too expensive and time-consuming to make elaborate forecasts. That would imply making an analysis of the company's competitive position, which is beyond the scope of this model. One of the purposes of the model was to reduce costs an increase speed of analyzing liquidity issues, not judging the market strategies of the business.The alternative, using the company's forecasts, has two advantages: since only large family businesses are considered, there is a good chance that they have their own forecasts. The second advantage is that family businesses are more apt to accept conclusions about liquidity based on their own forecasts than on someone else's, especially if that other forecast is less optimistic. Interviews with family business leaders made clear that they would not trust the results of the model if it made assumptions far different from their own. Another difficult aspect of the model, making acceptance more difficult, is the inclusion of 'soft' factors like the family effect. To reduce that problem, the model must clearly distinguish between 'objective' conclusions, based on sheer numbers, and 'subjective' conclusions, that include family matters.Another option that is included in the model is to make a 'worst case' analysis of the liquidity issues. The model can adjust the company's forecasts by assuming the same relationships between the items on the balance sheet and income statement, and reducing the sales growth. This worst case sales growth figure can be put in based on what the company still thinks is (even remotely) possible. Running the model for the worst case scenario makes it possible to judge the stability of the financial situation, which is a measure of the risk for liquidity problems.

Operationalizing the FactorsIn operationalizing the factors, this part will be restricted to the principles, not the final measuring instruments. To develop those final instruments, more research needs to be done on the exact influence of every variable, so that precise measuring becomes possible. When more experience is gained, the model can be improved to give a more and more precise risk analysis.

Competitive ReturnIn the model, the formula for shareholder return will be separated in two parts: the competitive return and the family effect. This is to satisfy the request to separate 'hard' from 'soft' factors. By explicitly showing the influence of the family effect and making it possible to vary that effect, family business owners will hopefully put more confidence in the results of the model.


The competitive return is the return that is acceptable for a non-family investor, given the company's risk profile and the level of illiquidity of the shares.

Risk ProfilePrivate companies often do not have a known beta, the standard measure of investment risk. There are two possibilities to estimate a beta, if the company does not supply one. The first one is to analyze past performance and calculate it. This can only be done if the company is old enough, and did not go through major strategic changes in the last years. The alternative is to take the beta for the industry that is closest to that of the family business, for example from Value Lineinformation.

Illiquidity PremiumThe appropriate illiquidity premium for a share is based on three factors:

- the marketability of the stock;- the amount of liquidity flexibility provided by the business;- the dividend yield.

The exact effects of these factors and their relative importance need to be researched further.The average difference in dividend yield between a private and a public company could be a good estimate of the average illiquidity premium.Additional indicators are the presence of outside shareholders and restrictions on share trade. They could be used to get to a more customized illiquidity premium. The base model uses a high/low/average division, based on the number of possibilities for shareholder liquidity and a high or low dividend yield.

Stock MarketabilityIn a market with little trading, like the market for family business shares, it is very difficult to judge the marketability of certain stock. For most companies, shares are difficult to trade, especially when there is little liquidity flexibility and low dividends. Only when a majority share is offered, is it easier to find a buyer who will give a 'fair' price.

Liquidity FlexibilityProviding liquidity flexibility is a way for the family firm to lower the illiquidity premium its shareholders demand. Programs that are in place to achieve liquidity flexibility should thus be evaluated in their effectiveness. The base model can not go this far, it will only separate companies who have some liquidity programs from those who do not.


Dividend YieldA high dividend yield, just as liquidity flexibility, lowers the illiquidity premium. How big the influence is depends on the financial situation and attitudes of the shareholders. Some shareholders prefer increased value over dividends, usually for tax reasons. A high dividend could be defined as 'a total dividend of more than half the increase in shareholder equity'. Increase in market value would be preferable, but not possible to establish objectively if there is little trade of shares. The amount of dividends paid out has not been included in the model for practical reasons.In the base model, there is also a provision for minimum dividend. This is the dividend necessary to satisfy those family members that depend heavily on it, usually the oldest, retired generation. The minimum dividend is calculated by taking the historical average dividend and adjusting it for the passing down of stock to the next generation. If someone gives away x% of his or her stock a certain year, the rise in dividend should be x/(100-x). This can become a large liquidity drain, because the extra dividend will have to be paid to all shareholders, even those who do not want or need it, and it rises exponentially. More customized solutions are less wasteful, dividend is a very crude instrument, which should be used carefully. The model can show the disastrous results of raising dividends too much, more as a warning than as an actual development, because it is unlikely that the rise in dividend will really happen.

The Family EffectThe family effect, the sum of all the factors that uniquely influence a family business shareholder, is very intertwined with the illiquidity premium. The illiquidity premium depends partly on the financial situation and attitudes of the shareholders, and so does the family effect. Both factors can sometimes reinforce, sometimes oppose each other. For the model, the illiquidity premium will encompass all financial shareholder issues, even those that an outside shareholder would not consider. Measuring the family effect is a major challenge. One approach to do it would be to ask family members how high they think it is. The drawback and advantage of this approach is that it does not need to know in the reasons for a high or low family effect. The advantage is that it is easier and makes a lot of research into the factors unnecessary. The drawback is that it does not give any indication to advisors about the inflexibility of the family effect, or the possible ways to change it.Another way to measure the family effect is to look at certain objective characteristics of the family business. The most important one that theory would suggest is the distribution of people over the 'three circles'. The number of active and non-active shareholders could be an important indicator of the family effect. Here again, the attitude of the next generation is important. The goal of most of the people in the 'parent' generation is to leave the business to their children, so if the children's attitude towards the business is positive, and they want to become involved, the parent generation is likely to value sticking with the business higher than if the children are not interested.


A third way to measure the family effect is by looking at processes and structures in the family business as a whole. This approach is currently used to develop a questionnaire for family members in a family business. The first version of this questionnaire is presented in appendix C. This version will be pre-tested among family businesses in the Chicago area, and developed further over the course of this year. The questionnaire addresses four major areas of interest:

- education/involvement of shareholders and family;- degree of agreement on important issues;- existence of written plans or formal rules on important issues;- family values and activities.

Ideally, all three ways of measurement should be used and compared. This could lead to a set of objective facts that have a high correlation with the family effect, thus making the analysis even easier: distributing the questionnaire among all family members would no longer be necessary.In the base model, the score on the questionnaire is combined with the percentage of working family members, active in the company, in the 'parent' and 'child' generations. This way, there is a developmental aspect to the family effect caused by the expected development of the family and the entrance or departure of active family members.

Financial MobilityAnalyzing the financial mobility of a company thoroughly is a time-consuming process. The necessary information is usually not directly available. However, for analyzing trends, a rough estimate like cash plus unused debt capacity can do.Another problem is judging the necessary level of financial mobility, which depends on the size of the threats and their probabilities. The threats from the product markets will not be evaluated in the base model. That would be beyond its scope. So assumptions have to be made about the part of the financial mobility that is necessary for threats from the market. This will be the capital shortage resulting from the worst case scenario: a much lower growth of sales than predicted, with equal capital expenditures. The financial mobility that is left after that, is the liquidity cushion for sudden liquidity needs caused by the shareholders.The liquidity cushion will be determined by decreasing capital expenditures to a minimum (set by the company), maximizing debt (until the maximum D/E (debt to equity) ratio acceptable to the company), and adding cash. It is an important measure of the vulnerability of the company, even though more research is needed before precise assessments can be made.One future liquidity need has already been included in the model: estate taxes. The model assumes that reserving a certain sum every year is necessary. That sum depends on the expected time until the current owners will pass away. If life tables indicate that a shareholder is expected to live another y years, and he or she owns p% of the shares, the reserve build-up in year i should be


(p/y)*(company value in year i)*(expected estate tax rate)21. The model will add up the reserves necessary for shareholders who are expected to live less than 20 years, based on US 1989 life table statistics. The company value for estate tax purposes will be the maximum of the book value or the EBIT-multiple (Earnings Before Interest and Taxes), based on the company's own estimate of the multiplier. Because estate tax is a very tricky subject, this reserve build-up should not be interpreted too rigidly.

Necessary InputThe model will need the following input to analyze the risk of liquidity problems:

- Four years of historical balance sheets and profit and loss statements;- Five years of pro forma balance sheets and profit and loss statements;- Information about the family involvement in the business now: number of working family

members, active shareholders, and active future shareholders;- Information about the family involvement over the next five years: retirements, new active

members;- Age of the major shareholders and their spouses, as well as their intended stock gifts to the

next generation;- Estimates about the risk-free rate of return and the market premium in the future;- The planned percentage of retained earnings;- An estimate of the company's beta;- Company goals concerning D/E ratio and minimal capital expenditures;- An estimate estate tax percentage as well as an estimated EBIT-multiplier in order to

determine the value of the company for tax purposes;- The size of the family holding in the business: percentage ownership and percentage

control;- Agreements about future stock trade, including the valuation procedure;- Liquidity programs available to shareholders;- Family score on the family effect questionnaire;- A worst case sales growth figure.

Provided OutputBased on the input, the model will generate the following information (for the normal forecast and the worst case scenario):

- The size of the family effect;

21 The estate tax will be over the future value of the company, so I assume that the value of the reserve grows at the same rate as that of the company.


- The size of the illiquidity premium;- Necessary dividend growth;- Estate tax provisions needed;- Return shortfall;- Trend in family effect;- Cash flow statements, adjusted for extra liquidity needs of shareholders;- The size of the liquidity cushion after adjustments.

An example of the base model and its fictional results are presented in appendix D.

Risk Profile AnalysisThe output generated by the model will have to be interpreted to judge the risk of liquidity problems for an individual company. That will be done by examining three factors:

1) The possibility to satisfy the liquidity needs of the shareholders in normal and worst case scenarios;

2) The size of the liquidity cushion in both scenarios;3) The size and development of the family effect.

These factors are listed in decreasing order of danger. If a family business can not satisfy the liquidity needs of its shareholders, the probability of a liquidity problem is highest. If the business can provide enough liquidity, but does not have any room for unexpected extra needs, liquidity problems are less probable, but the company is very vulnerable to mistakes in predictions or unexpected events. If a family business can support its shareholders and even has a sizeable liquidity cushion for unexpected events, the only danger lures in the diminishing of the family effect. Not only will a negative trend affect the expected returns, it will also make it more probable that family members want to sell out, they have no more attachment to the company.The last step in the risk analysis consists of evaluating the reasons for the height of the risk and the factors that can be influenced most efficiently to reduce the risk, the ones that create the most leverage. Which factor creates the most leverage depends on the cause of the liquidity problem: whether it is basically rooted in the performance of the business, the lack of involvement of the family, the lack of liquidity flexibility, or the limited financial mobility of the business. By working on the factors that create the most leverage, the risk of liquidity problems can be reduced at minimum costs.

Strengths and LimitationsAs discussed before, the base model presented here is more a framework than a forecasting model. A lot of research needs to be done in order to fill in the gaps. The framework does provide a useful conceptual framework though, by exploring the possibilities to translate family circumstances into financial demands on the business. The model tries to integrate business


financial performance, family values, and shareholder expectations. By separating the factors, more insight can be obtained about the possible interactions between them.The limitations of the model are that predictions of the future are always wrong, both in the areas of business development and family development. In addition, measuring family-related factors is very difficult and very unrefined, the model uses an aggregate family effect in stead of an individual one, for example.Apart from the model's limited capability to predict, it has the limitation of not taking the family business strategy into account. This was a conscious choice, based on the objective of keeping the model quick and easy.

Questions for Further ResearchThe limitations of the base model presented in this section are such, that it is unfit to base decisions on. It does raise some questions that, if answered satisfactory, can turn the model from a conceptual tool into an analytical tool. The main areas in which more research is requested are:

- Measuring the family effect, and trying to find objective indicators;- Evaluating liquidity flexibility and the necessary size of the liquidity cushion;- The influence of dividends in family business;- The influence of economic success of the business on the family effect.

More basic research into the competitive advantages of family businesses and how those advantages are sustained should also be done, to see if recommendations based on expected liquidity problems do not affect the business' 'core competencies'.


Use of the conceptThe concept for family business liquidity presented here can be used already in educating family business members about the needs and wants of the different constituencies of family business. The family must be made aware that liquidity problems are avoidable, and that there are several ways of going about it. A family business with a very low family effect can kill two birds with one stone by trying to create more 'family leverage'. This will lower the expected rate of return (and thus the cost of capital for the business), and it the increased involvement of the family in the business will make it more likely that the business will stay in the family for a long time to come.By finding businesses that are willing to subject themselves to the analysis presented here, there could be a big educational advantage, even if the forecasts are unreliable still. By discussing the results with the family, the dialogue between the different constituencies will be easier, since they all will be forced to acknowledge each other's interests. If the family is willing to let experts sit in on the discussion, they could find it useful for further improvement of the model, and consequently for further development of family business theory. The model thus provides a basis for family business to work improve their structures and a basis for family business theorists and consultants to improve their knowledge and develop the field further.

Appendices


APPENDIX A

Alternative definitions of Family Business (from: W.C. Handler, 1989)

Ownership-ManagementAlcorn (1982) "A profit-making concern that is either a proprietorship, a

partnership, or a corporation . . .If part of the stock is publicly owned, the family must also operate the business" (p. 23).

Barry (1975) "An enterprise, which, in practice, is controlled by the members of a single family" (p. 42).

Barnes and Hershon (1976) "Controlling ownership [is] rested in the hands of an individual or of the members of a single family" (p. 106).

Dyer (1986) "A family firm is an organization in which decisions regarding its ownership or management are influenced by a relationship to a family (or families)" (p. xiv).

Lansberg, Perrow, Rogolsky, 1988 "A business in which the members of a family have legal control over ownership" (p. 2).

Stern (1986) "[A business] owned and run by members of one or two families" (p. xxi).

Interdependent subsystems (familyinvolvement in the business)Beckhard and Dyer (1983b) "The subsystems in the family firm system . . . includ[e]

(1) the business as an entity, (2) the family as an entity, (3) the founder as an entity, and (4) such linking organizations as the board of directors" (p. 6).

Davis (1983) "It is the interaction between two sets of organization, family and business, that establishes the basic character of the family business and defines its uniqueness" (p. 47).

Generational transferChurchill and Hatten (1987) "What is usually meant by 'family business' . . . is either

the occurrence or the anticipation that a younger family member has or will assume control of the business from an elder" (p. 52).

Ward (1987) "[A business] that will be passed on for the family's next generation to manage and control" (p. 252).

Multiple conditionsDonnelly (1964) "A company is considered a family business when it has

been closely identified with at least two generations of a


family and when this link has had a mutual influence on company policy and on the interests and objectives of the family" (p. 94).

Rosenblatt, de Mik, Anderson,and Johnson (1985) "Any business in which the majority ownership or control

lies within a single family and in which two or more family members are or at some time were directly involved in the business" (pp. 4-5).


APPENDIX B:Possible factors influencing liquidity issue, after brainstorm sessions and interviews with the

consultants at de Visscher

Business

Externalfirm market valueBUs' market valuescompetitive positionsgov't regulationstaxestechnologiescompetitor investment

ratesmarket growths

Internalmissionagesizekey competitive

advantages# employees# active family membersownership distributioncontrol distributionboard compositionworking capital needspast investmentsinvestment policyleverage policydiversificationpast earningsprojected earningsprojected cash flowdividend policygrowth policyRONA targetasset structure

Family

historygenerationsfamily charter% ownership% control # family stockholders# heirs to stockholders# family board members# family executives# family employeescloseness in agedominant memberscoalitionsfamily relationshipattitude towards

businesswealth managementgeographical spread

Individual

agegenderlife styleattitude partnerchildrendivorcesrole in companyrole in family% stockincome outside family

businessambitions


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