Small, family-run businesses, which have faced an uphill battle in securing financing since the 2008 financial crisis, are increasingly turning to individual investors for fresh capital.
In fact, the union of private companies and individual investors is not surprising considering that both parties share a desire for long-term growth with reasonable risk, according to a new study by KPMG.
“Many say that attracting this type of investment is challenging because of a lack of availability and difficulties in finding a partner,” the accounting firm writes.
The study, entitled Financing Family Business Growth Through Individual Investors, notes that the 2008 financial crisis and the subsequent recession tightened the availability of bank financing, prompting businesses to more seriously consider individual investors as a source of capital.
“The recession made investments from individuals more valuable for small businesses,” says Beverly Johnson, a KPMG partner. “Banks want more paperwork and more reporting than many family business owners are used to, and banks often do not look at the longer-term investment, so an individual investor is more attractive.”
The study, which looked at 125 family-owned businesses and 125 HNW investors, shows that 58% of family-owned businesses are looking for outside financing and 42% have received financing from high-net-worth individuals.
The report noted that individual investors have warmed up to the idea of putting their money into private, family-run enterprises—particularly if they can become part of the company brain trust.
“Family business owners are often looking for someone with family business experience and experience in their industry to provide assistance, as well as money,” Johnson says. “The question then is how much control does the investor want and how much are the business owners willing to give up.”
The survey shows that 72% of high-net-worth individuals take responsibility for at least half of their own investments and the majority (60%) are focused on long-term capital appreciation, which makes them well matched for investing in a family-owned business. Nearly half (44%) of the individual investors surveyed have invested in family businesses in the past and 95% say it was a positive experience compared to their other investments.
The survey suggests that family businesses are more amenable to offering equity to the right investors than commonly perceived. One-third say they would be willing to offer equity in the short to medium term and half say they are willing to offer equity for the long term.
Avoiding The Pitfalls
Investments from individuals as opposed to banks are not without their potential pitfalls, however.
The issue of transparency can be a stumbling block for both sides, says Amelia Renkert-Thomas, a joint managing director of Withers Consulting Group, which advises family businesses on governance and succession planning.
“These types of partnerships are definitely going to increase because there are a lot of worthy, growing companies that are too small to be covered by the public market,” she says. “Investors who have expertise in the business’s industry have a tremendous amount to bring to the partnership.
“However, the business owners are going to have to be prepared for a level of transparency that they may not be used to,” Renkert-Thomas cautions. “The investor is going to need a direct line of communication to the team running the company and they are going to want to talk with the family frequently, both before and after investing.”
Demands for such transparency shouldn’t be considered unusual, as it’s the way individuals protect their investment, says Thomas D. Davidow, founder and principal of Thomas D. Davidow & Associates in Brookline, Mass. Davidow is a psychologist who specializes in family business consulting.
“The way the investor can protect himself is through due diligence and through the agreement itself,” he says. “Family dynamics can be unpredictable. The investor can ask for a seat on the board of directors and make it part of the agreement that the family cannot be paid until certain performance benchmarks are met.
“Extensive due diligence is needed on both a quantitative level and a qualitative level. The investor needs to find out about the family and its history,” Davidow says. “Continued communication between the investor and the family business owners is necessary.”
Women Key Players
Such investments are one avenue through which women have exerted more influence in the private equity sector, he notes.
“The number of women who are willing to invest in family businesses is rising because women are more relationship oriented, rather than task oriented, and that is what is needed in these situations,” Davidow says.
Individuals are also more inclined to invest in an industry that they’re familiar with, says Lorraine Fox, director of wealth management at Aspiriant, a multifamily office in California’s Silicon Valley. “The potential investors we deal with love technology and are risk tolerant,” she says. “They feel the risk is worth it and they like being part of the technology environment, so they like to invest in family-owned tech companies.”
Investors can either have equity in the company or debt; if they have debt, they get paid back first, she explains. “Those who invest or loan money usually do so in an industry where they have an interest and with people they trust. Also, the investors are not risking their entire portfolio; this is only part of the money they have to invest.”
Some high-net-worth individuals look at investments in family businesses as just another one of their asset classes, says Andrew Keyt of the Family Business Center at Loyola University in Chicago. “There are great opportunities in established family businesses, which are less risky than venture capital. Many families have great business models; they just do not have the capital to take on new strategies or expand to the next level.
“This is a trend that definitely will continue to grow,” Keyt adds. “Owners of family businesses are looking for sources of capital that have a longer term time horizon, and the investors are looking for a stable growth strategy for their investments. The investors usually have some sort of business experience and they believe in encouraging family businesses. So there is a real niche for those two to get aligned and marry up with each other.”
The Role Of Advisors
The financial advisor can play a crucial role in this partnership by seeing how it fits in with the investor’s entire portfolio. “You don’t want to put 80% of your portfolio into a family business,” says Keyt.
On the company side, the negotiations depend on how desperately the owner needs the money, says David Karp of Pagnato Karp, a wealth advisory firm in Reston, Va. “If the business owner absolutely needs the money, he or she may have to give up something, but if the money is discretionary, the business owner has more options to negotiate.
“There is always a concern about control from the business owner’s standpoint and that determines how the agreement is structured,” Karp says. “The owner may need money to grow in a new area or to penetrate a new geographical market. The fact that a company needs money does not mean it is broken or a bad investment.”
Business consultants and banks can be brought in to help find matches between companies and individual investors, according to the KPMG survey.
Individual investors should get to know the family and to seek out younger family businesses, the report says. “Our survey suggests the younger the business, the more likely it is to be open to offering equity,” KPMG says. “Therefore, first-, second- and third-generation companies are more likely to find the involvement of a [high-net-worth investor] more attractive than a sixth-generation company.”
