Seven Habits of Highly Effective Companies
Attention to sound financial practices - and to shareholder value - are what separate the best from the rest
By François M. de Visscher
Why do some family firms thrive while others merely survive or even wither away and die? Successful family firms are distinguished by their attention to sound financial strategies and practices. To borrow a phrase there are seven financial habits in particular that separate the best from the rest.
1. Successful family firms establish effective financial and governance structures that separate family issues from business
ssues.Whether it is by ways of Family councils, family holding companies, or even shareholders' assemblies where such forums exist, family members know there is a time and a place to discuss family matters related to the business. The board of directors can then focus on strategic issues and the pursuit of long-term shareholder value. Its time is no longer consumed by family issues (and sometimes quarrels) that should be resolved elsewhere. Likewise, when such structures are in place outside board members can be more easily selected on the basis of "functional fit" &endash; that is, on experience and vision that complements that of the family board members, rather than on just a friendship or social obligation. Outside board members often add value because they come from backgrounds in public companies, where maximizing shareholder value is a primary mission.
2. Successful family firms strive for "free cash flow" growth not just business growth.
To Warren Buffet, the single most important criteria in selecting and valuing his investments, is cash flow, not sales growth. While sales growth can lead to long-term business appreciation, it is growth in cash that pays off for shareholders. Cash flow allows dividends to be paid and the value of the shareholders' equity to increase. To measure cash flow, successful family businesses use "free cash flow," which is net cash flow of the business minus investments and dividends. What's left &endash; free cash flow &endash; is the financial bucket from which growth opportunities, diversification or even stock redemptions can be financed. Free Cash Flow is also different from Earnings Before Interest, Taxes, Depreciation and Amortization or "EBITDA". EBITDA, which is being used by many investment professionals as a cash-flow definition, it is in our opinion dangerous to use as a valuation or performance measuring tool because it does not include true cash outlays such as debt services maintenance capital expenditures.
3. Successful family businesses have in place adequately funded liquidity programs for shareholders.
While the value of the stock in a privately held company may significantly increase over time, shareholders usually have no means of realizing this value. The stock is illiquid &endash; they cannot readily find a buyer at close to a price that reflects true value. Hence value appreciation becomes either academic or a source of conflict between shareholders who are active in the business and those who aren't. Without a liquidity program, shareholders feel trapped in their family investment. This will ultimately drive them to demand higher dividends; and higher dividends, in turn, soak up cash available for growth thereby reducing the long-term value of the stock.
By enabling shareholders to sell some stock back to the company or the family if they so desire, a liquidity program allows both active and inactive shareholders to focus on long-term appreciation. More often than not, few shareholders want to sell any stock when such programs are in place.
4. Successful family firms invest year after year in the "family effect."
The family effect refers to the level of the family members' heritage and legacy with the business and their confidence in it, their dedication to it. Firms that work hard at maintaining the family effect face less pressure to provide an ever increasing cash/financial return for shareholders and higher levels of performance from the business leaders.
The family effect is the intangible, non-financial reason of maintaining an ownership in the family company. In many cases, the family effect is one of the most important "returns" from a family business &endash; perhaps, indeed, the most satisfying return. There are many ways to develop and strengthen the effect, including regular family information meetings, programs to stimulate next-generation entrepreneurship, and the creation of a family&emdash;wide philanthropy program. Philanthropy is an excellent way to explore, identify, and rally around the core family values while making positive impact on the broader community. It can be an ongoing source of family pride as well.
5. Successful family firms establish arms-length compensation policies for their active members and communicate them nearly to all shareholders.
The bond between active and inactive shareholder groups depends upon trust. Trust is easily shattered by the mere perception that the shareholders active in management are drawing excessive compensation or benefits at the expense of the inactive shareholders. The ire of inactive shareholders is aroused when family manager enjoy company automobiles, country club memberships and low-interest loans, even if these perks may be typical of what comparable non-family firms give their senior managers.
In today's business climate of corporate scandals, and shareholders' outcries to eliminate excessive executive compensations and perks, it is ever more important for active family members to adhere to fair compensation schemes which reward executives, family and non-family, for true performance.
By staying within industry parameters on compensation family businesses alleviate many of the jealousies of inactive shareholders as well as the concerns of banks, creditors, and employees. Many accounting firms and some compensation specialists will provide you with data from annual surveys on executive compensation and benefits of senior executives at various sized companies in different industries. Follow those guidelines as closely as possible and use them to document and defend your own policies.
6. Successful family firms use public company accounting standards.
A private firm that decides to go public is often surprised to discover it has to upgrade and make many adjustments in it s accounting practices to conform to public company standards. Are there two sets of accounting norms, one for private companies and one for public companies? There shouldn't be.
The recent case of Enron, Adelphia, and other corporate examples, remind us once again of the need for full disclosure and accounting transparency in closely-held businesses.
Annual audits and internal accounting controls foster shareholder trust and are useful tools in management decision-making. Hire a public accounting firm to prepare your annual audit and make sure it follows Generally Accepted Accounting Principles.
7. Successful family firms avail themselves of global financial resources.
The global economy is more than a cliché; it's a reality. More than ever, family firms need to think globally to succeed. Even if you aren't yet doing business overseas you need to understand global forces in your strategic planning because foreign competitors may be targeting your once secure domestic market.
Globalization also means the globalization of capital markets. With the current strong dollar and the low cost of capital in some countries, expanding your company through overseas investments or acquisitions may not be as costly as you think. In venturing abroad, you can match the currency of the financing with the currency of the investment, thereby hedging your currency risk while taking advantage of low-cost capital.
While many of the financial habits above emphasize shareholder value we all know that this is not necessarily the only value for many family firms. Nevertheless, paying attention to shareholder value is the best way to maintain the family's patient capital (which is, let's face it, cheap capital!). Ultimately that is what all family companies depend on for long-term survival.