Family firms' need for control and equity financing decisions

(MENAFN- The Conversation) This article was co-written by European School of Management and Technology's Bianca Schmitz and Warwick Business School Professor Johannes Habel.

Wal-Mart, Volkswagen, Bosch, Aldi, Dell, LVMH, Ikea, Mars, Nike, and L'Oréal are not only well-known firms, they're also all family businesses. Worldwide, family firms are the leading form of economic enterprise and responsible for a major part of economic growth. And while many of these family firms flourish, financing and especially equity-based financing is a major issue for them.

As Cascadia Capital managing director Christian Schillerexplains :

The passage in December 2017 of a US tax revision thatlimits deductions on debt interestcould hurt family-business entrepreneurs who rely on this forward-focused capital in order to innovate and expand. In response, an executive of a private equity (PE) fund – an investment vehicle that invests in enterprises not listed on a public stock exchange)statedthat 'family-business entrepreneurs should embrace private equity funding.'

Family firms are increasingly attracting investors' interest because they are the dominant form of economic enterprise and often do not have the necessary financial resources to survive or grow.

Despite investors' strong interest, firm owners are often reluctant to offer equity in the capital markets. According to theEY 2018 Family Businessreport, only 38% of the world's largest family businesses have either used or are currently using private equity as a source of capital. Studies have repeatedly shown that family firms are less likely to use external equity as a source of financing than non-family firms.

Prior studies have argued that family firms are reluctant to consider external equity as a source of financing because they fear a loss of control. However, prior empirical research has neglected potential contingencies that determine whether family firms' need for control affects their equity financing decisions. Providing a first insight into this research void is the purpose ofour articlepublished in the journal Family Business Management.

Based ondata from 125 family firms of varying sizes and industries , it includes published records and interviews with senior executives. The study shows that a full understanding of family firms' consideration of external equity does not emerge from examining direct effects or even two-way interactions. Rather, this consideration is largely driven by a three-way interplay derived fromrational choice theory .

We show that the effect of family firm owners' need for control on their consideration of external equity depends on the extent to which owners expect investors to interfere with management, and the extent to which decision-making is affected by emotions. The family indicates that family firm owners who tend to make decisions emotionally are less likely to systematically evaluate whether their goals (that is, maintaining control) and a course of action (such as issuing equity to external investors) are without contradiction (which may be the case if investors are unlikely to interfere with management). Instead, owners may be more likely to base their consideration of external equity on their need for control alone.

In other words, even if expected investor interference is low, we found a more negative relationship between need for control and consideration of external equity for family firms that base decisions on emotions, than for family firms that do not base their decisions on emotions. Thereby, the present study contrasts prior research by showing that need for control does not automatically reduce a family firm's consideration of external equity, and provides evidence that family firm owners' decisions to use external equity are more complex than previously presumed.

First, investors need to understand the complex interplay at work among family firms' need for control, expected investor interference and emotional decision-making, to correctly assess their chances of success when approaching them for equity.

For example, if family firm owners have a high need for control and are rational decision-makers, aspiring investors need to focus on maintaining owners' sense of influence and control. Therefore, we recommend that investors first analyse how important different aspects of control are to owners and to themselves – such as voting rights, seats on the board, special veto rights, information rights, performance-related options, or covenants. Based on this analysis, investors may engage in multiple-issue negotiations with owners, aiming for solutions by compromising on those aspects of control that are important to owners but less important to themselves. Furthermore, investors may focus on the managerial benefits they bring into the firm, such as their mediating competence in resolving conflict between family members.

For family firm owners, our findings suggest that achieving a better understanding of their underlying motivations for seeking external funding might be a worthwhile investment of time. Specifically, owners should develop a clear picture about which aspects of control are important to them, to what extent external investors may pose a threat to these aspects of control, and which managerial benefits external investors may bring to the firm. Only if owners understand these aspects can they make goal-oriented – that is, rational – decisions on whether to issue external equity, which investor profile to look for and based on what criteria to evaluate investors' track records.

For third parties such as banks, which help family firms identify and connect with potential financial investors, they should active search for information on the criteria outlined above. Expected investor interference and the degree to which decisions tend to be emotional ultimately influence whether family firm owners consider offering external equity in their firms. Therefore, information on these variables is key to understanding family firms' financing needs and advising them appropriately, for example by connecting them with potential investors or guiding them in deciding on the desirable equity-to-debt ratio.

Equity
Capital markets
Family firms
financing

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