Financing a family business

A family business run through a limited company will typically be financed in its early stages by a mixture of equity (via money invested in shares), and/or loans from the family shareholders and possibly by an overdraft facility with its bankers.

For those investing in shares in a company, they will be entitled to any dividends declared and paid on those shares and, potentially, any increase in value of the shares as the business becomes more successful. If, on the other hand, money is lent to the company, a lender will be entitled to whatever interest (if any) is agreed between it and the company.

As the business develops, however, the family may need to consider the possibility of third party investment, particularly if the business is not self-financing and the necessary funds cannot be found from family members, existing shareholders or the company’s bankers. Third party investment may not just be required to fund an expansion of the business but might alternatively be essential, for example, to allow certain family members to exit the business or to allow the family members to realise part of the value of their investment in the company.

There are a number of categories of third party investors prepared to consider investing in private businesses, ranging from business angels (typically entrepreneurs who have sold one or more businesses and are looking to invest some of the proceeds in growing enterprises) or high-net-worth individuals ('HNWIs'), to private equity or venture capital funds (funds established for the purpose of investing in unquoted companies). The growing crowdfunding sector may also prove a viable option where the family  business is adept at marketing itself to the 'crowd' through the relevant online portal.

However, sourcing this next stage funding is not always readily achievable, particularly where the market is less amenable or readily available. The UK has plenty of seed funding available for start-ups, but far fewer options when it comes to scaling up for the next steps. For some commentators business owners are part of the problem too, since their understanding of how funding works is limited. Reports have shown that many small family businesses have been unwilling to embrace further financing, particularly in the wake of the financial crisis. Yet there are two reasons why this reticence may be detrimental to a business once it is properly established.

Firstly, there are plenty of funding options to explore. Beyond the obvious commercial banks, angel investors, venture capital and private equity companies, there are also smaller providers, debt funds, challenger banks and crowdfunding platforms to consider. Secondly, for a business to remain innovative, open additional offices or recruit more staff, it will certainly require funding. As such, skimping on these areas may ultimately dilute the quality of the business itself, and its potential for expansion.

So expansion, potentially into new geographical markets, should be the priority for most family businesses in both the short and the long term. To fund this expansion, family firms may be willing to offer equity, where they can maintain a controlling position and their strategic independence. While equity as well as loan, and even donation based, crowdfunding markets are developing as an alternative source of funding, reports have shown that nearly half of family businesses have raised financing from HNWIs, with the majority of such well-resourced investors being close friends or relatives of the family business owners. Of those that have sourced financing from HNWIs, the overwhelming majority say that this has been a positive experience in comparison to financing from other sources. However, there remain challenges in attracting this type of investment, due to its lack of availability and difficulties finding a partner.

A consequence of outside investment may be that the investor demands one or more seats on the board of directors. This may concern some families, but independent directors can often bring additional skills to the company. Such investors may also demand certain operational consent rights within the company's constitutional documents. As such, third party investment may not always appeal to some family businesses given it will be regarded as a threat to the family’s control of the business and to its ability to steer the future direction of the company. Investment through a venture capital fund, or private equity investor, or even the 'crowd', may also come with certain expectations of an exit within a three to five-year time frame.

However, where the investors are well-matched in providing relevant expertise and experience, as well as much-needed funds, these risks to the family business should be outweighed by the potential benefits. Nevertheless, any such business should conduct its own due diligence into the various funding options available to ensure whichever is chosen is the most appropriate.

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