Any business owner who has children will usually consider transferring the business to one or more of those children as an eventual exit option. (I will use the expression “child” or “children” even though the offspring may be fully adult). This article will look at the issue of intergenerational transfer from the perspectives of timing and competence, then examine the issue of what can be done to improve the likelihood of success. Finally, I will talk about some of the common financial implications of intergenerational transfers.

Timing issues

When my 16-year-old son (my only child) expressed enthusiasm about taking over my corporate finance business, I said to him: “Ok, let’s see how this would work out as far as timing. You have four more years of high school, followed by about six years of university (undergraduate and MBA), followed by eight-ten years of work experience. That means you could be ready to take over the business in about 20 years time. A lot of uncertainty there! Will you still want to take over the business in 20 years? Will I remain healthy enough to run the business for the next 20 years? In my case, an intergenerational transfer would be a very long-term strategy indeed. And a somewhat risky strategy as well: unless there was some back-up plan, the likelihood of my being in good enough health to manage a grueling business into my seventies is certainly not 100 percent.

You should therefore think through the timing issues very carefully.

Issues of competence

Would you want to transfer both the ownership and the management of your company to your offspring? If you have professional management in place, the transfer of ownership may be easier (although overseeing or eventually replacing management is fraught with difficulty as well).

In most cases, owners transfer both ownership and management to their offspring. Parents often do not realize that skills that they have accumulated over many years, sometimes decades, are not that easy to transfer to children within just a few short years.

Have you made a full and honest inventory of the competencies required in the CEO position, or whatever leadership position you wish your child to assume? Sometimes the competencies required can be quite daunting, ranging from professional qualifications to people management skills, and from excellent salesmanship to business development skills within the industry. A proven track record is always better than theoretical competencies.

Improve the likelihood of success

A psychologist that my firm has worked with very closely in the past specializes in the area of intergenerational transfers. While he cannot predict the probability that a child will succeed in following in a parent’s footsteps, he can predict, with close to 100 percent accuracy, when a child is likely to not be successful. This can be invaluable information. Why set your child up for failure? (Not to mention the financial implications, if you are expecting payments over time from your child for transferring the business).

You might also consider rotating your child through several positions within the firm before they take on leadership or ownership of the firm. Have him or her learn the business from the bottom up—marketing and sales, production, finance, etc. This will allow your child to move up the learning curve; it may then be less of a leap to the CEO/owner function. It will also allow you to gauge whether your child is capable of taking the leap, and which staff would relate well to your child. Be careful: employing children usually creates some tricky dynamics with staff, especially if the child is promoted very rapidly. You may also consider making your child CEO and minority owner, while you remain chairman and majority owner. A gradual transition allows corrective action, if required.

Taking over a business from a successful (and often domineering) parent is an intensely personal affair, and not an easy task. Family politics or intergenerational issues may also create enormous difficulties. A successful transfer requires as much effort from the parent as from the child (and sometimes restraint!)

Financial implications

An intergenerational transfer is typically driven by the fact that one or more members of the family feel strongly that the business should remain within the family. This objective often has drawbacks from a financial perspective:

1. Intergenerational transfers seldom result in the type of valuation that might be expected from a fully competitive sale process. Hence, if the owner is looking to maximize proceeds from such a transaction, he or she is likely to be disappointed.

2. Because children seldom have the liquidity necessary to purchase your business, transactions are often structured in such a way that compensation to the owner is deferred, either by way of a promissory note or an “earn-out” type transaction. In either case, if the next generation of owners drives the business into the ground or does not meet expectations, satisfying the payment obligations or expectations could be a major issue.

    

Conclusions

There is only a small subset of businesses where intergenerational transfer is the most appropriate exit mechanism for owners. If you decide that you would like to investigate intergenerational transfers more closely, tax and estate planning should also be part of your strategy.

Several months ago I wrote about the subject of assembling a data room; this present article deals with the subject of operating a data room once it is assembled and will discuss: (a) data room rules; (b) answering questions posed during the data room process; and (c) the importance of the data room in subsequent negotiations.

While traditionally data rooms involved physical documents, a modern trend is to have all or part of the data room in virtual (electronic) format. Virtual data rooms will be the subject of a future article.

    (a)    Data Room Rules

Every well-run data room should have a written set of rules governing its operation, addressing issues such as:

Who may attend the data room, the registration procedure, and the hours of opening
The time period available for each investor in the data room (this is usually a finite period of several days, which are specified)

• Which documents may be copied or not copied or accessed through the virtual (electronic) data room
• Which member of the company and/or its financial advisor will be present in the data room at all times when an investor or its advisors are in the data room
• The terms of the prohibition of scanning equipment, cameras, etc.
• Rules are usually established for destroying any data gathered in the data room at a subsequent date, if the bidder does not invest in the company
• The rules for asking questions or requesting additional documents or information.  (Typically, where there are multiple bidders participating in the data room, the rules will specify that where one party asks any question, both the question and its answer will be circulated to all bidders)
• Breach of data room rules may terminate a bidder’s participation in a transaction.

The registration procedure should generally involve each person entering the data room signing a copy of the data room rules.


    (b)    Answering Questions Posed During the Data Room Process

There is usually a form provided for questions, or additional document requests.  For the company organizing the data room and its advisors, providing answers to the questions can be one of the toughest aspects of the data room process, as there may be dozens or hundreds of questions, which must all be answered comprehensively in the course of a matter of days. The company and its advisors should be very familiar with the company’s affairs so that they are prepared to answer questions promptly and fully.

Answers to questions should be vetted and approved by the management, company owners, and relevant advisors, and it is generally good practice to have all answers also reviewed by both legal counsel and financial advisors


    (c)    The Importance of the Data Room in Subsequent Negotiations

Where investors do not receive the breadth, depth or quality of information expected from the data room, they have a number of responses:

• They may withdraw altogether from the bidding process
• They may reduce the value they are prepared to pay for the company
• They may augment the representations and warranties that they expect from the sellers or from the company

In fact, there may also be a combination of the second and third responses. None of the options are particularly good, which is why it generally pays to provide full disclosure during the data room process.

In booming markets, or for an extremely attractive company, investors during a competitive process are often willing to be less rigorous in their data room requirements; my experience is that in times of recession, or where the company is less attractive, investors are usually more demanding, and require fuller data room disclosure.


In conclusion, operating an excellent data room is a prerequisite for a successful transaction. It is usually the most intensive part of the transaction, as it requires the full-time presence of the company and its advisors in the data room, not to mention the extensive effort involved in answering questions. Often there are concurrent processes going on, such as site visits by investors and management presentations to investors.

Many company owners simply do not realize the importance of the data room. One of my transactions once stalled for four months as my client refused to put together a data room, saying that if the investor requests information, he would be prepared to provide the information on an ad hoc basis.  

It is much better to anticipate the information that will be needed and provide it to the investors in a data room. Not only will that enhance the credibility of the process, and the investors’ assessment of management – it will often help reduce the enormous amount of work that the question and answer process involves.

Many investors often think that acquisition is the best or fastest way to achieve a strategic objective such as entering a particular market or acquiring a certain technology. An alliance, however, may be at least as good an option in certain circumstances (such as where a company lacks a budget for acquisitions). Alliances are very common: there are many tens of thousands of them negotiated every year, most of them across borders.

Types of alliances

An alliance may be defined as a association among two or more parties which involves a sharing of resources and coordination among parties to achieve common objectives.

The three main types of alliance are contractual, cross-ownership or setting up a special purpose vehicle (SPV).

A contractual alliance is generally a pure commercial agreement that sets out the objectives, the resources contributed by each partner, the division of the spoils, as well as in many cases the puts and calls, the representations and warranties, etc.

Cross-ownership may involve one party taking an ownership interest in the other, or parties taking an ownership interest in each other. The relationship may be cemented through representation on the board, or the contribution of capital. Most alliances do not require cross-ownership.

Setting up an SPV (a company, a limited partnership, etc.) may be a good way to structure an alliance. A board of directors provides a direct way of making decisions concerning the alliance. A shareholders’ agreement may be used to regulate the corporate governance of the SPV. The parties should also regulate who contributes what resources to the SPV, and how the spoils are distributed.

The rationale for an alliance

Alliances have several advantages over acquisitions:

• They are much faster to negotiate and implement than acquisitions. They typically do not require due diligence of the acquired firm (although considerable research on the strategic or commercial opportunities available at hand is usually necessary).
• There is much less risk that the management of the alliance partner will depart (which often happens with acquisitions). This generally means that there is a more committed team in place.
• There is no need for the huge investment that typically accompanies an acquisition. If, for example, two alliance partners join forces to develop a certain product, technology, or geographic region, each alliance partner contributes the human, financial, or other resources necessary to achieve the joint objective.

Elements of a successful alliance include the complementarity, compatibility and commitment of the alliance partners.

Drawbacks of an alliance

Alliances are not appropriate in all circumstances, however. They have a number of important drawbacks, which include:

• CEOs often like having resources under their direct command – but alliance partners do not respond well to commands. They expect to be treated like partners. Hence, achieving strategic objectives requires constant communication and effort put in to maintain the relationship.
• There is always a risk that the alliance partner will not hold their side of the bargain, which may jeopardize the efforts and investments of the partner that does hold their side of the bargain. (This risk may generally be mitigated by good project management, for example using benchmarks for what objectives are to be achieved by certain dates, as well as including representations and warranties in the alliance agreement).
• One of the most surprising tendencies of alliances is for them to unravel once they have been successful. While alliance partners may work together for many years to achieve their joint objectives, once these objectives have been achieved, and the venture has been declared a success, the partners have a tendency to go in different directions. One may wish to sell, the other may wish to expand the scope of the venture (such as expand into additional countries or related ventures). As a result, it is advisable to have good conflict-resolution mechanisms built into the alliance agreement (such as mediation).

Most authorities on the subject estimate that only 40 to 50 per cent of alliances achieve their objectives in the long run.

Conclusions

Alliances are often not considered or given sufficient weight as a viable option for achieving corporate objectives. While they are not appropriate in all circumstances, they are generally one of several viable options. Despite the relatively low track record of success for alliances, companies are facing increasing pressure to enter into them as a means of bolstering competitiveness. Proceed carefully!

My last article discussed how strategic investors typically choose acquisition targets; this article does the same for private equity investors.

Private equity investors typically have a charter which sets out well-defined parameters for investments to be made by the fund, including:

• Nature of investments. Some funds like high-growth companies, others prefer investments with stable cash flow or dividends. Still others prefer turn-around situations.
• Geographic scope. Many Central European funds restrict themselves to EU member states, the bolder ones will venture in to former Yugoslavia or Turkey;
• Preferred sectors. Some funds are generalist funds that will look at just about any sector, others focus on one particular sector, such as transportation, infrastructure, telecommunications, etc.
• Investment size. Most funds will specify a minimum or maximum investment size (e.g. €5-25 million).
• Ownership interest. Some funds insist on control, others will take minority interests.
• Fresh equity. Many financial investors are not willing to buy out shareholders, they only want to inject fresh equity into a company (e.g. to fund growth). Others will consider a combination of fresh equity and buying out existing shareholders. Buyout funds will want to buy 100% of a company.

It is therefore important to find a good match between a private equity fund and a company. It is likely a waste of time to enter into discussions with a fund if the applicant company does not fit the fund’s criteria; investing in such a company would put fund management into breach vis-a-vis its own investors. Business owners should therefore do a little homework before approaching funds – the investment criteria are usually on the fund’s website.

The average private equity fund in Central Europe will typically screen a few hundred investment cases every year. Not more than a few will actually become the object of an investment. The vast majority of private equity funds typically have an investment committee that makes all the investment decisions, and a local person (who may or may not be a member of the investment committee), who basically becomes the protagonist of the investment to be made in a particular company, at the level of the committee. Hence the owner of a business must first convince the protagonist of his investment case. The owner of a business seldom, if ever, communicates directly with other members of the investment committee. Hence the written information prepared by the company, most notably the Information Memorandum prepared by the company, particularly its Executive Summary, may become an important indirect communication tool with the investment committee.

A financial investor will usually subject a company to an initial due diligence, using its own internal staff, before obtaining a green light from the investment committee to proceed with a full due diligence of the firm, using external advisors (at a minimum lawyers, possibly financial advisors, auditors, tax advisors, technical experts, etc.)

So what does a private equity firm look for in its investment choices:

 

• A solid business opportunity that reflects its acquisition criteria (e.g. growth, size, geographic parameters, etc.);
• Exit strategy – who are the likely buyers for the company? What are the chances for a successful exit?
• A strong management team, who is prepared to stay until the exit of the fund. (An owner-manager who is cashing out is often too high a risk for the private equity investor – please see my earlier article on the “One Man Show,” available here and here.
  
• Strong corporate governance – good decision structures, reporting systems, and strong documentation. Private equity investors seek management teams that are highly motivated, are prepared to agree to ambitious goals, and are prepared to work extraordinarily hard to achieve significant financial gains. Conversely, if results are not forthcoming, managers that own shares may find their ownership diluted.
• Manageable risks. No actual, pending or potential litigation, or the potential for surprises on the downside;

After the due diligence, the investment committee (or at least certain members) will usually review the due diligence report of lawyers and other advisors, and the proposed Sale and Purchase agreement.

Sometimes private equity firms will purchase what they call “bolt on” investments. Bolt on investments are do not typically need to satisfy all of the investment criteria (e.g. they may be smaller than usual, or management of a bolt-on investment may choose to exit), as the acquired bolt-on company would be purchased to create synergies with one of their existing portfolio companies.

Private equity firms have taken an ever-larger share of the M&A market in Central Europe. They are an important potential source of financing for mid-sized firms that must not be neglected.

A strategic investor uses a very different process to identify acquisition targets than that used by financial investors (the subject of my next column). For a strategic investor, as the name implies, identifying an acquisition target must flow from the acquiring company’s strategy.

The worst methodology that a strategic investor might use to identify targets is to respond to the acquisition opportunities that it finds on an ad hoc basis. This simply will not work for two major reasons:

• First, responding to opportunities on an ad hoc basis typically means that deep strategic thinking has been short-circuited.
• Second, if a strategic investor acquires a company that it came across merely on an ad hoc basis, how does it know that there were not better acquisition opportunities elsewhere in the marketplace?

It follows from the above thinking that a strategic investor, before embarking on an acquisition, should have a clear definition of its overall corporate strategy, and from such a corporate strategy should flow its acquisition strategy. (Of course it is ideal to have these in writing: there is nothing that focuses the mind as much as putting something in writing, an approach which also helps to ensure that the different parts of the organization are also in consensus).

Some of the elements of an acquisition strategy might include definitions of the following:

• The rationale for the acquisition (e.g. vertical or horizontal integration, expanding into newer high-growth markets, acquiring technology or know-how, etc.)
• The precise profile of the target companies sought
• The geographic range of possibilities
• The financial criteria (revenues, profitability, etc.)
• The type of management or skills which may be required
• The type of clientele which the target company should have
• The valuation range in which such acquisitions may make sense

A company may choose to create a strategy broader than an acquisition strategy, namely an M&A strategy. Such an approach would also cover the criteria which a company would set for divestiture of its subsidiaries.

Once the strategy has been defined, the acquiring company should engage in a systematic search for and assessment of all those companies that fulfill the criteria (as opposed to an ad hoc approach). If there are a very large number of candidates, the list might be shortened by selecting only the most attractive ones. The most attractive ones might then be approached to ascertain whether they are willing to talk about a strategic partnership or acquisition, and with an eye to further fact-finding about the company. It is often useful to use an independent third party intermediary for this approach, as it allows the approach to be anonymous, keeping the name of the acquiring party out of the market.

Failure to apply the above approach may result in a bidder finding itself among a herd of bidders in a frothy, overpriced market, competing for a target company that might not even be the best strategic fit.

Some of the more astute strategic investors have been monitoring their potential acquisition targets for many years, sometimes even decades, and are ready to make a move on short notice if the owner of a target company becomes willing to sell or if price expectations are reduced. However, it is usually only a small percentage of potential target companies that a strategic investor is willing to acquire – the majority of potential targets quite often simply do not make the grade.

Central Europe is often an attractive area for acquisitions for global investors because most investors believe that Central Europe is on a convergence path with Western Europe, meaning that GDP per capita, incomes, consumption, etc, will catch up to Western European levels. This is based on the belief that, “A rising tide raises all ships.”

Nevertheless, different countries move at different speeds at different points in time, depending on their political and socio-economic environments, and some companies are better acquisition candidates than others. The importance of country and industry-specific knowledge at the local level cannot be over-emphasized.