On Diversification and Family Businesses

Generating and accumulating wealth is a difficult task. It generally requires the right combination of efforts, risks and time. Preserving this wealth is a whole other set of challenges, especially for entrepreneurs who have been focused on successfully growing and managing their businesses for multiple decades.

Oftentimes, people associate the concept of diversification exclusively with managing liquid assets, such as a portfolio of publicly-traded securities. Now, I don’t disagree with that view, portfolio diversification is a powerful – yet accessible – tool for all to use, no matter the size of your portfolio. Managing a balanced, diversified portfolio is an important first step to generate consistent returns by significantly lowering risks.

Unfortunately, many business owners oftentimes fail to consider all of their assets as part of one single portfolio – whether liquid or not, whether easily quantifiable or not. In many cases, entrepreneurs will consider their business as a source of income rather than as yet another class of asset. As such, it is not uncommon to see investors actively trade securities, real estate properties and other investments based on well-defined metrics or expectations of returns; and yet remain shareholders of their original businesses – oftentimes tagged as ‘core’ rightfully so or not – even though these would not meet their investment guidelines.

Starting a business has many similarities to raising a child. There’s a lot efforts put into it. The first years are extremely challenging as you need to protect this new life and do everything for them to survive and grow. Then, as the years go by, you get to see them grow, get stronger, and develop. The challenges, on the other side, also become harder to overcome and your efforts alone are no longer enough to nurture this person that is everyday more complex and more demanding.  Finally, comes a time when the child is ready and able to act with you and no longer needs you, or at least not on a daily basis.

For a child, that stage is basically adulthood, parents may not be ready for it but they do let go. First of all, because it’s the expected outcome of raising a child, and second, because the child will eventually break free by herself anyways.   For a business, it’s trickier, as a company grows, it typically gets more structured, adding over time more personnel and developing appropriate corporate governance – new levels in the hierarchy, boards and committees, strict policies, etc. – to deal with the increased complexity. Founders – or their heirs – generally don’t get to a point where they have to let go the same way parents do and, as such, generally have emotional attachments to their businesses that may impair their thinking when objectively evaluating the quality of their assets and their respective returns.

When the ‘original business’ is no longer a core activity

Hanging onto a business is not necessarily a bad thing, especially if it fills a void in the overall portfolio. It could, however, weaken your overall investment portfolio and create unnecessary risk or concentration if that mature business weight too much in the overall portfolio; does not generate the level of returns that can be expected from other asset classes; and/or has the potential to disappear or significantly decline in the foreseeable future due to changing environment – i.e. product obsolescence, category decline due to change in habits/usage, prospect of more stringent regulations, tougher competition with lower costs, etc.

Over the years, I’ve heard all sorts of rationalizations as to why not selling an underperforming or out-of-focus family business. It generally goes along those lines:
“Why should I sell my company if it has (a) made our family prosperous; (b) allowed us to build additional wealth through art, real estate, securities, etc.; (c) funded our other businesses; (d) been a profit center for so long; etc.?”

These questions are all valid, and the correct answers is always “you shouldn’t” whenever that business remains, today, core to the overall investment strategy.  Nonetheless, many times, that ‘original business’ is nothing more than just the first of many steps that group took to get where they are. In those cases, the current asset base is such that this specific business no longer represents much, the main income sources are now other businesses or other asset classes, and, thus, the operating focus shifts away from these ‘original businesses’ towards those newer, more profitable profit centers.

Learning to let go businesses that are no longer core

I’ve witnessed multiple times family groups reluctant to let go of their cherished ‘original’ business unit –  the one that started it all – and, as a result, seeing year after year its market value and sellability decline. It is still quite common to see family businesses being transferred from one generation to the next not because it’s a performing asset but rather because it is the root of the family’s wealth.  No longer being not high performers, these companies, however, may not receive the attention needed from their owners to stay relevant in their market and can become slowly mammoth, relics of the past, companies with no purpose other than to fulfill an emotional need for their owners.

More often than not, these businesses could return to growth under the right circumstances.  Investing enough time and resources into that businesses is generally the very first step to get there. Depending on the industry and the current state of the company, pivoting the business model to adapt to the changing environment and position for sustainable growth in the upcoming decades is oftentimes another needed step to breathe some life into these ‘original businesses’.

As a general rule, though, a different player is more likely to succeed in revitalizing these companies than their current owners for multiple reason.

For starters, if the business has not been under active consideration in the last few years (or even decade), it’s unlikely things will change in the next few years. A routine has established itself over time and sweeping the dust away under these circumstances oftentimes comes as a result of major overhauls that nostalgic owners have been reluctant to do so far.  It’s a much different story when you’ve acquired a business with the intent to turn it around. That major overhaul is the very first step in the turnaround plan and has already been accounted for in the project plan.

Another reason why original founders and owners often fail to successfully revitalize their ‘original businesses’ – after years of sidestepping them – is a myopia oftentimes caused by the nostalgic view of the business. Many of these companies continue to operate as they did at the prime of their success and have failed to adapt to their changing environment because their owners see them through an emotional filter that prevents them from seeing the issues and pitfalls.    Again, here too, a new owner also brings a new set of eyes and ideas to successfully turnaround the company.

In short, learning to let go a family business that is no longer core is the best for all parties involved. As the original investors, you get to free assets that can be reinvested in a more productive manner, even though for a lower than wished amount.   Unless dismantled, the company itself gains as a result of a sale as its new owners will seek to maximize their investment, and the acquirer scores a good deal, acquiring a company with a long-standing reputation and with strong growth prospects upon successfully turning it around.

The value of always evaluating all assets against the same investment criteria

We’ve covered the ‘worst case scenario’ – hanging onto a family business that is no longer performing or core for emotional or sentimental reasons.  There’s another, more common, case though, the business is still relevant to the overall strategy and is performing, but not as much as it ought to or used to.  That intermediate scenario could lead to the previous example over time but, as of now, is not yet a diversion in and of itself. What to do with this asset is a much more complex decision to make.

Naturally, the first question to ask is “why” – why is that business not performing better? How has it evolved over time and what has changed? Where is/was growth coming from – both in the company and in its market? What can be done to recapture this growth?   Answering these questions should give valuable insights as to what to do next.

The answer, here too, is not necessarily to sell the company. It could be, on the contrary, to buy a competitor to gain access to a technology, product, customer segment, or processes that the company does not yet have. Alternatively, the key to maximizing that company’s returns could be to invest in capital expenditures in order to reduce production costs; divest or discontinue a division that’s draining resources away from others, more profitable; expand to new markets – geographical or new segments – to diversify income streams; open the capital to new investors that can inject valuable knowledge or resources needed to bring the company to the next phase, etc.   In my opinion, the worst decision is opting for the status quo when noticing that a business – or a division – is not performing as expected but still contributing to the overall bottom line.

However, beyond that point, you can only identify that a business no longer is a valuable asset if you actually keep track of its performance and compare it to your expectations of return.  Too often, business owners with overall diversified portfolio have a clean understanding of their business’ P&L and financial situations but fail to evaluate these data points against a broader picture, an overall growth plan if you will.  Failure to do so will result in companies slowly falling behind until it’s too late for their owners to adequately take actions to change their course.

 

Image Credits: pxhere, pxhere, pxhere, pixabay.

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