The owners’ capital in a family business only looks like it doesn’t cost anything.
That can be a tough case to make with owners, who know there’s no obligation to pay themselves anything while they can sure see the cash interest they pay to the bank in the monthly financial statements. And they know the bank expects another payment next month.
The cost of equity is what the financial pros call “unobservable,” with no rates to look up in the Wall Street Journal. That likely explains why many owners don’t realize that the cost of equity could easily be three times the 5 percent or so cost of a bank loan.
Business owners who really grasp this can avoid a common mistake, of being such a mossback that they never borrow any money and end up with the most costly capital structure possible.
That kind of thinking was put on display last week in a courtroom in Minneapolis, as the owners of the basically debt-free Lunds & Byerlys grocery retailing business battle over its value.
The longtime minority owner and CEO Russell “Tres” Lund III hasn’t wanted to borrow money to buy out his sister or even fund growth, perhaps in part because he hasn’t had to. He’s enjoyed the luxury of having a lot of equity capital from his siblings, who appear to have not much to say about it.
This level of control may have artificially kept down the cost of the equity. That is, until the district court has gotten involved.
Perhaps for a lot of business owners there’s no point in discussing the right kind of capital, as they finance their companies with whatever they can get. Loans from a bank that the owners have to personally guarantee, a common practice in small business, have a level of risk that makes debt look a lot like equity anyway.
As companies grow in size and sophistication, however, the owners start having choices. To figure out how much the equity costs they have to look at the business with the eyes of any investor who doesn’t happen to be their sister. What kind of annual return would it take for an investor to accept the risk of ownership and then keep that money in the business?
For the stockholders, they get a share of profits and can see their investment grow in value if the company does well. That’s obviously a richer deal than a bank gets, because if the business doubles in size thanks to a bank loan, the banker generally only gets back the amount of the loan plus interest.
The owners take a lot more risk, though. If the business can’t quite keep the lights on and shuts down, the lenders can claim assets first, maybe leaving owners nothing. That’s a risk no one would take without a good reason to expect a double-digit rate of return. Even the stock pickers at mutual funds wouldn’t consider making an investment on a stock that trades on Nasdaq unless they expected maybe a 12 percent annual return.
For a privately held company that offers investors no quick way to sell, the equity returns have to be even higher. That’s the cost, and that explains why private equity investors put in only the capital that’s required to close a deal and not a nickel more. They start working on getting their capital back out the morning after the closing.
Family business owners don’t need to act like partners in equity funds, but if nothing else they at least should end up with an agreement that allows them some way to sell.
That kind of arrangement appeared to have been missing from the ownership stake of Kim Lund, a 25 percent owner through the usual sort of family trusts in the Lunds & Byerlys business, which is actually made up of three companies. She’s in court because she had become frustrated by a lack of progress on a buyout in discussions that have gone back many years.
It’s worth pointing out that owning a quarter of a highly successful grocery operation skillfully managed by a sibling is a very nice problem to have. Yet it’s not clear from the available information that the business distributes much of the cash flow to shareholders beyond what’s required to pay income taxes.
The Lunds & Byerlys business has had plenty of opportunity to use debt to acquire her stake. The easiest thing to have done would have been making Kim Lund the bank, paying for her stock over the course of years. This loan could probably be subordinated, too, meaning it would fall in line for claims on the assets behind any bank debt.
The next best option would have been borrowing the money from a financial institution. Given the financial information that’s come public so far, Lunds & Byerlys has plenty of capacity to take on debt. The business is planning on sales this year of more than $650 million and cash earnings of more than $30 million, although some of that will go into capital improvements.
There would be so many bankers crowding around Lunds & Byerlys, an investment banker said last week, that it would look a little like Saturday afternoon at the deli counter at one of the stores, as bankers pull a number and wait their turn to pitch for the deal.
Tres Lund has talked in court about how conservatively the business has been run, with no long-term debt and no appetite for any. That may have to soon change. For one thing, the company has a sizable unfunded pension liability.
It’s also already been decided that Kim Lund will be bought out, as the argument last week was only about the value. There’s a chasm between the two sides, with Kim Lund’s expert arriving at a fair value of $80.4 million.
If the court lands anywhere close to that number, coming up with that much money to pay a former owner will remind the remaining owners of just how expensive equity can be.