Building and Unlocking Value in Private Mid-Size Family Businesses

Read Time:15 Minute

Let me begin with some interesting facts about family businesses. India is home to the No.1 best performing family-owned business in Asia Pacific, excluding Japan. Any guess on the company? It is Bajaj Finance. The reason is that they have consistently rewarded shareholders over the last 10 years with approximately 54% return. This is based on a Credit Suisse survey conducted a couple of years ago on a thousand family-owned businesses.
The Strength of Family Businesses
Apart from Bajaj, there are a number of Indian companies in the best-performing list in Asia-pacific: TVS Motor ranked at No 6, Eicher, Britannia, Page Industries (a licensee of Jockey brand), MRF, Havells and Ashok Leyland. Most of these companies have created value for shareholders.
One more interesting fact is that family businesses generate higher returns than non-family businesses. While non-family businesses have given over a period of ten years only 6% return to the shareholders, family businesses have given 14% returns. The alpha is 8% between the two of them.
This is due to a combination of factors. Family businesses focus on long-term investments and they are there for the long haul. They finance the entire growth through organic cash flows and follow very conservative funding structures. There is a strong focus on quality growth and increasing reliability on the use of long-term incentive plan for management.
Focus on R&D and Capex
Globally, family businesses spend a higher percentage of revenue in R&D costs. In USA, family businesses spend 7.5% of the revenue in R&D whereas non-family businesses spend around 5%. In Asia-Pacific excluding Japan, R&D spend is close to 2% for family businesses compared to 1.75% for non-family businesses. The important differentiating factor is the long-term commitment and investment in Capex. Gross capital formation in family businesses is growing at the rate of 14% year-on-year compared to a much lower percentage in non-family businesses.
Many Indian companies feature in the Top 500 most profitable family-owned companies. Emami is the number one in this list; Bajaj, Godrej, Marico, Hero and all the good names of our country are reflected in the Top 50 most profitable companies. Importantly, profitability is measured in the most appropriate manner—that is, cash flow return on investment (CFROI). This is a new proprietary metric used by Credit Suisse to know how much cash flow these companies make as a percentage of investment. It is about 50% for Emami, which is a very healthy return on capital employed.
There are enormous strengths in family businesses in India. But the reality is that only 16 businesses out of 100 make it to the fourth generation, which is a sad reflection of how we manage the generational handing over of the business and creation of long-term value. A lot of companies get stuck midway and into family squabbles.
The Questions They Pose
I will highlight my experiences with family businesses, having worked for Ernst & Young for 20 years and managed my own business for 10 years. I have interviewed many family owners. They ask, “Why should I care about shareholder value? I am doing a business in the best possible manner and I’m going to hand it over to my next generation. So I’m not interested in unlocking any value. I only look at operational metrics.”
The second question they ask is, “Even if I unlock value, what am I going to do with that money? I have sweated it out and built this business. Why should I sell it? I don’t want to get stuck with private equity mindset. It will completely kill my freedom to take vacations.”
A lot of generational related questions come up. The elder generation feel that if they leave large money in the hands of next generation or other members of the family, they will get spoiled. Therefore they don’t declare dividends. They don’t pay salaries at market value and make sure their children imbibe the frugal culture and carry on the business.
When the conflict between family members comes to the fore, they seek the help of consultants and explain their pain points such as a member taking reckless positions in forward cover, leaving huge imports uncovered and resorting to speculation. The marketing guys tell me, “Why and what should I focus on—volume or margin? Cash collection or capacity utilization? I am totally confused.”
Value: The Pandora’s Box?
The elder generation think it is taboo to talk about value and that it will open up the Pandora’s Box. They worry there will be family squabbles on how to share that value. So they avoid talking about any value unless a major business crisis or a family dispute strikes them.
Now, though they start thinking on value, they are confused as to what value is. They think it is good will. They are not sure about how valuation is done. They also don’t know if they have created value at all.
If they have created value, how should they preserve it for the next generation and unlock it? They feel unlocking value means selling out the business. As the entire family is dependent on the business for survival, they question the wisdom of unlocking value. All these are genuine worries, doubts and dilemmas faced by the families. My objective is to address some of these genuine doubts.
Three Case Studies
Creating value is not a taboo and the firm will be in a better position if it has created value and can share it at the appropriate time. To drive home this point, I will share three recent case studies so people can understand what value creation means. The three cases are based on:
• Dr. Cyrus Poonawalla of Serum Institute
• Jio Platforms Limited, and
Serum Institute
Dr. Cyrus Poonawalla started his business in 1966. He owned a horse stable and tried to extract some vaccine from horses. Subsequently he entered into import substitution as a business. In the 1970s, India was importing a large amount of life-saving drugs at a very high cost. So he started his business model using import substitution.
After that, he invested in several acquisitions of technologies. He became one of the leading manufacturers of life-saving children’s vaccines and created a market share of 65% for Serum Institute globally, in the area of children’s vaccine. He then acquired a Dutch company in 2012 at a valuation of about Rs.2,500 crores. That was a visionary investment he made for injectable polio vaccines. The injectable technology today helps him in the Covid situation.
Dr Poonawalla also followed the affordable vaccine strategy. Today, he is able to produce vaccines at world-class prices to the entire world. Thus he has become socially relevant, at the same time creating wealth. He recently invested 250 million dollars of his own funds and because of his long-term commitment and social mindset, he was able to attract Gates Foundation and the Gavi Alliance to fund 150 million dollars for producing the Covid vaccines.
The value he has created has enabled him to secure funds at the right time and he is now positioned to become the largest vaccine manufacturer in the world. His vision is to reach a goal of 1 lakh crores revenue in FY22. This vision was created much before the Covid situation. It is easy for him to reach this milestone as already his turnover is about 60,000 crores.
Jio Platforms Ltd
Jio Platforms which was started only around 2017 has managed to create 400 million customers in a matter of three years. More importantly, they were able to position their business as enabling a digital society. What it means is to digitize services to customers, to help them shop online and pay online.
This is nothing new. But Jio Platforms have differentiated themselves by bringing the kirana stores of every city to the digital world. This is seen as a game changer by companies like Facebook and WhatsApp. Thanks to Jio, 400 million customers are suddenly hooked onto Kirana stores. They invested close to 10% but have got a huge valuation of 44,000 crores. This is the innovative platform they have created.
Normally Jio would have been viewed as a telecom platform and would have got a valuation similar to Airtel, which has much superior presence in the market and offers higher quality of service. However, because of their unique positioning as a digital society, Jio has created a valuation twice that of normal telecom businesses. They raised about 1.34 lakh crores in the last six months during the Covid period by diluting 33% stake. This translates into a valuation of 5 lakh crores.
Hindustan Unilever, which is there for decades, has a valuation of 5 lakh crores. HDFC bank, the number one private sector Bank in India is valued at 5.5 lakh crores. Tata Consultancy Services, the largest technology company in India is valued at 7.5 lakh crores. Astonishingly, 50% of the valuation of Reliance Industries, which is into oil and gas, comes from Reliance Jio.
Jio Platforms is valued at 75 billion dollar, much higher than Airtel, on the basis of EV/EBIDTA. Fortunately, they make an annualized profit of over 10,000 crores today compared to other companies, which make a loss of 30,000 crores.
If we use the base of 10000 crores, Jio’s valuation is at par with Alibaba, Alphabet and Amazon. This is the story of a company which has repositioned itself to tap the revenue sources from the same platform and same customer. The digital network is going to create revenue not only from telecom services, but also media and entertainment segments and also from local Kirana stores.
Thus, platform building is the asset which they have created and they are really leveraging it and restructuring the entire business so that they can create more and more value.
CRED is a startup of Kunal Shah, a serial entrepreneur and founder of Freecharge. He has launched his new venture in the financial tech platform. He acquired three million premium credit card customers with a credit rating of 750 plus in the last two years. He is using them as a central hook for giving them various types of financial services like credit card bill payments, helping them shop online and pay online and is enabling professionals who are very busy, to pay all their utility bills including rent. He is going on a subscription model.
Venture capitalists and Private Equity funds see great value in the three million customer base, which is growing, and they have put nearly 105 million dollars into that company. Their first round of funding was 25 million dollars. Recently, they have raised 80 million dollars at a valuation of 800 million dollars. They are close to becoming a unicorn—1 billion dollars valuation in the last two years. Again, it is a platform play where you can generate multiple sources of revenue using the same platform. This is a strategic asset they have created.
Learning from the Three Cases
Now, what is the commonality in and learning from these cases?
Trading is an operational mindset and many companies believe in operational excellence. It is important in creating a base value. But if you migrate to the next level of value creation, then your creation of value is multiple times than the normal valuation.
What are the valuation drivers? Conventional base value creators: use your capacity to the full; create a dominant market share; have reasonably high margin and a world-class differentiation in terms of either costs or product differentiation. Many companies do these well, but don’t get a decent valuation. What they get is free cash flows.
Companies like Bajaj throw up a lot of free cash flows to the capital employed. One of the conventional value creators is free cash flows. Approximately 10 times the current free cash flow is a valuation of the company. We have ourselves advised many clients in the old economy to look at free cash flows as one of the models for creating value.
Building Strategic Assets
However, new-age strategic value creators like the three cases which we saw create value even ahead of creating cash flows. They create tech platforms; they invest in brands and channels. So the key for creating value is not only free cash flows, which is very important. But at the same time you need to have some unique intellectual properties.
In addition to that, best practices in terms of governance are also going to create a lot of value. For instance in 1979 when Pond’s went public, one decision they took was that the majority of the board will have independent, external directors and the world’s best audit firm as the auditor. These decisions drove value.
I took a company to London for listing in AIM (a sub-market of London Stock Exchange). Apart from the vision of the company, the key thing which clicked was that we had on board the company one of the reputed global auditors. The investors were convinced that the entire presentation was transparent and can be backed by audited numbers.
Capital-related decisions, if they are taken in a very objective manner, can also be a key driver. Many companies, especially the industrial conglomerates like TVS practice related party transactions (RPT) at totally arm’s length basis. Professionalisation of managing is another key success factor.
If you are going to embark on a 500 million dollar project, you must do a proper market survey and feasibility study. Otherwise the decision making may go wrong. We have seen several cases of investments being made based on a single hook like raw material availability, coupled with gearing up the entire investment through 2:1 debt equity ratio. This is a recipe for disaster.
One more major mistake we make is not taking timely decision to divorce loss-making businesses sucking cash. We need to completely leave our emotional baggage and take decisions at the right time.
Governance of both the family entity and business entity is important. Family constitution must clearly address family employment policies where merit, rather than the birth right of being a family member, must be given importance. Family shareholding policies must address how each shareholder will be dealt with, in case of any dispute and how a family member who wants to exit will be treated and settled. Family Institutions must include family assembly, family councils that meet on a regular basis and evaluate the performance and family committees.

I am part of a family business that saw transformation from the third generation to the fourth generation. I am very fortunate that the business that my forefathers founded continues to exist but the family members will not be part of it and that is the difference. The business is not disintegrating, as our family members allowed it to continue to flourish. The critical factors that led us to create value and exit our family business are:
1) Personal value creation mechanism
2) Succession planning road map
3) Lack of communication between the shareholders
4) Exit options available for the shareholders
5) Identifying the right time to differentiate between ownership and management
6) Seeking professional help in addressing and overcoming challenges
I saw family members around me who believed subconsciously that nobody could manage the business better than them. This was the scariest part. I took it as a mission upon myself to do something about it and accomplish it in my father’s lifetime. I knew the path was going to be risky and it could backfire.
As some wise men have said, risk is not about rushing into some uncertain situations; it is about pushing the envelope when others want to take a safe route and caring more about potential rewards than possible losses.
We communicated with a lot of clarity and courtesy and stayed calm and collected. While this happened, trust, compassion, empathy and patience were tested to the fullest. Exits are not about giving up; they are about seizing opportunities. When it comes to exits, do what is good for you and the business. Your family will thank you. A timely exit can be the best business decision, and, in the same way, poorly timed exits can be the worst. You only have to do a few things right in your life as long as you don’t make too many things wrong.

Why to Unlock?
• To minimise external debt. With IBC in place, creditors will take control of business if there are mounting debts and defaults.
• To change focus area or to reallocate portfolio.
• To get liquidity for personal aspirations of family members.
• To invest in other growth areas like what Dr Cyrus Poonawalla did.
• To provide exit to a segment of the family.
• Due to lack of a successor
• For the owner(s) to retire.
• Driven by family feuds.
When Should You Unlock?
• One can’t time the market. Jio Platforms could unlock value even during pandemic.
• There needs to be planning and it depends on what one wants to exit from and how.
• The family must be aligned and there must be consensus on the need for unlocking.
• If they want to exit a part of the business, they need to wait till the right partner is identified.
How to Unlock?
• The entire ownership can be transferred in one go like it happened between Sunrise Foods and ITC, or in phases.
• Part of the ownership or part of the business can be unlocked.
• Even some assets can be unlocked.

• Different routes are available like IPO (Initial Public Offering) / REIT (Real Estate Investment Trust) and INVIT (Infrastructure Investments Trust).
There are many challenges in unlocking. If part of the value is unlocked to a PE player and a family dispute arises later on, how can the situation be addressed? Will the PE buy out the entire stake? Family members who are used to complete freedom will find it difficult to co-exist with PE players.
In Jan 2019, Mukesh Ambani declared that data is the new oil. It is interesting that he used the revenue from their oil business to build Jio Platforms. There are many similarities between the two. In fact Jio looks the mirror image of OiL.
To sum up, the takeaways for the family businesses are:
• Focus on building key strategic assets
• Implement governance practices which are professional in nature.
• Adopt a robust family constitution and governance structures which include merit based employment and succession policies
• Adopt a business-first approach
• Have clear shareholder agreements
• Have an open mind for partial or full unlocking of value created
• Leave emotional baggage and take decisions at the right time.