When Debt Proves to Be Best Answer

Pressure from more than 30 family shareholders to sell Friedman Bag Co., against the wishes of company management, was threatening to destroy the value of the closely held Los Angeles company founded by three brothers in 1927.

The far-flung shareholders, only one of whom worked at the company, wanted to cash out their shares. Management, including two sons of the founders, was desperate to invest the money in equipment needed to bring the company into the 21st century. Company workers were still sewing burlap and mesh bags for the agricultural industry by hand. Printing presses were slow and inefficient. Morale and sales were suffering.

“It was like a tug of war,” said Harvey Friedman, chief executive and son of one of the retired founders. As the debate intensified, rumors that the company was going out of business began to fly.

Friedman Bag didn’t have the money to cover shareholder buyouts and new technology. The shareholders weren’t interested in a note--a written promise to pay them in the future. And sale of the company’s real estate wasn’t an option because of the huge tax bill that would result, Friedman said.

For the first time in more than four decades, the company was forced to consider going outside for financing.

It’s a classic dilemma for a family business. The conflicting demands on company funds of growth or expansion and shareholder buyouts or dissolutions can push the most debt-averse company to seek outside money, particularly if buyout funding isn’t covered by insurance or some other previous arrangement. Perhaps it’s the founder who wants to cash out, or an owner dies and there are estate problems. Or an owner without an heir interested in the business may want to sell the company to the employees through an employee stock ownership plan.

“Growth, liquidity, unexpected dissolutions that can disrupt the business are needs for financing,” said Alfred E. Osbourne, director of the Price Center for Entrepreneurial Studies at UCLA.

*

A business typically has two options when it comes to outside money--taking on debt through a bank loan or selling a stake in the company to an equity investor.

Friedman Bag, like most family businesses, chose debt, unwilling to deal with additional shareholders and their demands. The company polled its industry contacts for potential lenders. After being debt-free for decades, it found itself being wooed by more than 20 banks. Friedman and his managers decided on Imperial Bank in Los Angeles for several reasons. They got a speedy response and a loan package that covered their needs: an equipment line of credit, a term loan to buy out the shareholders and an asset-based line of credit to pay for growth. The bank’s enthusiasm for the company’s prospects sealed the deal.

“When you borrow money, you want to feel like the bank is excited about your new venture and not that they are doing you a big favor,” Friedman said.

All things being equal, he’d just as soon lend to a family business, said Imperial Bank Executive Vice President Duke Chenoweth, who grew up in a family with a business.

“A family will generally put everything they have on the line to uphold the integrity of that family business and the family name,” he said. In addition to a potentially deeper level of commitment than an absentee owner or a group of professional managers, a successful family business often has a built-in successor, important for management continuity, Chenoweth said. And if worse comes to worse, often the retired founder can be relied upon for emergency guidance or deep pockets.

Bank debt isn’t right for every family business, of course. A company has to be able to generate enough cash flow to repay the debt, which naturally limits how much money a company can borrow.

Although it’s not as common for a family business, an outside equity investor can also provide needed cash. The downside is that most equity investors are institutional investors who typically expect a return on their investment within three to five years. That’s not practical for many family businesses.

“It would be a mistake to say private equity has no place in family business, but it would only be under specific circumstances where the family is willing to provide a liquidity event,” said Jourdi de Werd, a managing director and co-founder of investment bankers Greif & Co. of Los Angeles, one of several corporate sponsors of the Family Business Program at USC.

A family that is contemplating a transition to more institutional ownership or a founder that wants to take capital out of the business might turn to an outside equity investor, said de Werd, who also grew up in a family with a business.

Friedman offered several tips for family businesses thinking about outside financing.

He echoed the advice of several bankers when he suggested family businesses limit the number of family members working at the company. Bankers worried about the toll of inflated salaries. Friedman was more concerned about a company’s need for broad skills and the potential impact on the family itself.

“Success is a blend of family members and outsiders,” he said. “If there is too much family, then you have a lot of internal problems that are brought home.”

In addition to good-quality management, what else are bankers looking for? Organized and complete financial statements, according to Henry Walker, senior vice president at Farmers & Merchants Bank in Long Beach. The quality of your record keeping is a reflection of how you manage your business, he said.

Assessing management and financial strength is a two-way street, Walker said. Is the lender you are considering strong enough to weather an economic downturn without jeopardizing your loan?

“It’s a long-term relationship you’re looking for, and you shouldn’t lose track of that because of a point [of interest] here or there,” he said.

*

Planning company strategy before seeking outside money is also important, Friedman said. Friedman Bag invested in an intensive total quality management program and months of planning before it landed its bank loan. When the money arrived, the equipment purchases and a move into a new facility were completed within just three to four months of the shareholder buyout in early January. This week the new eight-color press goes online with triple the capacity of its predecessor and a setup time of 45 minutes compared with the five hours it used to take.

Friedman Bag Co. has come a long way from its modest beginnings collecting, sorting and reselling burlap bags used on farms in the 1920s. Today it employs more than 250 people and has operations in Idaho, Washington and Oregon. It supplies packaging and equipment to the agricultural industry and sandbags to the U.S. military, among others.

Employee morale has soared along with the company’s new prospects. The third generation, including Friedman’s son, a company vice president, has a future to look forward to, according to Friedman.

“We are a totally different company today,” he said. “A new Friedman Bag Co. was born on Jan. 5, 1999.”

Does your family-owned business have an innovative solution to a family business issue? Tell us about it. Write to Family Business, Los Angeles Times, Business News, Times Mirror Square, Los Angeles, CA 90053. Or send e-mail to cyndia.zwahlen@latimes.com.