Why family businesses score better than new-age start-ups?

As new-age tech companies struggle, family-run businesses with long-term goals and values may outperform in the long run.

A recent article said that 2,400 new-age tech cos wound up business in 2022; in 2021, it was 1012, less than half that number (Mint, December 29, 2022). Apart from a considerable loss of capital, there were employee layoffs too, affecting morale.

Overall, the sentiment in start-ups ended on a sombre note in 2022. Old fashioned business values and traditional metrics of operating efficiency such as free cash flow, unit economics, cost cutting, business model are now bandied about as profound words of wisdom by investors and founders alike.

Yet, the spectacle of absurd valuations for initial public offerings (IPOs) of new age start-ups continues in some pockets. The upcoming Mamaearth IPO is a case in point. Its price-earnings ratio that reflects how the business is valued by investors, is several times higher than even established companies in personal hygiene and skin care products such as Procter & Gamble, Godrej, Unilever and Marico. Mamaearth’s profit last year was a mere Rs 14 crores, while it is seeking an IPO valuation of Rs 24,000 crores (USD 3 billion).

This raises the following questions. Are these two sets of companies operating in alternate universes? Why does the new age start-up get higher valuations than well-known brands that have been around for a while? Is there some financial engineering or is it akin to Ponzi schemes? The incessant flow of money in the last couple of years into start-ups and investors making a beeline for these new companies pushed up valuations that backed growth targets made on paper.

Reality is slowly but surely hitting the start-up ecosystem hard. The going is getting tough and many are swimming in turbulent waters. In the SaaS industry for example, valuations have gone back to pre-COVID levels or even lower. Fundamental financial metrics (gross margins, customer lifetime value vs acquisition cost, cash burn and runway etc) are getting the hard look they deserve. Companies now need to work their way to justify the valuations than expect significant multiples of forward ARR (annual run rate). The prognosis: companies that have been judicious will likely survive!

The inevitable comparison with traditional businesses makes it appear that new age start-ups don’t come off well. According to Professor Peter Vogel, Director, Global Family Business Center at the IMD Business School, “Family-run businesses, on an average, are more future-oriented with long-term strategic goals, and more profitable in the long run even as they outperform non-family businesses”. He pointed to their “long-term thinking, financial prudence and deep-rooted values and loyalty.”

The ‘Credit Suisse Family 1000: Post the Pandemic’ report of August 2020 also showed family businesses in good light. “There was outperformance of family-owned businesses to non-family-owned peers in every region and sector as well as showing signs of greater resilience amidst the COVID-19 pandemic…Family-owned companies tend to have above average defensive characteristics that allow them to perform well, particularly during periods of market stress.”.

What are the key reasons? My conversation with investment bankers, investors and business owners came out with a few: Family business plays for the long term. They don’t compromise long term goals for short term gains.

They are under no pressure (from external investors) to hit some short-term value (nay, valuation) milestones.

There is significantly higher ‘skin in the game’ with the ownership and control vested in the same set of key individuals who usually play active roles in the business.

They are focused on stable cash flows and yields over sustained periods.

The commitment to various stakeholders at large and society is higher than the new-age start-ups.

An extreme view is that non-family businesses tend to chase valuation while family businesses chase value creation.

There are certain variables that are important in the development of family businesses, viz., the scale of aspirations of the family, capital availability, technology upgradation, leadership bandwidth and succession planning. Many families struggle with building scale quickly, thereby making new age businesses such as digital and fintech platforms a challenge.

Another key issue is talent, especially how to compensate professionals who may desire employee stock options, which they can get elsewhere in firms with external investors. Family businesses struggle to find a suitable solution to this, besides the fact that they have closely held shareholding patterns. Professionalism sometimes is compromised as the promoter has a final word in decision making. This is why they are often unable to woo top-notch professionals.

With the dramatic change in technology – mobile, digital, mobility to name a few–plus changes in demographics and consumption patterns, family-owned businesses would do well to take a leaf out of new age start-ups, shed their traditional mindsets and proactively disrupt their current modes of operation. We are seeing some evidence of it in groups such as the Tatas, Reliance etc acquiring or working with start-ups and moving into new areas of business.

The more family-owned businesses can quickly adapt to the changing environment, the greater the chances that they continue to outperform non-family businesses and start-ups.

Written by Chandu Nair. Mr. Nair, previously an entrepreneur, business journalist and corporate executive, is now an active investor and start-up advisor. Views are personal and do not represent the stand of this publication.