This is part two of The Top Value Drivers and Value Killers. In the previous blog post, we covered the three top value drivers:
- Recurring revenue
- Commanding a niche in a growing market
- Owner independence
To some extent, each of the top value drivers carries equal weight, although I would give a slight edge to a recurring revenue business model. We encourage owners to think hard and creatively about how they can develop and implement revenue models to consistently capture customer/client dollars (and loyalty) over time.
Now let’s move on to the dreaded Top Three Value Killers. Value killers represent risk. Unchecked or under-managed risks diminish business value. The good news: risks can be managed if you identify them early and address them vigilantly.
Vigilance is extremely important. Risks have a way of seeping back into a company. Sometimes they are insidious. Well-developed risk management systems and procedures are a hallmark of well-run, high value companies.
Concentration
Customer concentration is the star of the show in this area of risk, but its cousins are industry, geography, and product. Most owners understand the many problems associated with customer concentration but may not give much thought to the other three.
The prevailing benchmark for customer concentration in calculating business value is no single customer representing more than 20% of top-line revenue. But that might vary by industry is certainly more nuanced than a strict percentage.
One nuance could be a concentration of profit in one or a small group of customers. The nail in the coffin is a concentration of top-line revenue combined with a lower margin for the same customer. This often occurs when the larger customer has the power to demand price discounts. Now you have a problem at two key points in the financial performance of your company. Pile on with slower collection terms and it’s a triple whammy. Your company’s value will plummet unless there are very good reasons for maintaining such a high-risk profile (spoiler: there usually aren’t).
I once met a family business owner who had been doing business as a sole supplier of goods to McDonald’s for 40 years. It was 100% of his customer base. Although he sweated bullets over the catastrophic implications of losing his one customer, he rationalized the risk away by assuming that a 40-year value-added supplier and the customer enjoy an unbreakable bond. Think again. All big corporations have purchasing managers and McDonald’s changed its policy to require at least three suppliers for each good or service. A savvy move by McDonald’s. An “out of business overnight” decision for the owner, ending a 40-year family legacy. Ironically, abruptly putting one of its key suppliers out of business didn’t help McDonald’s either, but it didn’t put them out of business. There were many ways the owner could have diversified over the years. Weaning away from a long-time customer may have some unintended consequences. Waiting to act makes it more and more difficult to change the customer mix. If the risk had been managed earlier, the family’s business legacy could have carried on, possibly through multiple generations.
The other concentration risks – industry, geography, and product – are not always easy to see until they emerge. A geographic concentration (supplying a small footprint) may be unavoidable if your business is a retail storefront. But what if the neighborhood falls out of favor or, conversely, rents rise dramatically because the area becomes really popular. The Bay Area is a good example of what can happen to displace retail stores quickly.
If you are a manufacturer supplying customers in one metro area, the local economy can have a significant influence on growth or survival. Metro economies are dynamic and flex in cycles. Higher taxes or population outflow are two examples of local influences that affects both top and bottom lines. It’s also easier for a competitor to take market share from you if they target a smaller area – their capital risk is lower because of the smaller footprint.
Industry concentration means you do business with only one sector (or subsector) of the economy. Depending on how big the sector is, you may be fine if you manage customer concentration well. The healthcare sector is a good touchpoint. It’s huge and growing. But as a result, intensely competitive. Looking back at the top three value drivers, this is where “niching” drives success. What can you do to carve out your white space and dominate?
However, if you manufacture something for the printing industry or supply services to it, your market is shrinking and you will need to innovate out of it or diversify quickly. The printing industry is declining rapidly for obvious reasons as we consume more online. It’s likely at a point of no return. If you are concentrated in a shrinking industry, think hard about how you can penetrate another, growing sector.
Product concentration risk is less obvious. Every product or service has a cycle (commonly known as an “S-curve” where it begins slowly, catches fire (hopefully) and grows rapidly, and then turns the second S corner and exponentially slows and becomes obsolete. Research and development – an ongoing and funded commitment to innovation – reduces product concentration risk. The common phrase “staying ahead of the competition” reflects the need to innovate. And yet, most mid-sized and smaller companies forget to do it. The old saw “if it ain’t broke, don’t fix it” is terrible for sustainable enterprises. The natural cycles of businesses and markets dictate, without innovation, “it” is becoming more broke by the day.
You don’t necessarily have to make or deliver something entirely new. You can avoid or slow product concentration by continuously improving your offering and adding value. Your best source of how to do that is your existing customers. Make a point of asking them how your product or service can help them be more successful – and then do your best to deliver it before your competition does.
Lack of Succession Planning
“Succession planning” can be a confusing term. For our purposes here, we mean developing successors for key roles in your company to avoid significant disruptions if someone leaves the company on short notice, is terminated, dies, or is incapacitated by disability.
Without adequate succession planning, all sorts of ugly things can happen. The most obvious – but not the most important – is the loss of someone to do “regular work” until a replacement can be found. Many companies prefer to “hire from within,” which makes good sense for business continuity and a rapid return to full production. An inside hire knows far more about the company and its business processes than a new hire. However, that’s not succession planning in and of itself.
Full succession planning means the replacement can step into the shoes of the previous employee with no interruption. This is particularly crucial for key positions, such as executives or the owner(s). Why? Not because of lost production, but because a large part of a company’s value is vested in the brains of its key employees. Knowledge retention and availability are far more important than having a body to fill space on the organization chart.
If you are an owner, think about what you know about your business – customers, product, processes, suppliers, strategy, finances…the list goes on. Your successor needs to know all that in depth to fulfill your role if the need arises, whether temporarily or permanently. Without planning, much of what you have worked to build, possibly everything, is at risk.
What does good succession planning look like?
Intentional
Successors must be identified and recruited. If they don’t know their role, they can’t fulfill it, and they must accept it to be committed.
Proactive
It requires good knowledge systems and management – documented processes and procedures, structured education and training, and regular knowledge sharing among employees.
Written contingency plans
For example, what happens if the owner, or an executive, dies in a car accident? Clear written instructions are crucial, reflecting not just business decisions (i.e. Who’s in charge? What does the bank need to know? How should it be handled with key customers? What will be communicated internally? Etc.), but also personal matters. The steps necessary to protect the business and support family must be delineated. Contingency plans should be shared with the leadership team, company accountant, outside counsel, banker, insurance agent, and family. A good rule is “no guessing.” When something happens, your contingency plan is triggered and the process begins immediately and smoothly.
Consensus
Plans are worth less if those most directly affected do not agree on their validity. Succession often happens during difficult times when big decisions must be made rapidly. Infighting over process and authority when the business is vulnerable on many levels can be devastating. As plans are developed, seek consensus from stakeholders by being transparent and make sure all the key people sign off (literally). As new key stakeholders come on board, share the plans and require their approval so their will be no objections or doubts when the time comes.
Poor Financial Systems, Reporting and Management
This is a big area of risk with many land mines to avoid. Valuable companies manage finances with great precision. Let’s stick to the basics for now.
You should be able to produce accurate monthly financial statements (income statement, balance sheet, and cash flow). The three should be integrated, meaning the various financial inputs tie out on each report. We see owners who spend a lot of time on profit and loss, but not as much on their balance sheet, and almost none on the cash flow statement. All are equally important.
The need for accurate financial statements isn’t only internal. For a company to be “bankable” (meaning able to get a loan on favorable terms from a commercial bank), a history of good financial management is required. Accurate financial statements, based on strong financial controls, are a must. If you intend to grow your business, you will need less expensive debt capital to complement your cash flow from operations and invested equity. Be prepared.
Good financial statements not only reflect, but support, good financial management. They allow you to conduct historical trend analysis, make better decisions about how to use your capital, and develop defensible projections. Financial projections are difficult (but not impossible). Historical financial performance tells an important story that can be useful when planning for the future.
To create good financial reporting, you need a good system. Software is essential and there are many legitimate choices for businesses of all sizes. As your business grows, it’s likely you will outgrow your original software. Be open to looking at other systems when the time comes – software that isn’t the right fit is a millstone around the neck of a growing business and can expose you to real dangers related to control, treasury management and tax reporting.
Two tips:
- For smaller businesses, don’t depend entirely on your accountant to produce your internal reports (although do seek their help if you get into a trouble spot). It’s difficult to really understand the financial performance of your company if someone else is responsible for basic reports. Dig in, even if you aren’t a “numbers person.” Although it might not be much fun in the beginning, it will be far better in the long run.
- Do engage your accountant to review your financial statements from time to time. A quarterly review is probably sufficient for most smaller businesses. Your accountant may see opportunities or inconsistencies you can learn from, and it helps them prepare for tax filings. It a little extra cost but worth it. For larger businesses, invest in full annual audits. Your investment will pay a high dividend if you ever sell your company to an external buyer or seek outside capital for growth.
There is much more to consider when managing financing, including developing a capital investment strategy that maximizes returns for shareholders. We’ll reserve that for a future blog post. Until then, think about how these value killers show up in your business and proactively manage them to the extent you can. You can find more information about building value on RFN Advisory Group smart ideas page.
Concentration, lack of succession planning and poor financial planning systems, reporting and management are the three top value killers in a business. The flip side of the value coin are the drivers. The follow-up article focuses on the top three values drivers is now available.
About the Author
Sean Hutchinson is a Gellert Family Business Fellow. Annually, Fellows are selected by the Gellert Center because of their expertise working with family-owned firms and their recognized positions as leaders in family enterprise theory and practice over many years.
Sean is a third-generation heir to his family’s business, has founded half a dozen companies and has worked directly with entrepreneurs for the past three decades. Sean specializes in working with entrepreneurs and business owners to help them define and achieve their ideal business outcomes.
As one of the founders of RFN Advisory Group (previously SVA Value Accelerators), Sean’s primary focus is strategy and growth. He helps owners and their leadership teams imagine what being a ‘company of the future’ looks like for them, and then helps them achieve it.
Sean has invested heavily in education over the years – both in expanding his knowledge and sharing his experiences with other professionals. Sean sees his work as transformational, not just transactional, and it all comes down to getting business owners ready for next.
