A Life In Numbers

It’s a year since Lehman’s collapsed and threw the financial markets into turmoil.  And the last year has been an incredibly challenging period for many companies.  Whilst large corporates have been able to survive through budget freezes and cost reductions, although even this wasn’t enough for some, the SME sector has had even more challenges to face with the banks freezing access to finance, large customers pulling back their business, and cost cutting endeavours slicing to the bone.

There’s a big difference between a company of 10,000 cutting 10% of the workforce and losing 1,000 people.  It sounds a lot and can be distressing for all involved but it still leaves the company with 9,000 staff which can be plenty enough to take up the slack.  For an SME, there’s much more of a challenge.  The cuts have to be deeper to make a difference and for a company to reduce from 50 heads to 25, it means resources are stretched really thinly.  Sometimes to breaking point.

Any company who has lived through the last year or two and survived intact has something to be very proud of.  The challenges are by no means over yet but there are signs the worst may be over.

Building a business can be a challenge at any time but if you’ve survived through the current economic climate then it’s a a real sign that you have what it takes to succeed.  The key lesson is to remember what you learned through this period.  Actually companies can survive with tough decisions and the most useful asset in a business is not it’s resources but the resourcefulness of the management.

It’s also worth bearing in mind that there can still be more danger as we return to growth, especially if you don’t have a good understanding and control of the finances. 

So, if you’ve survived so far, well done.  If you didn’t quite make it, there’ll be other opportunities.  Whichever it is, make sure you look back and take some good lessons from the experience.

We’ve recently closed a funding round of just under £2m for a client and it struck me that with all the negative press around it’s easy to assume that all the positive growth stories have dried up. This tends to lead people to think that the time is not right to take action and consequently they put their head down and hope all the nasty stuff goes away. In their minds they tell themselves that they’ll start taking more action when the time is right.

It’s true that many more businesses are becoming insolvent and going into Administration. And many more may be trading insolvently (a criminal offence with personal liabilities) without even knowing it. It’s also true that there are many more people going into personal bankruptcy or IVA (Individual Voluntary Arrangements) in the false belief that after 2 years this will be wiped from the records (check any mortgage application for the question that says (have you ever been made bankrupt or entered into an IVA) to see that your credit record may never fully recover.

However, amongst all this there are still some companies that are raising money, expanding and growing as fast as ever. Admittedly it’s not easy and has the potential to get harder in the coming year but with the right guidance and the right business plan there’s still a huge amount of opportunity in the market.

The investment community is still sitting on considerable cash reserves and there’s more demand than ever for the right deals. This is balanced by an even higher level of paranoia and focus on cashflow that requires the investors to have a huge amount of faith in the abilities and plans of the management team but a strong team and a coherent plan can win through and the extra focus is on the right things.

Even the banks are willing to help those businesses who can clearly show they know what they are doing, keep the bank fully informed and manage their finances tightly.

Any business owner in this market has to make some tough decisions right now. You must know where they stand financially right now and for the foreseable future. If you don’t know that then you’re treading a very dangerous path that could lead to losing everything you have, including your personal assets.

Next, you need to decide where you want the business to go. Are you going to just knuckle down and tough out the the current market conditions or are you going to look at whether there are changes to be made to the business and strategy that could take you into new markets and consolidate and strengthen your current customer base?

Whichever direction you choose you will have to take some action. The most essential factor you’ll have to manage right now is your cash and that may mean some hard decisions such as reducing costs. You’ll also have to look at your business critically and understand what is working and what’s not. The absolute worst thing to do right now is to freeze like a rabbit in the headlights and wait to get run into the road.

This has turned into more of a motivational rant than I was planning but it would be really sad to see even more companies fail because they were waiting for when the time is right. Because, frankly, the time is right now.

You may have seen the Sequoia Capital slides doing the rounds amongst CEOs and Investors in the Private Equity world. They start with the bold statement “RIP Good Times” and take things downhill from there.

The overall conclusion is that there are some tough times ahead (no kidding!) and there are some fundamental actions that should be taken by companies to prepare for leaner markets. What struck me most about these actions is that the sensible companies have been taking these steps all along, whether times were good or bad.

The list including activities such as “perform situation analysis”. If you’ve not been figuring out where you are and what’s going on then it’s clear you may find the future a challenge. Another item was “adapt quickly”. Anyone in the SME world knows that this is essential in the early stages but it’s often forgotten as companies grow.

Other’s included were “become cashflow positive as soon as possible” and “spend every dollar as if it were your last”. These have long been the mantras for many successful entreprenuers.

The parts that many investors have latched onto are “make cuts” and “review salaries” and it’s always worth stepping back and looking objectively at the possibility for these. The challenge in this market is making sure that you cut in the right places and don’t harm your business more in the future.

If you haven’t been applying the rules listed in the action plan, then it’s likely you’ve been getting away with it due to the growth markets we’ve seen over the last 8 years. What you may now realise is that what you really need is the expertise to help you understand what you’re seeing and create a plan to make it better.

For many entrepreneurs, the apparent recession and crunch are just business as usual, facing the daily challenge of trying to find new customers in competitive markets and managing their cashflow as closely as possible. There are even opportunities in this type of market, as often competition can fall away and if you’re prepared and flexible new opportunities open up. It’s also possible to find new ways of doing things more effectively and efficiently.

There may be talk of this being a bigger, harder recession or downturn than we’ve had for a while, but these things all run on cycles. They’ve happened before and they’ll happen again. If you have any doubt then find yourself a copy of The Fourth Turning and see how many similarities you can spot in the current social, economic and financial markets. Other good cheery books for this market include The Great Crash by J K Galbraith and Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. They help put everything in perspective.

It is easy to get sucked into the bad news that the tv shows and newspapers like to promote. That’s their job and they’re very good at it. The worse it looks the more you tune in or read. By all means watch and read but you don’t have to believe it’s all true.

The key thing to remember is to step back occasionally and ask what’s really going on. Look past the doom and gloom and the same stories that get repeated over and over again to make things seem worse and seek out the opportunities. They’re there if you look for them and now’s the time when everyone else could be looking the other way. Join the few who can really prosper in this market. And prepare yourself for the good times that will inevitably rise again. And perhaps sooner than you think.

I was having a discussion recently with a business partner of mine about whether the value of companies in the Web 2.0 sector is fully understood.

Back in the days of the dotcom boom we sold a company called Smartgroups to Freeserve for £60m. At the time we had very little revenues and certainly no profit. But we had a very good piece of software, a fast growing customer base and a great idea about how to generate revenues off the back of the service. Luckily, in Freeserve, we found a number of key individuals who completely understood what our company and service could bring to their business. Applying our software and service to their customer base could generate huge value for the business and that changed the way that the value of the company was viewed.

Now it would be easy to write off this deal as just another (for a change successful) example of internet euphoria. However, the priciples are still intact today and companies are still being valued and acquired on the basis of the future value they can bring to the acquiror.

If you read any academic or financial books on valuation of companies (and I’ve read a lot!) they invariably go down the route of valuing companies through variations on discounted cash flows (with or without terminal values), NPVs, revenue and profit multipliers (with much debate about the relative appropriateness of EBIT, EBITDA, EBITDAR, PBT or PAt), p/e ratios, betas and other more complex calculations involving variants of the Black-Scholes model or the Modigliani-Miller theorem.

However, in the past 20 years of working in this field, I’ve found there is a more fundamental valuation technique that seems to be known only to a handful of financial alchemists and some of the highest performing sales people.

A company is worth whatever the buyer is to prepared to pay for it.

All the financial analysis is generally used to justify the valuation (or at least give it some credence) after the event. Sometimes it stacks up, sometimes it doesn’t.

If you’re a large company, especially a quoted plc, who is looking to acquire a company that will simply add revenue and profit to your bottom line then looking at your own p/e ratio and applying that to the profit that will be added through the acquisition is a perfectly rational method of valuation.

However, if a company is being acquired because it brings new technology or IPR, because it solves a problem that has been holding back sales or development or because it brings a business advantage that can be applied across a much wider customer base, then the value needs to be considered in terms of the additional value it can bring to the acquiror.

A company like Oracle, for instance, with a Market Capitalisation of over $100bn may see that buying a company with a technology or business application that could enhance their profits by 0.5% could add $500m to their market value. This means that, although there would doubtless be some shrewd negotiation, the value of that acquisition and the price they might be willing to pay could rise up to $499m and they would still come out on top. Of course in practice this would be unlikely given all the risk factors involved but it allows you to see acquisition values in a different context. And if you have a software company that is just breaking even then it might encourage you to think wider than just achieving a high multiple of your profits.

After all this, the conclusion we came to (following the discussion at the start of this post) was that many people, even experienced financial experts and business people, still don’t fully understand how valautions are achieved. And after last week’s episodes in the financial markets they might be even more confused.

Seth Godin has written an interesting blog entry today (as ever) talking about the magic of low-hanging fruit. It takes aspects of the 80/20 Pareto Principle and looks at a business perspective of where you can get the most benefit quickly.

He intially puts it in terms of changing the fuel consumption for drivers and shows how focussing on the drivers with the greatest usage provide the more beneficial outcome. He then expands this to compare the benefit of selling more to your existing customer base than selling to new customers.

In economics it’s long been recognised that a slight increase in price to all customers can vastly outweigh a cut in price to try and generate new customers. Price elasticity aside, it can be shown in simple terms that it’s better to generate £1 more on a £100 item from 100,000 customers (giving an extra £100,000) than to reduce the price by £1 and have to generate an extra 2,020 new customers at the new £99 price to make up for the lost revenue on the existing base (100,000 *1) and the extra benefit wanted (£100,000/£99).

Of course, in reality it’s not always that simple and in a very price sensitive market a 1% increase could drive away a chunk of your customer base (back to the price elasticity). However, we do spend a lot of time trying to generate new customers when you could provide enhanced service to your existing base to encourage them to spend more.

It relates back to the 3 main ways to grow a business:-

1. Increase the number of customers
2. Increase the average purchase value
3. Increase the frequency of purchase

Increasing the number of customers is usually done through an advertising or promotion campaign, which is rarely a cheap option. So it will generally cost you money to grow this way.

To increase the average purchase you can simply suggest an additional item at the point of sale. This is the model used by McDonalds (”would you like fries with that?”; “do you want to go large?”), Starbucks (”would you like any pastries?”) and the Electronics retailers (”would you like an extended warranty?”). Online, you see it with Amazon’s recommendations and “other people who bought this also bought …”). There are also other very effective ways to do this for services and products. It’s a very low cost method of increasing business and the customers feel they are being given a choice.

Increasing the frequency of purchase is generally achieved through education of the customer from the simple “your toothbrush is more effective at preventing gum disease if you replace it every three months, and just to make it easy for you it’ll change colour when it needs replacing” and the ever reducing “use by” dates in supermarkets to the more sophisticated bundled package for carpet cleaning or car servicing where you get a lower average cost per event if you buy a set and use them in a set time period. If done correctly (which may be questionable with the product warranties) the customers can feel that they are being looked after and given better service.

Think about where you can use these ideas in your business. Is there more you can do for your existing customers or are you always seeking to chase the new ones? Are you looking for the low hanging fruit or are you off planting new trees?