Aug 1, 2022 | Change, Small business
Covid has led to quite a bit of M&A activity amongst the difficulties of trading. I know several ‘baby boomers’ who have just packed up and left. A number have sold businesses they previously intended to continue for a while, and leave ongoing entities to family, and other shareholders.
Several have sold with an earnout period and discovered too late that there were things in the fine print that tripped them up and reduced the payout to next to nothing.
Poor planning and advice, but most importantly, lack of attention to the implications of the financial detail in the agreements.
Following are a number of the common pitfalls you should be aware of.
However, first and foremost, you must recognise that a payout period is really just a transfer of risk from the buyer to the seller. The degree of this transfer is dependent on the conditions in the contract and actions taken by the buyer post transaction.
Earnout revenue targets.
These come in many forms, often broken into categories.
- Many purchases are made for the sole reason of gaining access to the seller’s customer list. In this case, the seller is kept on to assure those customers that it is business as usual despite the change in ownership. Many things out of the control of the seller can impact on the attitudes of the customers, and often a change of ownership is just the catalyst customers needed to look around, and do an assessment of the levels of value being delivered. This usually results in revenue being lost.
- A buyer may cut the sales and marketing expenditure impacting on sales, a decision out of the control of the seller, but potentially impacting on the earnout numbers.
- A buyer often justifies some of the benefit of a purchase in the ‘back office’ economies they appear to bring. These projected savings can be the result of over optimistic projections around available savings made to fit the guidelines of the purchaser. They can have the impact of reductions in the level and acceptability of the service provided to customers. These can impact revenue and payout numbers while being out of the control of the seller.
- Post transaction, sellers often lack the drive and commitment they had prior to the sale, despite the earnout terms.
EBIT targets
EBIT targets are even more ‘manageable’ than revenue targets by a buyer. Being at the bottom of the P&L offers opportunity to load up expense captions from Cost of Goods Sold through trading expenses and fixed costs in all sorts of ways. This will be detrimental to the seller’s payout at the end of the period. Human nature being what it is, there is little motivation for the buyer to maximise the payout to the seller, and conversely, many reasons to take a ‘hit’ in the first periods of ownership that also serve to reduce the payout. Just a few of the many examples I have seen:
- IT integration costs, often the basis of M&A justification blow out way beyond expectations.
- One off costs associated with staff redundancies can cost a lot of money. Often there are assurances in place about staff, but who needs two of everything post acquisition, so job losses are frequent and often deep, creating unplanned costs.
- Changes in accounting practices of the acquired business, for example the valuation of inventory that is applied to the COGS, and unanticipated write-offs of excess inventory, can impact substantially on the payout numbers.
- Loading up advertising leading up to the end of the buyout period can damage short term EBIT, but benefit the long-term position of the business, post the buyout date.
One way of at least mitigating the potential disagreements and decisions taken outside the parameters of the agreement by the buyer to reduce the payout, is to base the payout numbers on free cash flow. The ways this can be manipulated are easier to define and agree pre-acquisition such that the seller is protected. The buyer still has the ability to make the changes necessary to integrate or take over the business and reshape it. Free cash flow is less complicated than agreeing what a post-acquisition ‘normalised’ P&L would look like, as the variables are reduced, and thus it becomes easier to make transparent and enforceable arrangements.
For many owners of an SME, the value tied up in the business is their superannuation. It makes sense to be very careful, as it is probably the case that the buyer has way more experience with these types of transaction than you.
Header cartoon credit: Scott Adams and Dilbert
Jul 19, 2022 | Change, Governance, Innovation
There must be some sort of magic in the water supplied to the Santa Clara valley, just outside San Francisco, originally famous for its orange groves. What started as a ‘nick-name’ for the area in the 70’s, stuck, and we now know it as ‘Silicon Valley’.
Somehow, that same water has infected other places and times, leading to an extravagance of brilliance. Athens in the time of Aristotle, Rome in the time of Marcus Aurelius and Seneca, the Florence of Leonardo and Michelangelo, Paris in the 1920’s that spawned Picasso, Monet, and Modigliani, Hemingway and Scott Fitzgerald. Even a little pub in Oxford with a writers club, calling themselves ‘The Inklings’ that delivered three of the most popular books of all time, Lord of the Rings, The Hobbit, and Chronicles of Narnia from the pens of C.S. Lewis, and J.R.R. Tolkien rates a mention.
Futurist Kevin Kelly in a 2008 blogpost, looked at some of these creative clusters over time and concluded that there were four common characteristics:
- Mutual appreciation. Appreciation implies polite clapping, but real appreciation requires the injection and debate of contrary views, critical peer review, and competition driven improvement.
- Rapid exchange of tools and techniques, facilitated by the common language and competitive instinct moderated by the mutuality of a ‘safe haven’
- Network effects, and the geometric nature of influence and information when something interesting happens.
- High tolerance for the novel, and different, with barriers to prevent the status quo responding. The renegades are protected by the herd, rather than expelled
Kelly concluded that these groupings of genius were spontaneous, and self-supporting over time, and the best you could do was ensure you do not kill it. They also occurred after a time of considerable social and economic disruption caused by war, rebellion, and plague. Catastrophe it seems leads to innovation, as many if not most of the usual institutional barriers to change are removed, and there is a hunger for the new to replace the old.
Lurking amongst these four common characteristics are several other common elements. There may have been mutual appreciation and exchange of tools and techniques, but there was also fierce competition. Michelangelo and Leonardo were ferocious competitors, Monet and Picasso never agreed on anything. The characters involved in the morphing of a slice of semi desert into Silicon Valley, William Shockley, Sherman Fairchild, Gordon Moore, and the companies they worked for and founded were intensely competitive, while building on the successes of their peers.
Also present is a communal meeting place and ritual, usually in a coffee house or pub, as in the ‘Inklings’ meetings in the Eagle and Child pub in Oxford. These places were the key node in the generation of the network effects that characterises all these innovative ecosystems. They are the neutral, informal point from which the magic water of innovation is first dispensed.
These informal places attract intellect and experience from diverse fields, enabling a range of perspectives to be brought to the discussion table that can then be applied to complexities and problems in entirely new ways.
As we observe the world we are now in, on its own, the Corona pandemic might qualify as a catastrophic incident, sufficient to create another explosion of innovation. It could be easily argued that it has already created such an explosion. The rapid development of mRNA vaccines involved networks of researchers, companies, and public funds from around the world to commercialise with unprecedented speed, technology that has been slowly evolving for 30 years. On top of that, we now have another war in Europe, which has kickstarted the restructuring of the global economic and political status quo, shattering the ‘globalisation’ of trade and giving huge impetus to the development of renewable energy. Together with the rise of China, and the relative decline of the US, this surely rates as a global geopolitical pivot point.
How can Australia leverage this seismic restructuring of the global order?
If Kelly’s observations have any validity, and to me they reflect what I have seen over a long career, we should consider our strategies in the light of the constraints imposed by the current status quo, and rebuild those guiderails in a more appropriate manner. Constraints are useful for innovation, only so long as they direct the process productively.
- Divert academic attention from the necessity to spend significant time chasing grants and dealing with bureaucracies to keep working, to creating safe spaces for intellectual exchange and competition. The pub and coffee houses of the past have been partly replaced by Slack and Zoom, although the value of face to face cannot be understated. The tools are there, the guiderails are just in the wrong places.
- There must be a shared mission that motivates and engages the best minds. This will be the catalyst to assembling the resources enabling the pressure to innovate to be felt. Public funding is essential, but the governance of that funding needs to be driven by those funded, and in a position to leverage the outcomes, rather than by non-scientific bureaucrats and political appointees.
- The ‘field’ in which the ideas will be planted needs to be fertilised and watered consistently, again over a long term if the seeds are to germinate and grow. There also needs to be the recognition that many seeds will not germinate, and they must be seen as a learning experience, not a failure.
Sadly, our mindset works against this.
It is a mindset built by the 20th century, one characterised by a combination of catastrophe in the first half, and unprecedented advances and comfort in the second. However, it is now the 21st century, and the institutions that evolved in the 20th are inadequate to accommodate the 21st.
Unless we can change, we will remain hobbled.
The header photo is of the Eagle and Child pub in Oxford where ‘The inklings’ met from the early 1930’s to 1949.
Jul 11, 2022 | Change, Innovation, Strategy
When you look over commercial history, there is a cycle in scale.
A new industry emerges, then scales using the capital captured to build production and productivity, which in turn leads to scaled volumes, fed by sales and marketing dominance. At some point, a ‘tipping point’ of some sort emerges and industry fragmentation and change occurs.
Out of the fragmentation emerges a new set of products/services that renew the cycle of scale.
Perhaps the first modern industry that emerged from cottages, leveraging scale and branding, was Charles Darwin’s uncle, Josiah Wedgewood. The industry he created established a global dominance that lasted to 1940. After the war, Wedgewood was replaced by a host of cheaper, more utilitarian products emerging from a reconstructed Japan, and other low cost suppliers.
Early in the 20th century, there were hundreds of companies building their versions of horseless carriages. Henry Ford launched the first Model T in 1908, and built a further 15 million by 1927, almost squeezing out everyone else. Those that remained in the US merged to survive and became General Motors, evolving to be for a while, the biggest company in the world. They dominated until the mid 1970’s when the Japanese, followed more recently by Korean suppliers, almost destroyed them.
By the end of the 20th century there were few legacy car companies left. They are now in the throes of being disrupted by a new generation of electric cars. The incumbent manufacturers completely missed the emergence of battery stored electricity as a replacement for the internal combustion engine, leaving an open playing field to Tesla.
Today, Tesla is the biggest auto company in the world by market capitalisation, bigger than the value of the next 10 manufacturers combined. In terms of unit sales, Tesla is a relative minnow, demonstrating the capital markets view of the power of the trend towards EV’s. Few remember that cars and trams were run on batteries in the earliest days of ‘motorised’ transport.
You can track similar trends in all major industries. Media, communications, heavy engineering, retailing, technology, the only things that vary much are the speed and amplitude of the cycles, which are now accelerating at an unprecedented rate.
Picking where your industry sits in the cycle is an important strategic consideration, as it offers some insights about the types of investments required to stay competitive over the long term.
Jun 30, 2022 | Change, Strategy
Promoting change is a major strategic and management challenge. Most will accept that change is a necessary ingredient in survival, but most will also hope it is the other bloke who changes, and they can continue in in their comfortable cocoon.
There are three ways to initiate and lead change, all based on behavioural psychology.
Incrementally.
When you ask people to make minor changes, and provide the background information so the changes seem reasonable, people will usually be prepared to make them. Minor change, on minor change, compounds to significant change is what seems like a short time when you look backwards.
You are not taking people too far out of their comfort zones by making these minor changes.
Anchored.
‘Anchoring’ is a core technique in negotiation that is fed by ‘fixing’ on the first number mentioned. In a negotiation over wages for instance, you often see what amounts to an ambit claim, a huge increase over what you are actually prepared to accept. The process then becomes one of compromising, meeting somewhere in the middle. The higher the starting point, the higher the ‘middle’.
Catalytic event.
When something happens that is an attention grabber, it can be used to demonstrate that the status quo is simply not viable, and change is a necessity of survival. This can be used at an individual and corporate level. Management jargon often uses the term ‘Pivot’.
Steve jobs did it on returning to Apple, by radically reducing the product range, and focussing resources on the ‘Mac’ and development of what became the iPod. Bill Gates executed the biggest ‘Pivot’ in corporate history in 1995 when he realised that the internet really was something big to come, and that Microsoft had almost missed the boat. Gates wrote a memo to all staff that instigated the pivot that in an instant, turned Microsoft 180 degrees.
On several occasions over the years as a contract manager and ‘change-agent,’ I have deliberately generated a catalytic event. On each occasion, corporate survival was at stake, and significant change was essential. Under normal circumstances, the scale of the changes necessary would have been untenable in the absence of the catalytic event.
The management challenge to successfully making change, whichever strategy is used to make those changes, is to ensure they will ‘stick’ after the initial pressure is removed. The tendency to revert to the previous status quo is always very strong.
Jun 20, 2022 | Change, Operations
Over time, as changes in the world trading environment evolved, corporations of all sizes matched that evolution through their supply chains by seeking efficiency.
China began to open its economy in the 1980’s, bringing a massive previously untapped labour pool onto world markets. The accountants in developed countries did what they do and took advantage of this cheaper labour by shifting manufacturing operations. This hit the labour market in developed countries hard, and drove change towards automation. The change also brought huge increases in the standards of living of millions of Chinese that increased total demand dramatically.
A key part of the automation processes was the deployment of operational improvement practises, lean, six sigma, JIT, and others. The driving force in these deployments was efficiency.
Over time as manufacturing focussed on efficiency, we did not recognise the downside sufficiently, and sacrificed the resilience in our supply chains against any sort of disruption. We engineered redundancy out, as it did not deliver efficiency.
This is all very useful in the relatively benign environment we had, barring a few hiccups like the 2008 financial meltdown. However, it becomes toxic when the brown stuff really hits the fan, as it did with Covid, and now the Russians. Having practised in Georgia in 2008, and the Crimea in 2014, they have gone after the bigger prize of Ukraine.
Suddenly the patterns of demand for all sorts of products from microchips to grains and consumer products have radically changed, and we discover the downside of engineering out resilience in favour of efficiency.
As one product becomes disrupted by the chaos, it creates waves of second and third level effects, many of which nobody has thought about. Suddenly, and belatedly, we recognise the interconnections and dependencies that compound the disruptions.
The huge challenge for manufacturing leaders is to devise new models that continue to build efficiency, while not sacrificing resilience.
Jun 6, 2022 | Change, Collaboration
Fragmentation of supply chains is the reality post covid, and now with the turmoil in Europe, evolving attitude of the world’s factory, China, Brexit, polarisation of the US, and the increasingly fragile geopolitical world order.
Many businesses I see have spent considerable effort internally, progressively optimising their own operations. Very few have spent anything like the same effort externally, optimising the interactions with others in their supply chain with the objective of increasing the strength of the whole, rather than just increasing their negotiating leverage.
Making one link in a chain stronger is great, but it is the strength of the weakest link that is critical.
One of my SME clients faces this dilemma.
His business is in a rapidly growing segment of a very large and well established market. He is the last link in the chain to the client, and has done an excellent job over the last couple of years building the foundations that will enable him to scale at an increasing rate. He has a number of suppliers for a key part of his offering, to which he then adds the value to the end client. Each of those suppliers has their own set of challenges, but the common feature is that they are modest sized, often relatively new businesses, all are underfunded, and management structures and discipline are generally poor. To varying degrees, and in differing ways, they present barriers to my client’s growth.
Question is, how does my client inject the ‘improvement DNA’ into his suppliers, so that they can grow together, make the pie for both parties bigger?
Collaboration is the easy answer, it is just that the distance between where they are now, and a fruitful collaboration is significant.
In my experience, there are four critical steps to be taken. These are not always sequential, although the deeper you become involved, the harder it becomes to extract yourself should that be necessary.
Pick the right partner.
Choosing a partner for a long-term collaboration is not unlike picking a partner for life. None is going to be perfect, and it will take time and effort, but in the absence of the right foundations, it will not work. Jim Collins in his book ‘Good to Great’ offers the advice to: ‘start with the who and then focus on the what’. Seems to be good advice.
Your chosen partner, and making a choice is essential so that you can focus resources where they will have the greatest impact, must be aligned with your strategy, and vision of the future. Only then can you engage collaboratively in the journey.
Learn together.
We humans learn better in groups than we do individually. The greater the variety of input and perspective the better decision making. Quicker recognition and wide acknowledgement of errors, and understanding of why they were made, leads to more robust recovery from those errors, and growth.
Leverage each other’s strengths
Every relationship requires ‘give and take’. When you assist a partner to improve their operations, you will benefit. That benefit may not always be directly evident, but indirectly it will be there. Reciprocity is a powerful motivation, on top of the commercial benefits that accrue from optimised operations. Often it is the case that the strengths of one partner fills the hole left by the weakness of the other, greatly benefitting both.
Measure together.
‘What gets measured gets done’ holds true, although you must be cognisant of Goodhart’s law. This states that when a measure becomes an objective, it ceases to be a good measure.
Both parties should be on parallel and intersecting continuous improvement efforts. Where these intersect there is significant opportunity for mutual improvement. Most often that is where there are shared measures. The most common I have seen are ‘DIFOT’ (delivered in full on time) and production scheduling and inventory measures. For example, years ago a business I worked for built a small number of measures that had shared production scheduling and inventory measures across the two collaborators. The result was a radically increased rate of ‘flow’ between the raw material and production scheduling of one party and the inventory and volume offtake of the other. Both parties benefitted enormously.
Such collaborative efforts, when they are successful provide the most effective antidote to the fragmentation of supply chains. While your competitors struggle with the fragmentation, you and your collaborators can leverage your success into market share and sustainable profitability.
