How to Future-Proof Your Business
Verit View- Q1 2019
Verit Advisors’ view is that rising interest rates, the threat of an economic slowdown and intensifying global trade spats are playing havoc with business planning for 2019, including at middle market and family companies. However, there are concrete actions business owners can take to prepare for choppier waters – and here are four principal ones.
No. 1: Adopt the mindset that tougher times are a meaningful reality. This doesn’t mean pulling in and halting investing, but it does mean making decisions with a view that a recession will, at some point, occur. Potential lenders, investors and buyers know this and, therefore, look skeptically at revenue and margin projections that only go up, despite challenging future scenarios. These external parties want to see how the business may perform in more stressful times.
To illustrate this more disciplined approach, consider a family-owned industrial company we’re working with that is completing what will be a transformational acquisition. It assumes for modelling purposes that it will achieve no cost or revenue synergies because the owners want the assurance the deal still will make sense. They also are gauging how rising interest rates will affect the transaction.
In part, this family business’ caution reflects the hard lessons of a large deal that went wrong in the past. Having touched a hot stove once, this company only has done small deals for several decades. The reluctance to bet the farm, a touchstone for this organization, is generating valuable caution as the owners contemplate a high-reward, but commensurately high-risk, transaction.
No. 2: Get your balance sheet in order. All businesses should focus on interest rates and liquidity risk and contemplate the sensitivity of margins and profitability in different scenarios.
When I was a young banker, we would look at a variety of interest rates as part of every underwriting proposal and project how the business would perform. But with rates so low for so long, many lenders and companies have neglected this discipline. Commercial bankers trying to build new middle market relationships encourage borrowing; i.e., “putting money to work.” This is true especially in Chicago, where Verit Advisors is based and where many good middle market banks reside. (Some banks have encouraged clients to apply the credit brakes.)
Yet, easy money will not remain with us forever. At two-or-three percent interest, many deals and investments look good. The economics become very different as rates climb into the mid- and upper-single digits. I am reading that middle market multiples of EBITDA for senior unsecured debt are contracting from 3.5 times to below 3 times, so it’s not just prudent but essential for middle market companies to plan for higher rates.
No. 3: Look to technology advances. And this counsel applies to all businesses. As Spencer Johnson’s best-selling “Who Moved My Cheese,” about change in one’s work and life, noted, the future that arrives may not be the one we planned for, and I am seeing technology’s de-positioning effect across the industrial spectrum.
Businesses run a real risk by not embracing new technology that reduces expenses and helps serve customers. Already, artificial intelligence is impacting all industries, not just in Silicon Valley. With no alternative to considering the impact of disruptive change, middle market and family business owners must ask themselves: How will business be done in 10 years? Do we have the financial ability to grow and compete in this new environment? Or should we potentially sell to someone who can compete?
A client recently received an offer from a large public company that fell below what the owners thought their business was worth. But they realized if they didn’t sell, the larger company would be such a serious competitor that their forward revenue and margins were at risk. They were smart to grasp that this large company was a huge future threat. So they opted for the offer. Had they rejected it, they estimate their business would have lost 20 percent of its equity value per year. These very real, but hard to quantify, risks from technology and other shifts in the business environment get to my next point.
No. 4: Find people and mechanisms that can help you see around corners and navigate uncertainty. Middle market businesses don’t have the resources of larger public competitors, but perhaps they can leverage industry consortia or research firms. A local college or university business school may have working groups or lectures, and may cities have so-called CEO Roundtables facilitated by third parties.
I also recommend my clients find independent board members or, at the very least, advisory board members to fill their knowledge gaps. Regarding boards, it’s useful to view the membership in thirds. Ideally, one-third of the directors will possess strategic insights about your industry, one-third will have financial expertise and the other third will provide experience valuable to your company or industry, say, in overseas sourcing, talent acquisition or crisis management.
For example, I was asked to join one board because the owners wanted a strong director who also understood capitalization. Also, if most directors are independent, they must work extra hard to acquire an understanding and appreciation of the company’s culture. Uppermost: You need directors with strategic insights about your industry or with knowledge of the technology accelerators occurring because you must be able to anticipate and respond to change.
Understandably, some private business owners are reluctant to bring external financial experts onto their boards, fearing they will be in cahoots with private equity firms and angle to position their company for a sale. Were that to be the case, of course, the director would not be fulfilling their fiduciary responsibility to the individual who appointed them. Selling is one way to realize value, but it’s certainly not the only way. Thus, it’s important that family and other middle market business owners vet potential directors to confirm they align with the opportunity for value creation.
Family owned business especially want to control their destiny. Compared to public companies, they are intrinsically long-term oriented, often making investments that achieve positive ROI over many years instead of in one or two quarters. The familiar analogy of the lazy grasshopper and the prudent ant applies. It isn’t uncommon that a perceptive company carefully watches its balance sheet and when others in its industry are pulling back, it possesses dry powder and can complete a compatible acquisition.
Over many business cycles, I have recognized that a sound balance sheet provides many options. I believe that in the next recession, companies that preserved their financial firepower will find rewarding opportunities. Conversely, should you decide to sell your business, it will be more valuable with an unstressed balance sheet. Either way, you will approach a sale analysis from a position of strength, perhaps making the difference between being the acquired or the acquirer.