The everyday assumption is that enterprise owners and managers are completely focused on and devoted to maximization of profit, growth and cash flow from their businesses. This assumption is one of the cornerstones or underpinnings of classical microeconomics. Yet the assumption is deeply flawed. The evidence shows otherwise.
What is the evidence? I have no empirical study, but over the past decades have talked to over a thousand business owners about their businesses and have looked into more detail into hundreds of companies throughout Central Europe. My back-of-the-envelope calculation is that approximately 40 percent of company owners are what you might call profit-growth-value maximizers. The majority – roughly 60 percent – are owners or managers of what might be called “lifestyle” companies, or are “tax minimizers”; often the two go hand in hand. What do I mean by these terms?
A “lifestyle” company may be defined as a business whose primary purpose is to support the lifestyle of the owner and his family. This might mean a generous salary for the owner/CEO, full with perks (company yacht, airplane, fancy car, clubs, travel, etc.) Or it might mean jobs for the kids, with outsized compensation and perks as well. Or it might just mean draining the liquidity and growth potential of a company via dividending all earnings.
“Tax minimizers” are companies that find creative – usually perfectly legal – ways to minimize taxes. It may be via the “lifestyle” methods outlined above, or purchase of tax shelters (which may distort the investment pattern of companies), or even illegal methods or reducing taxes.
So what are the downsides of a company being a tax minimizer or lifestyle company? In my opinion, there are at least three reasons:
- Where liquidity is consistently sucked out of a company, whether via perks or dividends, the company usually becomes incapable of sustaining any kind of investment program, continuous improvements in processes, or investing in sales and marketing. If the competition is making these investments, and a particular company is not, it is only a matter of time before the competition starts stealing market share, or squeezing your margins, or both. The competition grows while those that do not reinvest stagnate. There is an old Russian saying: “that which stops to grow begins to rot.”
- It becomes more difficult to achieve financing. Neither banks nor equity investors like investing in lifestyle companies or tax minimizers. The risk of investing is far higher, and the potential upside far less. In short, the cost/benefit is much worse than investing in a growth and cash-flow maximizing company.
- Corporate value is destroyed. One method of valuing a company is to apply a multiple to its free cash flow, or to its EBITDA (Earnings Before Income Tax and Depreciation). So for every dollar or euro that an owner or manager is cheating the tax department, or spending on his or her own lifestyle, he or she may be diminishing the value of his or company by five, six or seven euros or dollars (whatever is the applicable multiple).
One may have a nice lifestyle as the owner of a “lifestyle” company. But the really big upside occurs when a business owner is in a high growth industry, reinvests earnings to maximize growth as well as efficiency and margins, and then he or she can cash out with an amazing value, based on a very high multiple applied to a very high EBITDA or free cash flow number. There is a compounding effect when two high numbers are multiplied by each other. This is how true entrepreneurs create the really serious wealth.
For most business owners, this is an absurd question. “Of course I am, I created the business!” But the fact that you have paternity rights does not necessarily make you the best parent.
The same is true from a corporate strategy and corporate finance point of view. Allow me to give four examples to illustrate the point:
- Company A has developed a world-beating technology. But it lacks the money to even register the necessary patent protection across the world, hence has been going nowhere for the past few years, losing valuable time. Meanwhile, the competition is catching up. In technology, no advantage is ever permanent.
- Company B is a FMCG (fast moving consumer goods) company, that has a local brand, in one particular country. The owner knows that the brand could be rolled out to other countries, but lacks the capital and local market knowledge in these other markets to carry out its strategy.
- Company C is an ESCO (energy savings company) that installs new energy-efficient heating systems in old buildings (hospitals, prisons, etc.). The only problem is that the equipment is very capital intensive. The banks were thrilled to finance the company in the first years, because the company was very profitable, but even though earnings were retained in the company, the equity base of the company became too thin to support such rapid growth.
- Company D has had none of the above problems. It was founded by the owner and grew rapidly. But the owner realized that he is both happier and better at running smaller, start-up type companies. When a company grows beyond a certain size, it requires different systems, a different type of management, and yes, a different type of CEO.
So what do these four examples have in common? The company would probably be worth more to someone else than it is worth to the current owner. It would be worth more to someone with deep pockets or the necessary expertise to take the company to the next level. If a new owner, thanks to its deeper access to capital or expertise, can accelerate the revenue and cash flow growth of a company, it is worth considering a change of ownership, or at least bringing in a strategic or financial partner.
I would suggest that the aforementioned four examples are not isolated examples, but archetypes – there are probably tens or hundreds of thousands of businesses in each of these categories around the world.
Yet there are a number of obstacles to business owners cutting the umbilical cord with their own companies, most of them of a personal or psychological nature:
- Many business owners have such tight emotional bonds to a company, that the option of parting with a company is unthinkable or heretical, like parting with one’s child. But does a parent do a child a service by keeping the child at home forever?
- Some business owners fear that if they sell their business, they will have nothing else to do. Have you ever heard the expression “serial entrepreneur?” These are typically business owners who have recognized that they are better at starting up and growing small business, spinning them off when the reach a certain size and maturity. And then on to the next one. Do you have it within you to start another business?
I am not advocating that anyone sell their business against their will; but I do advocate that every business owner should occasionally look in the mirror and ask whether they are truly the best possible owner of the company, the one that can maximize the potential and value of their company.
There is such a myriad of insurance products available on the market,ranging from property and casualty insurance, to health insurance,from product liability insurance and key man insurance to disasterinsurance, from business interruption insurance to directors’insurance and life insurance. And the list is far from exhaustive.How should a business owner or manager choose what kind of insuranceto buy? How might these insurance products help manage the risks inyour business?
A business owner or manager should at any time have a full assessmentof all the risks affecting his or her business. These need to beprioritized, as few businesses can afford to insure against allrisks. You may be aware of the analogy that a hole below the waterline will sink a boat; a hole above the water line will not. Youshould always try to insure against potential holes below thewaterline, if they are insurable. Those holes that are not below theline can still cause a huge amount of damage, potentially destroy theearnings of a mid-sized company for a number of years. So “abovethe waterline” risks should not be ignored either.
The hesitation that business owners and managers face in purchasinginsurance stem from several sources:
-
Complexity. Few business owners who are working incredible hours can take the time to fully understand the complexities of insurance and read the fine print. This is where a good broker can be of assistance. Given that the broker typically makes a commission by selling an insurance product, it may be a challenge to find a broker for whom your relationship is more important than making the sale. Trust is of the essence.
- Difficulty with collections. Many insurance companies in Central Europe have developed a reputation for exploiting “loopholes” in insurance contracts. (This might have something to do with the fact that there may also be more insurance fraud in certain Central European countries than in Western Europe). Once again, a good broker can help you pick the insurance companies that have a better payment record, and when it comes to collecting, the broker may also exercise some leverage to obtain payment. (My personal opinion is that there is a fortune to be made by an insurance company in Central Europe who develops a stellar reputation for payment).
Always shop competitively for insurance; and always look at the fine print. Once again, the former might be a role for a good broker; the latter should be reviewed by both broker and lawyer. It is often a challenge to negotiate “boilerplate” clauses in insurance contracts, and costly, in terms of legal fees. On smaller contracts insurance companies sometimes refuse outright to negotiate terms.
One of the dangers in a financialcrisis is that companies and individuals generally purchase less ofthe vast majority of insurance products. Cash and liquidity is sotight, companies will choose to meet payroll or pay that invoice thathas been outstanding for more than 100 days, rather than purchase aninsurance product – and just hope that risks do not materialize.The problem is that sooner or later, risks do materialize – andbeware if it is of the “below the waterline” variety.
When you thinkabout it, many Central European individuals and companies areunderinsured at every level: a surprising number of homes no longerhave insurance; businesses are buying less property and casualtyinsurance in most CEE countries, as well as product liabilityinsurance and other types of insurance. When it happens on such amassive scale this also creates systemic risks, for example forbanks. It is also contributes to a number of households andbusinesses getting wiped out, tragedies for many business owners andfamilies, when “below the waterline” risks do materialize.Particularly if your company’s cash flow is beginning to pick upagain after the low point of the financial crisis, it is time to takeanother close look at risk management and insurance.
Business owners often think that there is no equity capital available to them, yet there is far more money available in private equity coffers than quality projects to satisfy them. How can we explain this anomaly? Perhaps the single greatest explanation is that firms lacking proper corporate governance, as is the case with the majority of firms in Central Europe today, lack the corporate governance structures necessary to attract outside equity investors. There are other explanatory variables as well – such as the need to show an attractive financial proposition, a growth story, etc. – but there are so many firms that eliminate themselves from consideration for equity financing due to poor corporate governance that the question of corporate governance in itself deserves careful consideration.
This article will deal with two main subjects: (a) Practically speaking, what are the types of things a business owner/manager may do to improve corporate governance? (b) What are some of the resources available to a business owner/manager looking for additional information in order to address this issue?
(a) Improving corporate governance
For any investor, a company that is dependent on one individual for any crucial function creates a risk factor. The reality is that most SMEs in Central Europe are governed by very talented individuals, who run the entire business (what I call “One Man Shows”—see my earlier article on the subject
here and
here). So, the objective of a business owner who wants to attract equity capital or sell his business is to create a business that will run just as effectively – and will have the same growth prospects – without him.
While for many owner/managers this is not possible in the short term – there are many shades of gray – one should at least be aware of the need to take the business in this direction. Some of the possible steps one might take include:
- Installing a board of directors, preferably that includes strong independent members, that meets regularly and acts as the supreme governing entity of a company. The board should be responsible for risk oversight and establish appropriate internal controls. If the creation of a board is not possible, the establishment of at least an advisory committee would be a step in the right direction.
- Where a business is of sufficient size and has the necessary resources, the owner might consider appointing a chief operating officer, or even a chief executive officer, and giving him real operating powers. In the case of appointment of a CEO, the owner might act as chairman of the board. This helps commence the transition in management and will reduce the risk for any investor, assuming the new individual is successful.
- Once again, where resources allow, create a second tier of management with strong and competent individuals in key areas such as sales, marketing, finance, production, etc.
- Strengthen systems. Again, where resources allow, introduce systems as appropriate, whether Customer Relationship Management (CRM), Enterprise Resource Planning (ERP) or obtaining certification from the ISO (International Standards Organisation).
(b) Places where a business owner/manager might look for additional information
I would take the liberty of recommending three sources:
First, the Corporate Governance Committee of the American Chamber of Commerce in Hungary is perhaps the strongest think tank and driving force in the area of corporate governance in Central Europe today. Led by Laszlo Czirjak, an American-Hungarian investment banker turned private equity financier, the committee has numerous publications, including
a position brief on the subject of corporate governance.
And third, you may wish to consider my book,
Unlocking your Company’s Value (available at
www.lesnemethy.com), which has a chapter on corporate governance and other useful information for business owners/managers who wish to attract equity or sell their companies.
In conclusion, corporate governance is not just a subject for large, publicly listed companies. It is a subject that must be addressed by every company, however small. And it is never too soon to address the issue.
On
a trip to the US several years ago, the aircraft I was on pulled away
from the gate on time. However, within a minute, the engines suddenly
powered down. We waited almost three hours on the tarmac, in the
sweltering heat, without air conditioning, until the flight finally
took off.
The
gentleman seated next to me explained what had just occurred: the
airline staff’s bonus was based on the aircraft pulling away from
the gate on time. They were not going to forego their bonus just
because there was no available slot for taking off on the runway.
With the best of intentions, the airline had actually created an
incentive system which made passengers suffer. My point is that great
care must be taken when designing a bonus system, so as to avoid the
seemingly perverse effects that may actually destroy company value. A
well-designed bonus system, one that creates genuine motivation for
staff, is therefore a necessity for creating corporate value.
In
different organizations, it is different combinations of the board,
CEO, and senior officers who create the incentive system for all
staff of the company. Creating the right incentive system is one of
the most important functions each group fulfills. The following three
considerations must be taken into account when designing any
incentive system:
-
It must be
motivating. There is no use in trying to motivate staff with
equity if staff members have a short-term perspective, or are at a
phase in life where they need cash to start a family or buy a first
home. As the saying goes, “happiness is getting what you want, and
wanting what you get.” It is therefore crucial for anyone
designing a bonus plan to know the people involved quite well, to
know what will really motivate them. Very often it can be
non-monetary factors such as recognition or a title. In such cases,
throwing money at trying to motivate people can actually be a
complete waste. Very often, there is a conflict between designing a
system that is tailored to everyone’s individual needs, versus a
“one-size-fits-all” type of bonus system that has the advantage
of being consistent, but may not take into account the preferences
of a few individuals who are outliers.
-
Create the
appropriate alignment of interests, particularly between senior
management and shareholders. Generally speaking, equity, an option
to obtain equity, or profit share may create the right kind of
alignment. However, it is extremely important to factor in the
appropriate level of risk that may be taken by management –
witness the undue risks taken by bank certain bank CEOs leading up
to the financial crisis. Another example: if you reward someone with
a percentage of revenues, don’t be surprised if there is suddenly
pressure on margins. Are there checks and balances in the system? Is
the CEO allowed to make unfettered decisions about risk? Is the
person on a revenue-share bonus allowed to make decisions about
margins? If not, there is less of a problem.
-
Reward the types
of behaviors you wish to encourage. Is it top-line growth you
wish to encourage? Or is it frugality in terms of expenditure? Is it
the taking or avoidance of risks that you wish to encourage? Is it
team work or individual performance? Make sure that your bonus
scheme truly does create the desired behaviors, and that you are not
creating undesired side effects (like cut-throat competition amongst
your own staff) or inadvertently neglecting to encourage other
behaviors that are equally important for the success of your firm
(e.g. rewarding sales alone is unlikely to achieve the desired
effects of quality, customer satisfaction, etc.)
A
bonus system makes a statement about the values of a firm. If you try
to sell your firm or raise capital for your firm, investors will
inevitably ask about what kind of incentive systems your firm has in
place, and how well they are working. Ultimately, you need a
motivated team to build corporate value. But there is no magic
bullet, no ideal bonus system that works for all organizations. The
devil is, as so often, in the details.
