Public market companies get their knuckles rapped for sitting on their excess cash and not putting it at risk in order to grow their businesses. An MBA finance class would agree that unused capital indicates a lazy balance sheet. But does this apply to private companies too? Do they need to risk their capital too?
Here’s a quick test for you. Put yourself in the shoes of the owner of a business and assess your appetite for risk. Let’s say you are the owner of a medical device company and your management team comes to you and wants to launch a new product. Your team has done the analysis – it would cost R5 million to bring to market and the expected returns would be significantly greater.
As the owner, you know R5 million would come directly from your own pocket or your credit line at the bank and, depending on how it goes, might affect the amount of money you can take out of the business for retirement. The other option is to carry on with the normal business, which is going at a slight growth rate within a relatively stable market. Here is how you, as the owner, might weigh the risks: “Right now, I’m profitable. If all goes well, the new product will grow my R10 million company to R30 million, with a cash flow of R1 million. If it does not go well, I’m in the hole for R5 million and it will take me five years to break even and get back to where I am now. No thanks – pass!”
You can understand why so many small and middle-market companies are growing at a low rate because they believe their business is good enough. Their revenues are sustaining the owner’s lifestyle and they are a manageable size. Growth in revenue of a private company depends on the owner and their appetite for risk. In public and larger corporations, overconfidence is a natural bias in managers. In stark contrast, private companies tend to avoid risk because the money is coming directly from the owners’ own pocket.
The profit foregone by passing on the new product is not seen to be drastic – in the example above, it was under R10 million. Yet, the decisions to push back from business expansion risk are being played out across many owner-managed firms and, collectively, this has a large impact on the country’s economy.
Owners make hundreds of decisions about their risk appetite, often alone. The penalty to the business owner and their company of this low-risk versus reward bias is that the company ends up with underinvestment and it underperforms. The impact will become evident at the time of sale, with a weaker retirement fund for the business owner. In the end, their poor risk appetite will reduce their potential lifetime earnings.
A business owner interested in improving the quality of risk may want to borrow a few best practices from private equity.
First, the business owner can ask how much risk they are prepared to carry on their own. Family business owners, in particular, can be vague on this key point, and it freezes their staff and discourages them from seeking new opportunities. Key personnel may even leave the company. The business owner can draw on the expertise of a financial advisor who is an expert in risk and can work with the owner and the CFO (if there is one) to manage and reduce their risk bias. Retooling how to assess risk can help a company’s revenue increase and take pressure off the owner.
The place to begin to improve risk assessment is by size of project. Owners and their CEOs who look at the projects requiring larger investments will naturally have a bias against risk. Their job, and the company’s performance, will be impacted if the project goes badly.
In contrast, the middle level of the business will be taking smaller risk decisions, which on their own do not risk the financial health of the overall company. In fact, managers at this mid-level tend to err on the side of risk aversion too. All across the company, the growth is being held back.
The CFO and senior management can work with a financial expert to assemble an overview of the portfolio of risk decisions being proposed and made across the business. The individual small investment decisions can then be pooled and the discount rates applied will be far more realistic. For investments under 5% of capital, a discount rate can be used and management can be encouraged to work with a higher level of risk.
Business owners should have a time and place to invite senior management to put out a project idea and describe its potential returns. They should then do a Scenario B, but increase the risk of the project. If possible, one should try for three or four scenarios with different levels of risks.
Scenarios should not be an easy percentage increase, but should include additional costs, such as production, along with the increase in sales force and other costs, expected market penetration rates and brand impact.
The manager should give an analysis of the best outcome and worst flop for each scenario. By pushing for the highest potential upside, risk can be made more tangible and it becomes clearer how the project could be achieved.
In the beginning, it will be difficult, but using the scenario process to try out different levels of risk will develop the skills of the team to make for better investments in projects with higher returns. Scenario planning can be run on a regular timetable and the skill of risk analysis will be better developed at the management level.
Being the sole decision-maker, with the bulk of ownership, raises the risk profile of the business. What would happen if the owner got hit by the proverbial bus? By understanding how to spread the risk, the business will be more resilient. The family and employees might appreciate that spread of the risk!
For example, a manufacturing company’s founder and owner was happily engrossed by his business and making a great deal of money. Inspired by a speech by Apple founder Steve Jobs, his dream became to grow the company. This owner knew that he had the drive, but he worried about putting so much of his personal money at stake. He could not afford to take the risk, but nor could he go to the public markets at that stage. To help his company evolve, the owner sold 75% of the company’s shares to private equity partners. They helped build up the staff, create systems and identify acquisitions. Ironically, his 25% share ownership ended up giving him more financial return when they did sell a few years later, than if he had kept 100% to himself. How incredibly satisfying when the difficult path turns out also to be the best one!
Of course, if you’re following Jobs’ advice, you would also recall his risks versus reward for growing Apple in the early years, Jobs may have lost his spot at Apple for a decade, but he says the company made it through that period due to private equity financial partners. If Jobs had not gritted his teeth and brought in financial partners, Apple would have disappeared.
A company owner who has an advisory board or financial advisor telling them they are too risk-averse might weigh up the benefits of bringing on board a private equity partner. These financial experts know risk assessment and understand the psychology of managers and owners. Their business is to analyse the net present value of investments relative to the risk. In addition, private equity partners work within the behaviours of owners and their teams and are familiar with the capital allocation and evaluation process.
Sell full control
|Likely more silent
|Board skills and strategy
|“Heavy lifting” and active participation
|Take over and you walk away
Private equity partners will be lured to the possibility of growth. They catch a glimpse of the big fish in the dark water and appreciate the gleam of its scales; they will pick up the harpoon and take on the struggle, bleeding from holding the line, facing unbelievable adversity to bring home the fish others can only admire from the shore.
Remember that medical device company discussed at the beginning of the article? The owner decided on private equity partners and his corporate finance advisor encouraged him to fess up to the conservative nature of his personal and financial goals. “I built this business in my garage and now it has to fly without just me. Let’s get in partners and share the risk.” In the end, he got enough cash off the table to cover his retirement and compensate for the lean years. But he was still able to stay around to enjoy the new growth with the partners who gave valuable new skills, vision, contacts and patient capital through the storm.
The business owner sets the risk by the amount of shares they sell to a private equity firm, and the financial advisor is an expert on assessing the value of the sale of shares. It is vital to realise that you control the level of engagement and you have options – you can sell:
- 100% or 90% and walk away from the company. By selling 90%, you can keep shares and get some upside to the new ownership;
- 75% and keep some control, but benefit from the skills and Herculean effort put in by your new partners; or
- 30% and take on a minority shareholder — but you cannot expect these partners to be seriously hands-on for that amount, advisory at best. Realistically, private equity partners will not be motivated to do a great deal of heavy lifting for just 30% of the rewards. Private companies appreciate that the more ownership shared by the investor, the more effort they’ll make to help build revenue.
When it is the owner’s money being put at risk, usually the potential loss outweighs the potential rewards. Sole ownership results in a bias against risk, yet for the owner to retire with more wealth, risk is required. Sharing the risk – whether by growing robust risk processes and practices with a financial expert and running it with the existing management team, or bringing in private equity partners – will improve your company’s ability to grow. Sound growth is good for everyone – your former MBA finance professor would agree.
Jacoline Loewen is a director at Crosbie & Company, which focuses on succession advice for family businesses and closely held small to medium-sized enterprises. Crosbie develops customised strategies, particularly in relation to M&A, financing and corporate strategy matters. Loewen is also the author of 'Money Magnet: How to Attract Investors to Your Business'.