Having spent a lot of time in this column looking at how to value and increase the valuation of your business, it’s time to look at how things can and do go wrong. In our current turbulent and uncertain times a global recession is only one creditor nation default or central-banker decision away, and the impact of increasing energy costs will also strip most economies of part of their real growth for the next 2 decades too. So this stuff is very real and very important. Let’s get stuck in:
The official definition of a recession is “two consecutive quarters of negative growth in GDP”. What is really means is a slump in consumer demand leading to slowdown of the manufacturing sector and a loss of jobs in manufacturing and distribution industries. Since consumer demand typically powers about 60% of the economy, the effects are widespread. If the recession is global, then a drop in consumer demand and real income around the globe will ultimately affect the demand for base minerals sourced from our country and with it mines are closed and more jobs lost.
So how does it affect the typical entrepreneur? To answer that question I’ll start with exploring how a recession impacts large businesses:
Take a large manufacturing company in the early stages of a recession. Demand falls and as it does so, revenues and profits decline. Stock may pile up until production is cut back to meet actual demand, which means that working capital sits idle in the stockpile and the firm has less cash to run on. In order to keep expenses down the manufacturer will respond with a hiring freeze, or even laying-off part of its workforce. They will also cut back on R&D, and cancel orders for new equipment. They’ll most likely reduce expenditure on marketing and advertising too. Each of these cuts has roll-on effects to the people and companies that would normally supply them to the firm. As the recession continues investors will be disappointed with performance and may force management changes and/or sell the share. The firm may seek to change suppliers at this point – for example they may fire their advertising agency or shift other production to lower-cost suppliers. Tensions with labour will increase as the firm struggles to increase productivity by doing more with fewer people. Wages for those who still have jobs might be reduced. Expensive ‘managerial’ staff will face certain cuts. On the capital market side, the firm will find it harder to raise money on the public markets and the cost of debt would also have risen as banks scramble to protect themselves against increased lending risk. It’s valuation will go down, possibly even to the point that debt may be restructured or else the firm will be placed into business rescue or even liquidation.
Quality of production will almost certainly suffer; for example an airline might put in more rows of seats yet drop the number of flights on a route. It may also cut back on maintenance costs – with an increase in mechanically related delays and even catastrophic failure. A recent example of this is the airline 1Time, which had several maintenance related issues before their liquidation. (Having seen this pattern before, I’d regard maintenance-related issues as a clear sell-signal for anyone holding the shares in that airline). Other companies may reduce the quality of ingredients, changing the flavour of their product and potentially driving away consumers who don’t like the change.
The drop in advertising means that not only is the agency under threat, but that media spend is reduced and suddenly there are newspapers, magazines and web-sites that can no longer stay in business. Consumer confidence drops and the recession spreads further.
How does this affect the smaller business?
Almost all of what happens to the bigger firms also happens to the smaller ones. However with smaller reserves and possible dependence on fewer customers and suppliers for their business, the smaller firm is more at risk. Without substantial capital assets to be used for collateral, the smaller firm will struggle to raise the money it may need to survive. Bankruptcy rates are higher for smaller firms than large ones during hard times – one of the reasons why smaller firms carry more risk and thus have higher costs of capital than large ones.
The trick is in being prepared: having multiple sources of supply and multiple customers, so that the loss of one doesn’t kill the business. Most SMBs fail here with a huge concentration of risk. A well run SMB will be managing working capital tightly and will quickly respond when hard times loom. When buying a business think carefully through what the impact of a recession on it would be: most of the factors that come into play would be outside of your control for the first year, and as such you should think carefully about how to structure a deal so that the seller carries this risk.
The silver lining:
Lastly, recessions don’t last forever and although the entrepreneurial spirit can take a beating the growth opportunities for those who survive the recession can be immense. If your competitor is struggling there is a good chance you can win theirs customers over to you and win through market consolidation. There is also ample research to suggest that businesses founded during a recession do better than those founded during boom times. If you can sail your ship in rough waters, you can certainly sail in smooth.