When love (or other major things) get in the way of your business

I know of a small entrepreneurial team who met at university, discovered they shared a passion for the tourism industry, graduated later and went to work in tourism as employees of the dominant company at the time. After a few years valuable experience they decided they could do better than the incumbent and left, joined forces and set up their company. They kept costs down for many years.

In any industry it takes time to build up trust and part of this trust is simply being around over time, so keeping costs way low meant that conservative international distributors who met them at a travel show one year, would see them still alive a year later, and would start to trust them with some business only a year or two after that. Inbound tourism has fairly low barriers to entry but long sales cycles, where products are often finalised and marketed 1-2 years in advance, so the experienced distributors know to wait it out and see which of their suppliers survive. Only then can they trust them with their business 2 years from now.

What typically happens with new entrants is that they buy expensive new vehicles in which to carry clients around Africa, and equip them well. They put fewer seats in their trucks so that customers have more comfort, but then make the mistake of pricing their trips the same as the lower cost operators in an effort to win business. The result is that each trip is marginal, if not loss making and within a year or two they are out of business and all capital is destroyed. The experienced distributors have seen this all before, so they hold back on giving business to new operators. This means that new operators must have a differentiated offering, a lot of luck, and very low costs to start with. They have to get around the 2-4 year phase of building trust with their distributors.

This is what the team I know did, almost too well. Pretty soon they had the number 1 distributor in a large foreign market signed up and were in all their brochures and getting all their local business. Then the number 2 supplier in that market approached them also wanting to sell their trips. The problem was that they couldn’t supply both. So after some thinking they set up a separate company, which they owned, and gave some equity to their chief lieutenant who was then tasked with driving the new business. Through the two businesses they could now service both distributors and grow things well. Indeed for the first year or two this is what happened.

Then the Lieutenant’s girl (whom he met on one of their trips) became his wife and this led to pressure from her for him to get his ‘fair share’ of the business. So there were lots of negotiations and eventually he was made the majority owner of the business. I asked at the time what would happen if he didn’t meet targets or how he could be replaced and they response I got was that he was fine and knew his stuff and there wasn’t any need to put these kinds of clauses into the deal. You know what is coming next of course: the Lieutenant’s wife moves back to the foreign country where she came from, pregnant, and he goes with her. Suddenly the local business is being ‘run’ from a distant foreign land from a ‘stay at home dad’ and things don’t go well.

Its been nearly a decade since this happened. The original business is now big enough that it employs nearly 100 people. The spin-off business is still only 5 people, some of whom are seasonal. The original shareholders can’t change the shareholding in the spin-off and haven’t been impressed with the returns, so they have simply stopped supplying the business with managerial expertise or further capital. They’ve considered selling it too, but it’s not easy given the low growth rate, foreign owner and other issues. So they’ve rightly focussed their efforts where they can influence returns.

When they setup the spin-off, they never planned around what could go wrong. They didn’t anticipate the people’s lives change and that someone so committed to the early success of the business could meet someone who would effectively force him to move country and neglect things to such a degree. They screwed up the legal side of things and its cost them some money, but mainly its cost them all the growth that could have been.

The lesson here is around legal homework – any shareholding-level agreement needs a lot of thought not just in terms of what each person gets, but also in terms of what happens when things go wrong. How do you revert? How do you claw back? How do you measure performance and strip away any free gifts of shares before it’s too late. Get an attorney on your side before you sign the deal.

Can your industry cluster?

One of the key concepts in strategy is that of the Industry Cluster, and the underlying economics of agglomeration. Broadly, a cluster is a geographic concentration of interconnected businesses, suppliers, and associated institutions in a particular field. In theory a business that is situated next to its suppliers and across the road from its customers benefits from dramatically reduced transport costs, and almost certainly from far more immediate sharing of information and shorter feedback cycles. The same goes for competitive businesses that are closely clustered – they share suppliers – for example several automotive manufacturers would share the same suppliers of steel, tyres, energy, labour and expertise. Clusters are a core part of industrial policy at a national level, and therefore the analysis around which to support and how to support them has made some consultants very wealthy. The success of Silicon Valley is around the clustering of venture capital and the entrepreneurs in which the capital is invested. Las Vegas is a cluster of hotels and casinos. London is a cluster of financial services. Johannesburg began as a cluster of mining related businesses situated right on top of the reef that they mined.

Done properly, clusters provide a long-term economic advantage to their members. An article in the BBC earlier this year illustrated just that: in the small town of Markneukirchen in Germany, the musical instrument making industry is 400 years old and still going strong. The story is one of survival – of how skills are passed down to the next generation who then adapt further to stay alive. The idea of an industry cluster wasn’t formalised when the makers of Violins set up their shop next to the makers of the bows needed to play them in the 1700’s, it was just the way things made sense. By the early 1900’s the town accounted for over 80% of musical instrument production around the globe. Being in the former East Germany, the town survived communism too: in fact the musical instruments were a prized source of foreign exchange for the East German government and the industry was actively supported. Today the town has over 100 different businesses all involved in making traditional musical instruments, yet using all the modern ways to connect to distant global markets.

Most of the businesses are very small, family owned workshops where skills are passed from grandfather to grandson and both tradition and quality matter. Musical instruments are increasingly mass produced or even digital. So how do the Markneukirchen manufacturers compete with low-cost competitors in China? The answer is the quality of the product and the ability to offer something that meets the exact needs of a highly trained musician playing in an orchestra somewhere. Their instruments have a reputation for durability, for consistency and this means that their customers (who are by nature self-referencing markets) are willing to pay for the quality of the European instrument rather than a cheaper Chinese generic. Their long-lasting profits mostly depend on quality – yes they use new manufacturing techniques where possible – and on selling the market that appreciates the difference they bring. They make sure that if a classical musician wants a particular part on his/her instrument, then they provide exactly that and at top quality too.

In our modern, globalised world clusters are no less relevant especially in manufacturing industries. It’s the service businesses where the walls have come down – modern information systems and telecommunications allow customer support to be outsourced to India, programming to the Ukraine, and design to California. The high quality, non-digital stuff is harder to commoditise, and here clustering may well still have major benefits.

Clustering should be something you think about in the strategy of your business, particularly those involved in manufacture or anything where transport or energy costs are significant. These costs are only going to go up in the future, and the more they do so then the more it will make sense to be very close to your suppliers or your customers, and if it makes sense for you then it will probably make sense for your competitors. Where can you cluster? Can this be a source of long-term profit for your business? How will rising energy costs affect these decisions?

What happens when you grow slower than your WACC?

The value of your business is calculated from 2 things: risk and return.

Returns can be forecast into the future – with some good modelling skills one can build a financial model that projects the likely growth of the firm into the future within ranges that are reasonably certain. My general approach to building a model is to work from the target customer first: understanding the market size, how it will be reached with what budget, then understanding actual customer behaviour in response to marketing and sales efforts. Through this we get to understand how much revenue happens when. Once you have the revenue line it’s relatively easy to work out Cost of Sales, operational expenses, profitability and then balance sheet effects – all of which distil down to the Free Cash Flow calculations a proper valuation model uses.

Risk is really the risk to the capital used by the business. In previous columns we’ve discussed the Weighted Average Cost of Capital (WACC) in some detail; the core concept is that each business has a mix of debt and equity capital that can be optimised. Equity costs more because it carries more risk; debt costs less because it’s typically secured by assets and gets paid out first if things go wrong. The trick is in reducing risk so that you can use more debt and thus reduce the overall cost of capital. The WACC is what’s used to discount the future earnings of the business to arrive at the present day valuation of the business.

How do you create long-term value? Simply put you need to grow free cash flows at a rate faster than your WACC. In other words, you need to grow returns faster than they’re discounted by the perceived risk to the capital used to create those returns.

I’ll use 2 different scenarios from our demo business on ValuationUp.com to illustrate how value is created or destroyed when free cash flows grow faster or slower than a firm’s WACC:

Run-Away Train

The first scenario is called ‘Run-away train’ and here the firms value grows from a baseline valuation of R13,7M (the red column on the left) to R38,5M (the green column on the right). To achieve this, the business must apply resources to a number of projects, each of which contributes differently to free cash flows and thus to valuation. For this business, the biggest wins come from reducing Cost of Sales, reducing Operational expenses, and in improving working capital management (which together give the business an extra R19M of valuation improvement and an extra R9M of free cash flows in year 1 alone). Contrast this to sales (the gold-coloured blocks in the graph), where growing the business at a steadily ambitious rate of 10% a year raises its value by only R6M with an almost negligible increase in free cash flows in year 1.

Slow coach

In the second scenario “Slow coach”, all variables are exactly the same except sales growth, which is set at 5% for all 5 years rather than the 10% used in the ‘Run-away train’ scenario above. It’s lower than the initial 8.2% used in the baseline valuation calculations, so sales achieving sales of only 5% immediately causes a drop in valuation by nearly R5M in year 1, and slower than forecast growth reduces the company valuation by a further R1.2M over the next 5 years.

The effect of this lower sales growth is that free cash flows in years 2-5 grow lower than the risk to the capital used to generate them (the WACC for this business is 18% in all scenarios). When your free cash flow growth rate (not the revenue growth rate) is lower than the Weighted Average Cost of Capital then value is destroyed over time, which is exactly what is shown the graph of the “Slow coach” scenario.

This difference between these scenarios is R12M of valuation – all of which comes down to whether the firm can grow at 10% or only 5%. The other R19M of valuation improvement comes entirely from operational measures that are far more controllable for most firms, and thus make a better bet as to where to focus efforts when growing the business.

Uncertainty and risk

Risk is a core part of any business, and understanding the risk associated with uncertain future returns is at the core of Valuation. As a result, we spend a lot of time trying to reduce uncertainty, which has two problems: firstly we don’t understand uncertainty very well and secondly, profitable opportunities only exist where returns are genuinely uncertain.

There are two different kinds of uncertainty: Risk is where we know the potential outcomes in advance, and even maybe their probability. Think of rolling a dice: we know the range of potential outcome in advance, as we do their probability. Genuine uncertainty is different and occurs when complex systems interact over time: we know neither the possible outcomes of their probabilities in advance. The Geo-political economy is an example.

In his seminal work on the topic, Frank Knight wrote (in his 1921 book “Risk, Uncertainty and Profit) that real opportunities for profit exist on in the face of real uncertainty. In other words, if you want to make a profit you must not just deal with uncertainty, you actually have to seek it out.

The problem is that we act like everything is just a risk: In other words, when we use our opinions to estimate the probability of something, we treat this opinion as if it’s a real probability. We give mathematical weight to our subjective opinions, to our gut feel, and we treat anything uncertain as a risk where assume we understand the possible outcomes and their probabilities.

The alternative, where we act like everything is unknowable, is also fraught with problems. We live in a world of denial, of a self-image far better than it really is. When the occasionally some event is strong enough to break through our mental image and force us to face facts, the façade is revealed the world is terrifying…and seems too uncertain to act with conviction. So it’s back to our happy mental model where we treat everything as a risk.

So how to deal with uncertainty?

  1. Aggregate: we have insurance because it’s possible that our house will burn down. Insurance works because when you add up individual cases of uncertainty you get a probability. From an innovation perspective that means that you have to have many ideas to have a good chance of having one really great one. Volume reduces uncertainty, and this is what VC firms do when they invest in a lot of smaller deals (such as the Y Combinator or 500 Startups models).
  2. Seek out uncertainty to hit it big: innovation is good bet – while the average innovation makes only a small return, a small number of these innovations produce returns that are orders of magnitude different. This means that we need to treat innovation like a portfolio – we should innovate widely and cheaply, then throw our weight behind the ones that show real promise.

The better VCs use both of these models: they are risk averse (ask any entrepreneur whose pitch has been rejected), but the better ones actively seek out uncertainty.

So how do we measure uncertainty? Through waste: As William Janeway writes in his book Doing Capitalism in the Innovation Economy:

“Schumpeter’s process of creative destruction can only proceed by trial and error. We see that which is created through the lens of survivors’ bias and ignore the “hopeful monsters” that economic evolution has spawned and left behind in metaphorical emulation of Darwin’s process of natural selection. No doubt every one of them was launched on the basis of an exercise in forecasting future revenues, costs and an expected value to be compared with a rough estimate of the cost of capital. As Schumpeter well knew, the wastage is the measure of the inescapable uncertainty that attends the practice of doing capitalism: We need only visualize the situation of a man who would … consider the possibility of setting up a new plant for the production of cheap airplanes which would pay only if all people who drove motorcars could be induced to fly. The major elements in such an undertaking simply cannot be known … Neither error nor risk expresses adequately what we mean.”

So here is my challenge to big corporate innovation departments, to university IP commercialisation efforts, to the venture capital community, bankers and entrepreneurs: what are you doing to minimise risk but seek out uncertainty? How wasteful are you? As an economy are we wasteful enough, or are we a socialist state?