How Much Should you Risk for Growth?

Contributed by Robert Sher

 

At one of many Alliance of Chief Executives meetings I participated in recently, I watched one member present his thinking on some significant but risky growth strategies. His $300M+ revenue company is a cash-machine with strong and accelerating profitability, mid-teens annual revenue growth and a dominant market share.  The risky strategies he proposed were designed to propel even faster growth. I had to wonder how much risk he should take on for the sake of faster growth.  How will he know (in advance) the level of risk he’s undertaking?

It’s tempting for mid-market executives to believe that the only time their companies could face a liquidity crisis is when revenue is dropping off a cliff. On the contrary: mid-sized firms striving for growth are just as susceptible to becoming cash-dry, perhaps even more so. Simply put, they can spend too much too fast, or spend too little too late. It’s like the driver who braves oncoming traffic to pass in the passing lane—misjudging speed, distance and timing can be deadly.

Unless management can incisively gauge the speed with which their expenses and revenues are likely to grow, mid-market companies with robust growth face the prospect of running out of money and all its ugly consequences – e.g., shelving new product development or cutting the sales force. Indeed, those moves will save cash. But they will also erode revenue over time, extending the cash drought. I’ll talk about how Alliance member Rick Martig, then CFO of data storage company BlueArc avoided falling into this cash black hole.

The dilemma is real and broad-based. A clear majority of the U.S. mid-market companies surveyed in the fourth quarter of 2012 (released January 23rd 2013) by Ohio State University and GE Capital were highly concerned about costs. (OSU and GE Capital say the companies, which range in revenue from $10 million to $1 billion, are representative of the 195,000 mid-market companies in the U.S.) When asked about their key challenges, 90% pointed to the cost of health care; 85% worried about the overall cost of doing business and 85% complained about their ability to maintain margins.  Hanging onto cash is critical for mid-market companies.  Driving the top line upward to offset expenses isn’t an easy option either, with 86% of surveyed mid-market companies having concerns about their ability to grow revenues.

Examples abound of mid-market companies that couldn’t or didn’t adjust the velocity of their spending in a timely fashion.  When a giftware company merged with another, company leaders were optimistic about the opportunities for growth as a larger player. But they greatly underestimated the cost and time of integration. While expenses mounted, integration hiccups angered customers and hurt sales. Undercut by growing customer defections and a deep industry downturn, the giftware company’s revenue plunged 40% in one year. The business was operated at a loss for more than a year since they were ever hopeful that a higher top line was just around the corner. But the crumbling balance sheet grew less and less able to support its burgeoning debt. Last-ditch spending reductions cut to the bone, delaying production and subsequent billings. The downward spiral continues to this day.

CEOs and the boards of mid-market companies deal with negative cash flow from operations in numerous ways. Those with everything at stake act to defend what they have and become intensely frugal. By curbing investments in new products, marketing, sales and technology, they let cash-rich competitors gain market share and often never catch up. The business shrinks and delivers less cash to its owners over time. More aggressive CEOs try to spend their way out of the problem with the conviction that cash inflow will increase. But in all cases, they know they are making a critical judgment call, and most lose a lot of sleep over the decision.

From our research and consulting experience, we have found three elements of sound decision making when cash flow goes negative. Getting to the heart of these issues increases the odds of achieving positive cash flow:

  1. Market predictability. Will sufficient market demand exist for your product when you need it?
  2. Execution confidence. Will your team be able to build the product or capture the sales at the level you require when you need it?
  3. Forecasting acumen. Are the pro-forma financial statements comprehensive and accurate? If the market is there and the team executes, will the financial reality match the pro-forma?

Assuming excellent forecasting acumen (a big assumption), spending velocity should be determined as follows:
Growth-Risk

If only it were as easy as this chart makes it look! Most CEOs believe in their vision and mission—too much so. They believe the market is more predictable than it turns out to be.  They have false confidence in their team’s ability to execute.  So many surprises pop up that weren’t accounted for in the pro-forma.

Making a Sober Assessment of Demand

To assess market demand, the CEO and his top team must get out of the office and into the marketplace. Trade shows and industry association meetings are excellent venues for meeting other business people and asking their opinions. Customer visits are also invaluable. With your customers’ permission, you should record their responses to a standard set of questions (asked conversationally) and then look for patterns. For more ideas on this, read the article “Get Out!

You can gain further insights on the status of your marketplace by tracking competitors and measuring objective indicators of their success. For those industries large enough to be followed by research firms (like Gartner in the IT industry), plenty of secondary data is available. Regular meetings with investment bankers who study your industry will yield more pieces of information. New data trumps old data; what you learned last year may not be relevant today.

But investigating the marketplace is not just the job of the CEO. Every member of the top team and sales department must collect this type of data. The CFO in particular should be involved since he will be the ultimate architect of the pro-forma financial forecast. Letting the management team – not just the CEO and CFO – gather and jointly discuss this market data will greatly reduce the chances of acting on biases and pre-dispositions.

I put far more trust in executives who have a stake in a business than in those who have only their job at stake. Venture capital firms often insist that all top management executives have stock or stock options. They have so much more to lose if they’re under- or over-aggressive. But mid-market companies are established enterprises, not startups, and so distributing equity is a little trickier. I’m not suggesting changing ownership in the short term. But as your executives weigh in about the state of your marketplace and the company’s ability to compete in it, you must carefully consider the source. Those with real skin in the game are much more likely to strive for the truth.

These dynamics helped the company I mentioned at the beginning of the article – BlueArc, a venture-backed data storage manufacturer – build cash despite having to make huge, risky investments. In 2008, BlueArc’s chief financial officer, Rick Martig, saw a worrisome trend: negative cash flow from operations and the macro environment started to decline by the end of calendar 2008. From getting out into its fast-changing marketplace, Martig and other BlueArc executives realized they had to add a mid-range product to complement their high performance product portfolio.  However, this required continued investment in product development and thus significant investment in R&D when cash from operations was not improving.  Based on the information they received from customers and market experts they knew this was vital for the continued growth of their company in midst of declining economy and cash flow.

Several larger competitors had started down the initial public offering path (before being snapped up pre-IPO by Dell, EMC and HP), so their financial and operating results suddenly became visible and were critical to proving that sales growth and market expansion via a mid range product was a way to expand their market. On the strength of all the research from Rick and the senior team  Rick initially raised $7 million in venture debt to bridge the company to complete the R&D work to complete the mid range product and introduce it in the market.  The senior team knew they needed longer term cash to continue investing in the business which the team did raise another $21 million in subsequent years prior to the acquisition. The new mid range product became a major market success, which enabled BlueArc to hit its targets and contributed to getting the company to EBITDA break-even a year and a half after market introduction. As the company prepared for its own IPO in 2011 (by that time, BlueArc’s revenue was $85 million, according to its stock prospectus), it was acquired by Hitachi Data Systems at excellent multiples of both revenue and earnings. The BlueArc team knew it was critical during a tough market and cash times to find resources in any way possible to invest where they thought the product would be successful and help the company grow in future years.

I doubt that this is your first time trying to assess your marketplace. But have you been caught by surprises where sales spiked up or down without a clear reason? Have you introduced new products or run promotional campaigns and received a very different result than you expected? Your past market assessment accuracy is a strong indicator of future accuracy.

Following the process suggested above takes time and resources. Some owners and CEOs of mid-market companies have a level of hubris that leaves them feeling invincible. Some of their sales leaders are very aggressive—cowboy style—and don’t have the patience for it.

But the key to not running out of cash in good times or bad is making a market assessment an ongoing process. Once it is part of your company’s DNA, all your forecasts and decisions will be far better informed.

I wish I could tell you that all markets are predictable. But they are not. You may have a gut feeling about the marketplace and you might be right. But your risk of failure is high, and it could well take you two or three adjustments to get it right. Reserving enough cash to finance several attempts to bring in new revenues is the best approach.

Step one in gauging how much cash should go out the door is getting clear on the predictability of your market.

 Calculating the Odds of Successful Execution

How likely is it that your team will ascend the learning curve and deliver the expected results on time?  Examine our Optimal Spending Velocity illustration.   You’ll see that low execution confidence – even in a highly predictable market – warrants proceeding slowly and keeping extra financial reserves on hand.

Too often, we accept false confidence from our executive team.  Just like the football squad in the locker room, the adrenaline-fueled excitement of the project whips up a lather of bravado in our team and they exude confidence.  In the face of such passion, we get carried away and our businesses spend more than they should.

To calculate your execution odds objectively, consider these five critical pillars of execution success:

  1. A proven team.  The ultimate proven team has worked together before and recently succeeded on similar projects.  With both the learning curve and team-bonding risks out of the way, such a team can focus single-mindedly on the task at hand.  For example, one management team in the aviation industry became redundant because of an acquisition; the entire team joined an industry startup.  On the other hand, a team whose individuals don’t have specific work experience relevant to the function they will be playing (even if they are quick and intelligent) cannot be considered proven.  Likewise, if the collection of individuals has not worked together before, there is increased risk that the team will not gel.
  2. A realistic budget.  While it is true that there are successes on a shoestring budget, more often than not underfunded efforts fail.  Salaries are too low to attract top talent.  The vendors selected are lower priced and lower quality. High quality partners, if they are enticed to participate, give lower priority to the project because of pricing concessions.  In the rush for expediency, we take short cuts like sacrificing testing time or product quality.
  3. Strong vendors/partners.  It is popular to outsource the aspects of a project that lie beyond our core competency.  Yet with the benefits, like less overhead and sharper focus, come the risks that your partners won’t perform well.  They often don’t.  The ideal vendor/partner should need your project to succeed as much as you do, so they’ll fight through obstacles and strive to keep you happy.  Ideally, they’ll have executed successfully in many similar projects and be financially and technically strong.  Read an excellent case study on partnering best practices here.
  4. Tested, proven processes.  Assumptions are the enemy of good execution, and testing is your secret weapon.  Kicking off a project that will devour significant budget without establishing at least small scale testing is risky.  At the very least, test the sales process with one or two people, even on a part time basis.  Perform small scale testing in a development environment and project management processes.  Draft several training protocols and test them on a few people.
  5. Technical risk low.  Technology can be a great barrier to throw in front of competitors, assuming that we have surmounted the same barrier ourselves.  It is easy to say, “We’ll figure it out—it’s easy”, but actually delivering on a technological breakthrough is seldom easy.  Executive leadership must listen carefully to the concerns and opinions of those performing the technical work.  CEOs with too strong a mindset can stifle truth from bubbling up; trust your technical experts to identify obstacles. Strong technical oversight is required to confirm the level of risk.  Ultimately, testing is your final proof.  Read this case study about how poorly assessing technical risk cost one company millions of dollars and months of delay.

This specific case, the failed installation of a warehouse automation system by a $50M revenue clothing distributor, illustrates a number of these five critical pillars of execution success.  An executive with no systems integration experience took charge of installing the system, with the help of the firm’s in house programmer (an un-proven team).  They didn’t want to spend money on outside experts:  the firm was tight on cash, having just acquired another firm and bought a new building for their headquarters (insufficient budget).  They decided not to run parallel systems since they were making the change just in time for the peak season (unproven, unwise processes).  Not surprisingly, the cutover was a month late and still failed, triggering massive shipping delays, a pile-up of excess inventory, a list of angry customers who refused to pay, millions of dollar in losses and a full-blown liquidity crisis.  The firm barely survived.

Forecasting Acumen

It is not enough to have a great team who can get the job done, and a marketplace ready to buy.  We must predict the future with enough specificity to plan in detail, so we have what we need, when we need it.  It isn’t safe to spend on plan, if the plan is flawed to begin with.

Forecasting is difficult.  Most of the time, projects take longer than planned, cost more than expected and are full of surprises.  That’s bad forecasting.  Even if the project exceeds forecast and sales are higher than planned, unplanned success brings its own set of problems, like working capital stress, materials shortages and a poor customer experience.

Effective forecasting also provides the opportunity to strike bargains with the external parties we will need for success.  That includes investors, public markets, suppliers, contract manufacturers and others.  If we want to gain their trust and access their resources the next time we come to the table, we must deliver on our promises this time—and hit our targets on plan.

If we are likely to miss our forecast, we must reserve more cash to handle the surprises, or perhaps even to make a second try for success.  So what are the best predictors of forecasting acumen?

 Past forecasting performance of the company

If a company has previously been successful in forecasting, there is a strong likelihood they’ve acquired that competency.  It matters that most of the same people are on board.  Also look to the kind of forecasts they succeeded in making.  Forecasts for a line extension or new service line can be difficult, but they’re not nearly as complex as a large acquisition, or developing a new business unit in a nearby adjacency. If the past forecasting performance of the company is poor, look out!

 Past forecasting performance of the CFO

While many people will provide input to your forecast, there is one person—often the CFO in a mid-market company—who drives the forecast.  That person’s track record is crucial.  Only through much experience can a forecaster learn where slippage usually occurs.  They know where the surprises often lurk.  Additionally and most critically, they learn to include the costs and items which inevitably make an impact on the forecast, but are usually overlooked.
Creating the forecast is only the first step.  Staying on forecast requires an active financial manager, who not only monitors what has happened, but projects what is going to happen—or fail to happen—in the immediate future.  Having such a CFO on board (or acquiring one) significantly increases your accuracy of forecasting, provided this person is not overruled too often, or sidelined.

Past commitment to hitting forecasts by the CEO

Companies often miss forecasts because the CEO drives off “the reservation”.  He or she may decide that priorities have shifted and want to pursue another direction, or may panic and start to look for other solutions.  In some cases, the CEO just does not like the discipline of sticking to plan.
It is true that circumstances sometimes call for a change.  Yet this implies that the management team was unable to foresee the situation when the forecast was originally created, a failure just as bad as undisciplined spending or insufficient sales. The CEO can singlehandedly cause the company to miss its forecast.  Looking at his or her past behavior is critical to any assessment of probability for hitting the next forecast.

 Number and clarity of fallback plans

It is naive to think that the path to hitting a forecast is a straight line.  Management must usually make significant adjustments along the way.  In a mid-market firm, those adjustments must come early, before too much damage (over-spending, missing critical timing windows) can be done.  Good forecasters identify the areas of risk up front, building in triggers that spur implementation of backup plans to keep on target.  The presence of triggers—in writing—and the visibility of those triggers increase the likelihood of staying on forecast.
In the case of Alliance Member Rick Martig, then CFO of BlueArc, a manufacturer of hard drives, the firm was just coming off a poor quarter during the 2008 and 2009 financial crisis.  The team knew they needed to make some tough decisions and cuts to the organization.  In doing so, they focused on preserving a key focus in developing their next generation product but had to make cuts in sales and other teams.  They built a longer term plan around preserving cash, focusing on delivering the next generation product and then adding more sales people as things improved in the macro environment.  The plan was a long term business plan that drove the organization to certain metrics and profitability was critical to enable a possible exit in the public market.  As it turned out, sales delivered, and the firm was ultimately sold at very competitive multiples to Hitatchi Data Systems.
The likelihood of distasteful consequences if management misses its forecast
The stock market punishes public companies immediately if they fail to meet their forecasts.  As a result, they are more likely to pour time and effort into setting realistic benchmarks and fighting hard to achieve them.  Yet in many private companies, missed forecasts are met with shoulder shrugs.  There are no consequences for poor forecasters.

In fact, there is often more pressure to agree to an overly optimistic forecast than there is to achieving the forecast.  This is a mistake of great consequence.  Pressure to perform is a critical factor in all business operations.  Identifying missed forecasts as failures and delineating serious consequences for those failures increase your likelihood of hitting forecast.

If we have confidence in our forecast, we can spend more aggressively.  If we do not, we must hold more cash in reserve, to allow us to recover from surprises or potentially to try again.

Determination of optimal spending velocity stems from understanding the level of market predictability, the proven ability of your team to execute, and the likely accuracy of your forecast.

Spending too much too fast can leave a company at a dead end—with no money to shoot for success a second time, and owning a track record that won’t impress any new money sources.  On the other hand, spending too cautiously when a strong team sees a strong opportunity often results in the loss of that opportunity to competitors.

Before you lay down a significant bet, spend time and effort on assessing market predictability, execution competency and your team’s forecasting acumen.  Then make the decision about your spending velocity and the level of risk that is prudent.

Robert Sher is the founding Principal of CEO to CEO and has been a Member & Director of the Alliance of Chief Executives since 1996.  You can find them at: www.allianceofceos.com.
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