By: Jacoline Loewen, EMDA Director, Director of Crosbie & Company Inc.
Public market companies had their knuckles rapped by Mark Carney 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?
Risk and the Private Business
Here’s a quick test for you. Put yourself in the shoes of an 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 and it would cost $5M to bring to market, and the expected returns would be significantly greater.
As the owner, you know that $5M will come directly from your own pocket or your credit line at the bank, and depending on how it goes, might even 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 $10M company to $30M, with a cash flow of $1M. If it does not go well, I’m in the hole for $5M and it will take me five years to break even and get back to where I am now.”
No thanks - Pass!
A Bias Against Risk
You can understand why so many SMEs are growing at a low rate because they believe their business is “good enough”. Their revenues are fulfilling the owner’s lifestyle and they are a manageable size. Growth in revenues 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 comparison, private
companies’ lack of risk is more prevalent 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 $10M. Yet, these decisions to push back from business expansion risk are being played out across many owner managed firms in Canada and collectively this has a larger impact on the economy.
Owners make hundreds of these decisions about their risk appetite, often alone. The penalty to the business owner and their company with this low risk vs. reward bias is that the company ends up with underinvestment and fails to achieve financial performance. 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.
Build a Company Approach to Risk
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 team and discourages them from seeking new opportunities. Key personnel may even leave the company. The business owner can draw on the expertise of an Exempt Market Dealer (EMD) 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 revenues increase and take pressure off the owner.
Size of Investment
The first 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 awry.
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 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.
Portfolio of Risk
The company CFO and senior management can work with an EMD 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 lower discount rate can be used and management can be confidently encouraged to work with a higher level of risk.
Sensible Appetite for Risk
The EMD can assess what causes bias and will look at how the company weeds out good projects from too risky ones. They will assess if the incentive program rewards the people within the business for the right decisions. The right EMD is a valuable resource in risk management for the ambitious owner, and of course can be a valuable partner in raising the capital needed to support taking those wise risks.
Set a Process for Risk
Have a time and place to invite senior management to put up a project idea and ask them to describe the project and potential returns. Then get them to do a Scenario B but increase the risk of the project. If possible, try for three or four scenarios with different risks.
Scenarios should not be an easy percentage increase, but should include additional costs such as production
along with sales force considerations, expected market penetration rates and brand impact. Have the manager 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 achievable. The process will develop the skills of the team to make better investments in projects with higher returns. Scenario planning risk analysis will be more developed at the management level.
The Risk of Sole Ownership
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 owner, and his/her business would not need to die too. The family and employees might appreciate that spread of the risk!
A manufacturing company’s CEO 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 more. This CEO 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 CEO 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 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 Steve Jobs’ advice you also recall his risks vs.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 the private equity financial partners in place.
Private Equity Reduces Risk
For the company owner who has an advisory board or their EMD advising them they are too risk averse, they 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 analyze the net present value of investments relative to the risk, but in addition, private equity works within the behaviors of owners and their teams and are familiar with the capital-allocation and evaluation process.
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 shoreline.
Remember that medical device company discussed at the beginning of the article? They decided on private equity partners and his EMD 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 all the hungry years. But he was still able to stay around to enjoy the new growth with the partners who brought valuable new skills—vision, contacts, and patient capital through the storm.
Decrease Ownership But Gain Growth
The business owner sets the risk by the amount of shares they sell to a private equity firm and the EMD is an expert on assessing the value of the sale of shares. It is vital to realize 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.
• 30% and take on a minority shareholder—but you cannot expect these partners to be seriously hands-on
for that amount, advisory at best.
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 is shared by the investor, the more effort they’ll make to help build revenues.
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, the winners have shown that risk is required.
Sharing the risk, whether by growing robust risk processes and practices with an EMD and running it with the existing management team, or bringing in private equity partners, both will improve your company’s ability to grow.
Sound growth is good for everyone - even Mark Carney would agree.
Published in the Exempt Market Dealers's magazine
Jacoline Loewen
Director, Crosbie
416 362 1709
