If you are a business owner, you may be thinking that diversification is not a good thing. You are, indeed, focused on the one basket represented by your investment in your business. And indeed, you should be focused on that basket. You are “concentrating to create” wealth. But you may also need to begin to “diversify to protect” your wealth.
You may be thinking that your investment in your business has achieved better returns than any other investment available to you, so why shouldn’t you keep everything in that basket? After all, it has worked so far. Just remember this: If you wait until it is too late to diversify, it will be too late.
Concentrations Can be Risky and Value-Destroying
Why do I preach the benefits of diversification of private company wealth? In more than 30 years of working with business owners I have seen many bad things happen to otherwise good companies that had high or extreme concentrations of something. Those concentrations led to a variety of disasters, including:
- Key customer loss. A substantial business lost its dominant customer and was forced to liquidate. This business did not have a “diversified portfolio” of customers and the loss of one was sufficient to force it out of business.
- Key supplier loss. Another business purchased 80% of its products from a single supplier. When the supplier was purchased by a competitor, its supply chain was terminated. The company barely survived and it was never able to achieve even a fraction of its former sales and earnings.
- Key owner/manager loss. A business owner was key in all decision-making for his business. He trained no one and allowed no one to assume any real authority. Although the business was of substantial size, it rapidly deteriorated in sales, earnings and value in the months following his unexpected death.
- Key product is outdated. Another business had a dominant, single product that is analog in nature. As technology advanced, this business never invested in newer product lines. It now sells its single line of products to diminishing markets in the third world and is on a slow and painful decline that will likely never be reversed.
- Key employee loss. A company had a salesperson who was, directly or indirectly responsible for more than 40% of its sales. The owners never tied this salesman to the company, either by contract or by making him an owner. They were shocked when he finally left them, set up a competing business in the same city. He took several of the other salespersons with him along with 75% of their business.
This list (without details of the examples) sounds innocuous enough. However, the event at each company was far from innocuous when it happened. They were company-threatening, wealth-destroying, anxiety-provoking, and otherwise devastating for the owners and managers of the businesses. Bad things do happen to good companies.
A Quick Valuation Aside
Just a quick aside to talk about the business valuation impacts of the things above. The value of a business is a function of its expected future cash flows (earnings), the expected growth of those cash flows, and the risks associated with achieving the future cash flows. Using what is called the discounted cash flow model (“DCF”), we project expected future cash flows into the future and then, discount them to the present at an appropriate (risk-adjusted) discount rate.
The DCF model can be summarized by a single equation that will help illustrate why I’m concerned, not only with diversifying customer and other concentrations, but also in encouraging business owners to be in a process of diversifying wealth along the way. The equation is:
Assume we have two companies that are alike in all respects such as revenues, margins, cash flow and everything else – except… One company has 50 customers with no single customer providing more than 5% of revenues. The other has 100 customers, but one customer provides about 60% of its sales.
In this example, the R, or discount rate for the second company would be higher than for the first. It is riskier and buyers and appraisers recognize this. Therefore, even with all other things being equal except for customer concentration, the second company will be worth less than, likely a good bit less than, the first. R is in the denominator of the bottom equation above, so the math illustrates the common sense. If R, or risk, increases with other things remaining the same, V, or Value, will decline.
In essence, investors do a form of anticipation of the bad things that can happen to good companies when they assess the potential impact of customer concentrations, supplier concentrations, and other risks in their determinations of offering prices. Business appraisers do the same thing in the process of valuing businesses.
As we develop the concept of The One Percent Solution, I’ll be advocating working on your business over time while beginning a disciplined process of wealth diversification outside the business. If, for example, you know you have a concentration risk that is currently having a dampening impact on your company’s value, you can increase its value by working to reduce that concentration over time.
Regulatory and Accounting Changes
Customer and other concentrations aside, other things can change adversely. But good things can happen as well. The following example is but one of them. As you will see, it is somewhat personal in nature.
President George Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 in early 2001. One of the features of this act was the so-called “repeal” of the estate tax. The act had adverse consequences for any companies or service providers who were involved with assisting business owners and other clients with gift and estate tax planning. Sounds innocuous enough, but change can get personal.
With the stroke of President Bush’s pen, about 50% of nearly 50% of the revenue of my company, Mercer Capital, disappeared, and almost instantly. That was almost 25%! Not fun at all, and bad news. Our earnings and value took a hit in 2001, as did those of many other business appraisal firms.
Fortunately, another change was underway, which brought good news. During 2000 and 2001, the FASB was publicly in the process of issuing a statement to supersede Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long Lived Assets to Be Disposed of. Whew!
Statement No. 144, Accounting for the Impairment or Disposal of Long Lived Assets was in process and was finalized in August 2001. It was effective for companies filing financial statements after December 15, 2001, with some companies electing early adoption. Statement 144 required that goodwill on companies’ balance sheets be “tested” for impairment, which basically created a new valuation requirement, much of which was likely to be performed by independent firms like Mercer Capital.
While still reeling from the regulatory change and its impact on our company, we did respond, and almost instantly, to counter the adverse change. Our younger leaders identified revenue replacement potential in the then-emerging financial statement reporting business, which was a direct result of the issuance of Statement No. 144.
They conceived the idea of writing a book, Valuation for Impairment Testing, that went from thought to publication in 75 days. Fear of loss can be a strong motivator. We shipped it by FedEx to 2,500 accounting firm partners and CFOs of companies in perhaps ten states and we were instantly in the financial statement reporting valuation business – and still are. Aggressive action on their part helped mitigate a good bit of the revenue loss from gift and estate tax planning, and we ultimately had a decent and profitable year in 2001. Our financial statements, however, like the stories above, did not convey the angst of dealing with that year.
Good things can happen from bad things. The young leaders who stepped up then are now the senior management of our firm. However, as the stories above illustrate, the outcomes from the adverse impact of concentrations are not always so favorable. We were lucky. We no longer have so much concentration in any line of business – and certainly no concentrations of clients. We learned our lesson.
I could go on, but I think you get the picture.
You may be thinking that nothing like the above could happen to your company. Think some more. Bad things happen to good people and bad things happen to good companies.
When (or if) that time comes for your business, you will want to have sufficient assets set aside so that you can live comfortably and independently of your business. I said earlier, when it is too late to diversify, it is too late.
What I can tell you is that a time of reversal in your business is not a good time to attempt to sell. Selling following adverse events or amidst adverse trends puts you in the position of what I call “Yes, but…” selling.
Question: “Didn’t you just lose your largest customer?”
- Answer: “Yes, but you can find another…”
Question: “So, your best salesman just left and took twenty percent of your business?”
- Answer: “Yes, but we’ll get that customer back and more…”
Question: Your margins have been declining for the last three years?
- Answer: “Yes, but I’m sure you can turn them around…”
You get this picture, as well.
As we saw in the Ownership Transfer Matrix in my previous post, you will sell your business – it is just a matter of when and how. You will do so in whole or in part, and either voluntarily or involuntarily. So a major focus of this blog is to encourage you to take voluntary action under favorable terms and with timing of your choosing. Again, bad things do happen to good companies.
When you do sell, you want to be sure you have sufficient assets to provide the lifestyle and legacy that you intend for your family, for charity, or for other purposes you deem important.
The only way to be sure that this will happen is to plan for the important transitions in business and in life and to manage your wealth so that it will be available when you need it.
Please do call me (901-685-2120) or email me if you would like to discuss any of the concepts of this blog, as they relate to your business, in confidence.
What stories can you share of bad things that have happened to good companies? Disguised, of course unless the example is public. If appropriate, I’ll share them with our readers at an appropriate time. Comment below or share with me by email. We all need reminders.