Talking Points

Getting The Finance Team Right

Privcap recently released a video of private equity professionals discussing the importance of having good finance talent within portfolio companies. You can see the video here. We have previously talked about the importance of financial reporting, but Privcap makes a good point about the importance of having finance talent. For most private equity firms financial information is the lifeblood of the business. At Hadley Capital, our first choice would be to retain the existing controller of CFO. Our evaluation process typically works something like this:

1) Working with the controller during due diligence and closing.

During this time we get a pretty good understanding of how the company currently is managing its finances. We see their monthly reports including – income statement, balance sheet, accounts receivable aging report, accounts payable aging report, and pipeline reports. At this stage, we are evaluating how accurate the reporting is, what information the controller is tracking and what kind of ability the company has to create useful financial reports.

2) Working with the controller post closing.

Post closing the monthly financial reporting requirements typically change for the controller in a couple ways. First, financials are typically required within 30 days of month end. Previously the company may have been more lax on the timeliness of reporting. Now not only Hadley Capital, but also the lenders require the financial information on time. Second, the controller will also often have to provide new financial reporting. For example, quarterly financial covenant calculations will likely be part of the new financing agreement. We work directly with our controllers during this time to make sure they understand what kind of information we need and why we need it.

Usually within 90 days of closing we have a pretty good feel for the capability of the controller. In many cases the controller has the necessary skills to take on the additional financial requirements. If not, we will either a) work with the controller to acquire new skills or b) make the necessary change to find a new controller.

Getting the finance team right is an important first step in professionalizing a small business and it is one of the the things we like to work on with our portfolio companies.

What is Depreciation Recapture?

Yesterday I got the email below from a good friend who is considering selling his small business and is concerned about the potential tax liability that will be created by depreciation recapture at the time of sale.

Paul – Hope all is well. Have you ever dealt with depreciation recapture issues during a transaction? For example, does a seller get worried about the potential tax consequences of a sale if they’ve depreciated assets in their business for years?  

Here was my response:

Yes. We see it both in depreciation and inventory.

Depreciation recapture happens because a seller has used accelerated depreciation (particularly section 179 deductions) in order to reduce income taxes. However, the recapture is only a make-whole for the IRS. That is, the seller is not harmed by the recapture because it simply brings the tax bill back to what the seller would have paid had they not taken accelerated depreciation.

Same happens with inventory when a seller has aggressively marked down inventory in order to depress earnings and save on taxes. When a buyer puts the inventory on its balance sheet at fair market value, the seller faces recapture. However, just like depreciation, the taxes due by the seller are simply a catch-up or make-whole for the IRS. The seller is no worse off than if they had correctly accounted for the inventory in the first place.

So, that’s a long way of saying that we don’t make special considerations for sellers in these scenarios. We try to spend some time educating sellers on why the recaptures is not a “loss” to them in the transaction.

If you are considering selling your business and have questions about depreciation recapture, please contact us. We have experienced this situation many times and can walk you through the financial impacts of depreciation recapture.

ISS mentioned in The Packer

Bob Rust’s (founder of Hadley Capital portfolio company International Specialty Supply) letter to The Packer was published this week. The Packer is a leading news and information source for the fruit and vegetable industry. In the letter Bob outlines why, despite a few recent recalls, it is misguided to remove sprouts from restaurants and grocery stores. Nice work Bob. Check out the letter here.

If You Can Measure It, You Can Manage It

The title of this blog post is most commonly attributed to management guru, Peter Drucker. I saw it again recently in a venture capitalist’s blog post. I think it captures the spirit of how Hadley Capital works with its portfolio companies. After acquiring a business we work with business owners to use good data to manage their business. This usually occurs in three steps:

1. Getting The Right Data

Sometimes a business doesn’t have the right systems in place to get good data. For example, the current financial system might not allow a company to see their margins by product or they might not be able to see margin by customer. Getting this data is really important to managing your business effectively. It allows business to make the right decisions about what products to sell and which customers to focus on. At Hadley Capital, we help our portfolio companies get the right systems in place so they can get good data about their business.

2. Identifying Opportunities

Once we have good data it’s important to know what to measure it against. If a company’s gross margin for a certain product is 30%, is that good or bad for your industry? Is margin improvement a real opportunity or should we focus on improving something else in your business? Hadley Capital helps our portfolio companies answer these questions and helps them focus on the right opportunities to improve their business.

3. Consistent and Timely Reporting

After the business owner has identified opportunities a big part of managing a business effectively is measuring data on a consistent basis. A lot of small business owners have trouble making timely financial reporting a priority. As a result, at any given time they might not know the details on how their business is performing. At Hadley Capital we make sure our portfolio companies have the resources and personnel to provide accurate, consistent, and timely reporting. For example, if the business thinks it can improve its gross margin by 10% by making some changes it’s important to see how those changes are affecting the business. By getting good data on a consistent basis the business can see very quickly how the changes that are being made are affecting performance of the business.

We find the majority of small business just don’t have the time or resources to get good data and manage against it. Most of the businesses we work with want to do it, but they just never had the time or resources to get it done. It is a rewarding experience when we help our portfolio companies get where they want to go.

Keeping Up With Demand

One problem we often hear from small business owners is “I’m having trouble keeping up with demand”. The business owner is typically talking about two types of demand: customer demand and skill set demand. Experienced small business owner can usually get their arms around customer demand. However, when their business demands new skill sets this can cause a lot of ongoing stress for the business owner. They may start to wonder if they are still the right person to run the business. We hear how this self doubt prevents them from sleeping or how it negatively affects their relationship with co-workers and family members. It is a genuine fear and a real problem. The skill set that is required to get a business from $0–5 million in revenue is often different from the skill set to get a business from $5–10 million. The business owner is not sure if they have what it takes to get their business to that next level. They often have spent 10–20 years working very hard to get the business where it is. They don’t want to screw it up and let down their employees and customers.

Hadley Capital has had a lot of success in helping small business owners that are struggling with this problem. We like this situation for three reasons: 1) overwhelming demand is a good sign that the entrepreneur has found product/market fit  2) we have the experience and skills to help the entrepreneur manage through this phase of the business and 3) we can give the business owner some liquidity and they can remain involved in the the business. This type of liquidity event can lower the business owner’s overall risk while increasing their risk appetite to go after new opportunities.

We have helped many of our portfolio companies deal with the challenges of growth. We help them get the right systems and people in place so the business can embrace the growth and manage through it. If you are entrepreneur feeling overwhelmed by demand for your product or service, please reach out to to us. We would love to talk.

Managing Working Capital

Working capital is the short term liquidity (read: cash) required to operate a business. Working capital is defined as Current Assets (primarily accounts receivable and inventory) less Current Liabilities (primarily accounts payable).

When Current Assets increase (inventory goes up), cash goes down. When Current Assets decline (inventory goes down), cash goes up. Likewise, when Current Liabilities increase (payables go up), cash goes up. When Current Liabilities decline (payables go down), cash goes down.

Each of our portfolio companies have different working capital “situations”, some more advantageous than others.

Our magazine publishing company has the most traditional working capital situation. When it sells advertising, customers generally receive terms (net 30) and so the company carries accounts receivable from advertisers. Current Assets up, cash down. The company also owes money to various vendors that we work with including our printer, freelance writers, etc. It carries these as accounts payable. Current Liabilities up, cash up.

This is about as simple or traditional a working capital arrangement a business can have and results in some matching between cash uses  (increase in receivables) and cash sources (increase in payables).

Our event rental company has an advantageous working capital situation. It collects deposits from customers in advance of completing a job. These customer deposits are a current liability. Current Liabilities up, cash up. At the completion of the job, it typically receives final payment. A receivable is created and instantly paid. Current Assets down, cash up. Some of it’s vendors provide terms so it carries account payables. Current Liabilities up, cash up. Cash up, cash up, cash up. Hard to beat that arrangement.

Our eye-wear distribution company has a disadvantageous working capital situation. Like most distributors, it buys inventory from suppliers that require substantial upfront deposits before they will begin manufacturing product, then an additional payment when the product ships. These deposits are Current Assets. Current Assets up, cash down. The company makes a final payment when the product hits it’s warehouse and becomes inventory. Current Assets up, cash down.  The company sells the product to its customers on terms of Net 30, creating accounts receivable. Current Assets up, cash down. The company carries some accounts payable, helping to offset the significant amount of inventory and accounts receivable. Current Liabilities up, cash up. Overall, the working capital position is pretty rough. Cash down, cash down, cash down, cash up.

Managing working capital is critical to the cash flow of any small business. Small businesses with disadvantageous working capital positions may require a working capital line of credit (also know as an asset-based revolver or revolving loan) in order to finance operations, particularly during periods of rapid growth.

Assessing Technological Change in Small Businesses

I recently read an article about the future of LED lighting entitled “Solid-state lighting:  ‘The case’ 10 years after and future prospects” by Roland Haitz and Jeff Tsao (published by Wiley in 2010).  In it, the authors make compelling arguments for why LED lighting will displace most traditional lamps by 2020.  One of the things I found most interesting was their summary of what it takes to win a technological revolution.  They write,

“The most common ingredient is benefit to the user.  This benefit can be measured in performance, cost, convenience, or environmental factors.  But benefit alone is not sufficient.  The path to successful revolution most provide at least two additional ingredients: (1) The existence of stepping-stone markets to finance the required investments and to hone manufacturing processes to the required performance; and (2) the targeted technology must be mature and/or incapable of reacting to the attack in a timely fashion.”

The article then goes on to discuss the benefits of the automobile over the horse carriage, the semiconductor transistor over the vacuum tube, and other less successful examples.

While Hadley Capital is not a venture capital investor, we often review companies that may be affected by technological change and thus we need to form opinions about whether such a change may occur, and if so, how fast.  This article framed some of these factors well.

Alignment of Interests and Incentives

In an earlier post I wrote about how the partners at Hadley Capital eat our own cooking. The investors in our funds appreciate this alignment of interest.  We extend this alignment of interest to the management teams at our companies through incentive programs that reward employees for achieving key objectives and goals. When times are good, all boats rise. When times are bad, everyone works hard to bail out the boat. And there has been a decent amount of bailing over the last 24 months…

 

The senior managers of our companies are all owners of their respective companies either through purchased equity or through equity incentive programs. All of our managers also participate in incentive cash bonus programs and many of our managers utilize incentive cash bonus programs for their employees.

 

Of the hundreds of small companies we evaluate each year, very few are effectively utilizing incentive programs to drive positive change.  Effective incentive programs are not complex and are not difficult to implement. Sales commissions represent the most basic form of incentives. Sell more = make more. But incentives havea place in all areas of a business from purchasing to manufacturing to development to customer service to administration. There are a few simple guidelines to keep in mind when structuring incentive programs:

 

Set goals – establish goals that are specific, measurable, easy to communicate and well-aligned with overall company goals

 

Measure results – design processes to measure and collect results on a regular basis

 

Display outcomes – employees need to know the score so display the information measured and the status towards the goals

 

Deliver timely rewards – reward employees as soon as possible after achievement of goals so that there is a clear feedback loop

 

Collect feedback – listen to employee recommendations for changes, improvements and problems and incorporate them into future incentive programs

 

Obviously the goals and objectives of each business are different. Defining the objectives for your business (or a part of your business) is the most important step. But a close second is developing incentive programs that will align the interests of the employees with management and ownership.

 

One of my favorite books on this topic is Jack Stack’s Great Game of Business. There are lots of other writings on incentive structures but, like most things in business and life, sometimes it’s easiest just to get started and learn as you go.