"Investment Banking is 10% Financial Analysis and 90% Psycho-analysis" – André Meyer  This blog is about the "other 90%"…

Choose wayWe wasted time on non-core activities – lamented a client the other day. – “Our business would be worth more, if we didn’t” – he drew the conclusion. I first sympathized with his plight, which was as easy as feeling sorry for my own failed attempts at innovating in my business. If only I had resisted the siren songs of the ideas that were born out of the desire to grow… or the desperation to prevail. In hindsight, it is only too easy to see the time and money wasted by these trials and tribulations.

On the other hand blaming ourselves for our failures is questioning the entrepreneurial process itself. Creating means looking for a way where previously none existed, so it bound to lead to failures. It is the defining characteristic of the entrepreneur that he is willing to take risks (lose money, miss opportunities, suffer humiliation, attract scorn, etc.), to satisfy the craving to create. Churchill – who may be called an entrepreneur in the field of politics – defined success as “the ability to go from failure to failure without losing one’s enthusiasm”.

On the other hand, we cannot afford more false starts than our resources permit. The art of entrepreneurship is the ability to sustain financial and moral integrity until finding the way to a sustainable business. This requires faith in one’s self, but checked with a sense of reality.

These two traits are contradictory and rare to be found in a single person, This makes the case for a partnership of the dreamer and the sober. Be that partner your CFO, accountant, or spouse.

Istvan Preda

Mortgage and payroll“Business Man” – read the status description of a former colleague on an association website. Last I checked, he was the employee of a bank… and sure enough, he still worked for the same. “Intrapreneur” – quipped a retired executive upon my question of what he did for a living. “This is what you call individuals who autonomously create businesses inside companies” – he explained. A couple of my friends started an internet business when a conglomerate funded their business idea. The enterprise lasted until the seed capital got burnt up. The “founders” then took refuge in middle management jobs at a local bank.

My own mindset was similar over 10 years ago, when in charge of the corporate finance department of a bank. Management knew little of the business and I enjoyed substantial autonomy in picking colleagues and going after clients. Heck, why be an entrepreneur when I could enjoy all the freedom AND be sure of a salary check? My euphoria lasted until the bank was hit by a slow summer, and on a September Friday afternoon, me and my deputy got fired on account of our higher salaries. Our staff was shocked and promised to jump with us to a competitor… but by Monday all was forgotten. “My business” turned out to have just been a job.

The ensuing years have taught me what entrepreneurship is all about. It has nothing to do with building a business – that can be done by any hired hand that enjoys the confidence of and gets a budget from their employer or investors. Entrepreneurship begins where your business hits a rough spot and you commit family silver to keep it alive. When you mortgage your house to survive a downturn… dip into retirement savings to make payroll… forgo salaries for months to stem losses. These are the true tests of entrepreneurship.

On the other hand, nothing fosters creativity like being desperate. Are you prepared to go there to stay in business? Are you strong enough to hang in through a drought with no income? Do you believe in your venture enough to put your financial future on the line?

If yes, than you are, or have what it takes to become an entrepreneur.

AgricultureThe private equity industry is obsessed with EBITDAs. Not that they don’t know it’s not money, but the banks treat it as such, so they play along. We don’t mind, as it magnifies profits and makes deals easier to sell. EBITDA makes businesses look larger than life. Talking “dividends paid” destroys the party.

Similarly most financial analysts look at margins. The higher the better they say, as wide margins imply competitive strength and dominance. True, but high margins also invite competition, which than destroys profitability.

Many investors worry about liquidity. High inventories and slow paying customers put many businesses in debt and recycle profits into dead equity. Only the taxman celebrates.

There is a critical ratio however, that few financiers monitor… Even though, it speaks volumes about growth and value creation potential. This ratio is the ROE – return on assets employed. If low, the business is just working to earn its keep, rather than to reward shareholders. Slow recovered CAPEX eliminates upside while leaving all the downside with the company. Assets amortize, machinery grows obsolete, and technologies get replaced. Make sure your assets produce high, double digit returns, enough to cover depreciation, pay operating expenses and leave a profit.

Watch ROE, whatever you do.

systemLower middle market companies are dependent on their founders. Such founders are often not just the President but the CFO, the Sales Director and the Head of Operations as well. If the President was to depart, a huge abyss would remain, disrupting the company’s operations and diminish its growth prospects.

How is it possible then for a buyer to take over an owner-dependent company?

First, as a precondition of the sale, or as part of the process, the President has to be replaced. Chances are that multiple employees will be needed to make up for the talent and drive of the entrepreneur. The seller will be lucky to find an administrative CEO, who is adept to become salesperson No. 1 at the company. The CFO and head of operations functions, as a minimum, will likely also have to be filled by outside candidates.

Second, hiring new managers, even if costing a bundle, will be insufficient. Those people will have to be trained of the specific ways the company is making money, so that they can perpetuate the competitive edge of the business.

Finally, the drive and creativity of the entrepreneur will have to be replicated. This is the trickiest part, as without it the company’s ability to continually renew itself to remain prosperous and growing, will be lost. Therefore, the new owner will want to both find talented individuals for the leadership, as well instill systems that will keep managers on their toes to continue growing the business.

Such systems include stock options, a planning process, regular input from management consultants and industry experts and perpetuating through training the culture of the company that made it successful in the first place. In other words, to “institutionalize” the impact of the founder, so that he is liberated from running the company, as well as the company is freed from the limits of growth imposed by its dependence on a single individual.

Pc_blogThe late copywriter Gene Schwartz, author of legendary “Breakthrough Advertising” stated that one should never try to create demand for a product or service. Demand is too great for anybody to create… it must rather be spotted and channeled into your product or service.

It is foolish to aspire to “true originality”. Steve Jobs was a genius, but he did not try to create demand for his products. He rather recognized unsatisfied demand, whether for a well-functioning, legal audio player, a stable and user-friendly smartphone, or a light, portable, versatile and affordable computer-and-entertainment device. The demand had been out there for years crying for products to fulfill it. Job’s talent was to synthetize and articulate that dormant demand in the shape of practical, intuitive, dummy-proof products.

This idea applies equally to private equity investments. Investors do well to invest in companies that are riding a trend, i.e. which are, or seeking to exploit existing demand by delivering products or services. The value creation triangle of growth-leverage-strategic fine-tuning remains… but look for wind behind the sail that give you a margin of error for executing those strategies.

Istvan Preda