Made from Concentrate: From Owner/Manager to Owner/Investor
One of the lessons most investors learn early is the risk of a concentrated position. As the saying goes: “Don’t put all your eggs in one basket.” An ample library of academic research exists to back up the validity of diversification as a risk management strategy, but it also just makes intuitive sense. Diversification makes so much sense that many investors have extended the concept to hyperbolic proportions, taking the position that there is no point in owning individual stocks at all; that owning “the index” is the only rational decision (…another topic for another time).
Even investors who are not militaristic in a belief that “more-diversified = more-better,” are impacted by the well-founded principal that diversification mitigates investment risk. For instance, under a normal 401k plan employees are given a list of index-hugging mutual funds to choose from, not a list of stocks. Diversification is so embedded in our collective investment-rule-book that it has become a guilty pleasure for some index investors to have a “risk-portfolio” of a very-few individual stocks: the high-fliers (think Facebook, Amazon, Google to name a few), IPO’s, and “too-cheap-to-ignore” stocks (somebody still owns Blackberry…) that they just couldn’t pass up.
But, as championed as it is, diversification does not eliminate ALL risk; in principal, it eliminates COMPANY-SPECIFIC RISK. This is the term for risk that is unique to the company underlying the stock. Acknowledging company-specific risk means acknowledging that a share of stock is more than a point on a line-graph, or a percentage of an index. Stocks represent ownership of real-world companies that (in principal) operate with a primary purpose of increasing shareholder value. No where should this hit home more than for owners of privately held businesses.
A widely-used but difficult to prove rule-of-thumb is that privately-held businesses represent at-least 80% of their owners’ total net-worth. This means that in most cases owning a business is like putting 80% of your investment portfolio in one stock with no intention of diversifying. If you are a business owner, you are probably shaking your head and moving your mouse toward “X” right now, because in the same way we intuitively understand that diversification is a good thing, you understand the impracticality of anyone seriously suggesting that you can apply conventional methods of diversification to the concentrated position you have in your business. Not only is it impractical, but for most business owners it is undesirable because the opportunity for returns is higher in general for privately-held businesses than public markets.
The key message here is this: Diversification is just a tool that addresses the problem of COMPANY-SPECIFIC RISK.
The inability to diversify without selling your business or diverting cash flow from it to public securities should not stop you from at some level considering your business as a holding in your wider investment portfolio. What if there were other ways to address that risk? This changes the discussion. Besides the benefits to current owners, purposefully addressing sources of company-specific risk also makes your business more attractive to buyers, which can result in a higher price than you would have achieved otherwise, when and if you are ever ready to sell.
Before we get to the how of reducing company-specific risk, we must address the elephant in the room: most of us don't believe our business is riskier than a diversified portfolio of stocks. We believe this for the same reason that most people believe that car travel is safer than air travel: THE ILLUSION OF CONTROL. Even though we can all recite “you're more likely to die on the way to the airport than you are in a plane crash,” very few of us feel that way during take-off and landing. The difference that drivers and business owners share is the belief that simply sitting in the drivers seat makes us more likely to be able to prevent disaster. For drivers, believing it doesn't make it so, but there are ways to increase odds of success (building extensive experience, safety technology, defensive driving classes, etc…). Similarly, there are ways that business owners can reduce risk in their own businesses.
Each business has its own challenges and opportunities in reducing risk, but here are a few:
- Diversify Customer/Client Base: I know I just finished arguing that diversification doesn't work well for business owners, but this is a different kind of diversification, so please bear with me. What is riskier: a company that provides toilet paper to all Walmart employee bathrooms to the tune of 80% of its revenue, or a company that sells the same amount of toilet paper to thousands of independently owned restaurants? I would argue the former is riskier, because even though the customer is solid as a rock, if for any reason Walmart decides to switch suppliers, the first company would be done. Comparatively, even though we know small restaurants fail often, they don't all fail at once, and new ones are always opening. A simple way to evaluate your company’s customer-concentration risk is to calculate the % of last year’s revenue attributable to each of your top five clients/customers.
- Focus Growth Initiatives On Recurring Revenue: I used to think there were only two types of revenue: recurring and non-recurring. Recurring revenue is revenue that occurs at a regular amount and frequency, and is usually based on a contract or agreement. Non-recurring revenue is for “one-and-done” projects that are not expected to be repeated at a regular frequency. Yet a third type of revenue is Re-Occurring, which is revenue that is expected to be repeated, but the timing is unknown and the purchase is not usually subject to an agreement tied to the original work.
A good example of re-occurring revenue is Microsoft Office, which can be purchased and used, even long-after Microsoft has released updated versions. Microsoft hopes that you buy the new version, but you are not required to do so. An example of converting revenue from non-recurring or re-occurring to recurring is Microsoft’s replacement of Office with subscription-based Office 365. Now, users pay a monthly or annual price to have a product suite that is updated to the newest version automatically, and Microsoft can invest in improving its products with increased assurance that the investment will pay off in higher adoption. The subscription results in continuous revenue recognition and easier pricing growth as they re-price subscriptions rather than charge a higher lump-sum for a new box of CD-ROMs that contain a product update that most people could justify as unnecessary.
- Address Key-Person Risk: Out of necessity, businesses usually grow around their founders. The common sound bite of wisdom is “build your business to run without you.” The common interpretation of this is “hire someone to run your business so you never have to be there.” Heed the sound-bite, beware the easy interpretation. The truth is, whether it is you or anyone else, if your business depends on any one person to survive or even to thrive then you have a major source of company-specific risk to deal with.
- Build Out Robust, Sustainable Information Systems… And Use Them!: My firm recently began working with a client generating over $10MM of revenue annually that was still using the same customized accounting software that they had started off with in the mid-80’s. Before anyone passes judgement on them for this, you should know that the company has survived as long as it has because its management is extraordinarily capable. Getting new accounting software was never at the top of their list of priorities, because what they had, worked and it was actually very robust. They decided to change not because it wasn’t new enough, but because they had begun to realize some of the risks of obsolescence. For instance, the solution the software company had built that allowed their DOS-based software to run on Windows 7 created a glitch that made the Balance Sheet impossible to balance. The system was robust, but unsustainable.
On the other end of the spectrum is a business that uses Quickbooks, and only Quickbooks. There is really nothing wrong with doing that, provided that the users of it are capable of setting up and maintaining the books in a way that can provide meaningful information to management, beyond what the CPA asks for to complete tax returns. It is also important that the information is organized in a way that can be understood by those outside of the company. While you might speak your own language inside the walls of your business, it helps to be fluent in the language of your clients, suppliers, competitors, and potential acquirers.
The other thing to be aware of is that we live in a world that is experiencing a swift revolution in the ability of companies of all sizes to capture, organize, and use data; not just financial data, but also customer, supplier, and operating data that can form the basis for indicators that identify unexpected opportunities for significant growth, higher profitability, and more efficient, higher quality delivery of a company’s products and/or services. Of course, the danger here is wasting significant resources on a problem you don't even have, or on a solution that was developed by a company that was built to sell itself to investors rather than to sell its product to customers. If you are aware of those risks, you should be able to take them into account.
This article has identified one impractical way that company-specific risk can be mitigated for privately-held businesses (diversification), and four ways that business owners can actively work to meaningfully reduce risk; but more importantly I hope that it has provoked business owners and advisors to think about the importance of the role that businesses play in the financial futures of their owners. Our country’s business culture applauds entrepreneurs who are willing to go all-in, neglect risk, and give opportunity a suffocating bear-hug. But, as with any good story the audience far-exceeds the cast in number: there are a lot more people encouraging the risk-takers than there are people who are willing to take the risk.
An unbiased evaluation of the past few decades of entrepreneurship would most-likely conclude that it is not the taking of risk that should be encouraged or discouraged, but the ignorance of risks that will prove destructive. The most meaningful success stories I have observed and even had the fortune of participating in as part of my work have been the result of business owners’ hard work identifying and capitalizing on opportunities while consistently remaining aware of and minimizing risks along the way. Try it.
Matt A. Morley, CVA, CEPA
Chief Investment Officer