Situation: A technology company has established a leadership position in their niche. Nevertheless, they struggle with individual performance and buy-in to company performance. The CEO asks whether increasing ownership through stock incentives in a non-public company is an effective incentive for employees. How do you strengthen internal incentives and ownership?
Advice from the CEOs:
In the past, employees voiced a strong predilection for share ownership as recompense for the personal risk and sweat that they have put into the company.
It may be advisable to revisit this, particularly given the increased risk that comes with share ownership as a result of regulatory changes of the last 10 years.
As a substitute for share ownership, they may be open to some proxy that will provide them with value and the opportunity to have their opinions heard in the case of a buy-out.
Another company looked at this closely at the time of formation. They decided that proper recognition for contribution did not equal ownership. Ownership also entails personal liability and risk, which many don’t realize and, once they understand the implications of owners’ liability, don’t want. As an alternative they adopted a liberal profit-sharing structure that has met with employee enthusiasm.
Think about this discussion in terms of incentives:
Short Term – Annual-type incentives
Make sure that incentives align with desired behaviors so that individuals’ contributions contribute to business plan objectives and the next step for the company.
Long Term – consider the trade-offs
Broadly distributed share ownership not only complicates future flexibility but may also complicate a buy-out or merger opportunity. Consider the implications of a situation where most shares are in the hands of past rather than current employees.
Strategic Partners wishing to invest may be reticent to work with a company with broadly distributed ownership.
ESOPs, while frequently referenced, tend to eat their children. They have several complications:
They are governed by ERISA, so you cannot discriminate. All must be able to participate.
Ownership is prescribed – with a maximum of 10% per employee. Will a future CEO candidate be happy with 10% when the admin assistant gets 3%? In this way ESOPs can impair succession and recruitment plans.
Annual valuations can be expensive.
Phantom or Synthetic Equity Programs
A company can tailor these to meet changing objectives.
Valuations are cheap and valuation metrics are easy to monitor.
To work through the options, sit and talk with the employees, and listen. Ask what concerns them. Don’t try to come up with a solution until their concerns are understood. There is an array of options available.
Situation: The CEO of a family business seeks to create a succession plan. One family member has expressed an interest in taking the reins of the company but has failed to take the initiative to demonstrate that he is prepared to take on this role. Another family member is now demonstrating both interest and initiative. How do you plan for succession?
Advice from the CEOs:
How should this situation be approached?
Do not view this situation competitively, but rather from the standpoint of what is best for the whole family because many family members stand to benefit from the ongoing success of the business.
Whatever decision is made, the successor will need support and assistance understanding both the financial and business sides of the company. This individual must also be aware of conflicts and challenges that face the business.
What else should be done to prepare for succession?
Given that there are two individuals interested in becoming CEO sit down with each individual and negotiate a clear boundary statement on what you, as CEO, can and can’t do, as well as what can and cannot be expected of you, as CEO, as the succession decision is made. This understanding should be documented in writing and signed, signifying understanding by both the CEO and the candidate. Each candidate should have their own signed agreement with the CEO.
In a family business, the CEO, as guarantor of the company, may be faced with a different level of financial risk than other family members. Both candidates for the CEO position must understand that if they accept this position, they also accept this risk.
Situation: A company is transitioning from a service model to a product model. A major challenge is meeting funding needs during the transition. Funding sources perceive the current service model as heavy on cost of sales vs. implementation and this hinders acquisition of funds. The CEO sees this as a short-term problem as the company will quickly start to generate more cash through the product model. How do you transition from service to product?
Advice from the CEOs:
In a competitive funding environment, it is important that the offering be credible. While others may be offering similar solutions, believability will prove to be a strong differentiator.
Where to focus over the short term?
Create a hybrid model as a transition between the current service offering and the planned product offering. Demonstrate that current customers have responded favorably to the product/hybrid opportunity.
Test this concept with an investor. The story is that the company needs funding to get to a saleable product model.
What is the message to investors?
Helping the company to achieve a short-term and very feasible objective gives the investor the following advantages: purchasing at a lower valuation, getting a larger share of the company for less, and at a low risk.
As the valuation of the company increases, the earliest investors will get the best deal!
During meetings with investors, ask them for advice on the current and following rounds and financing, and what they will find most appealing.
How do you mitigate the risk to the first investor?
Have a solid business plan and projections that have been vetted by others.
Have a list of referenceable clients.
Utilize the current service model and demonstrate the product/hybrid Package. Build a case on the advantages of the hybrid model including the financial case. The company is always there to provide back-up assistance to meet customer needs in the hybrid model.
Demonstrate flexibility – the customer can always choose the service model or convert to this if they wish.
A Key Point: You are selling yourself as the trustable resource, not the product or service.
Reference previous investment including founders’ investments. The founders did not invest to fail!
Situation: A company has built a very successful specialty manufacturing business in the US. Their manufacturing operations are labor intensive, with manufacturing practices optimized using motion studies and sharing best practices developed on the production floor. The CEO is evaluating whether it makes more sense to expand production in the US or to explore international options. Do you produce domestically or internationally?
Advice from the CEOs:
There are trade-offs between domestic and international production. Quality labor is available internationally at lower costs than in the US. However, risks include potential loss of quality control and higher levels of waste.
While investigating international production options, focus first on less critical operations where savings from lower labor costs outweigh the potential cost of wasted material.
Do not try to move highly controlled operations. These will include critical operations which require both an elevated level of operator skill and close supervision.
Before evaluating international options, break down the steps of manufacturing or processing to identify specific subcomponents or subprocesses that could be outsourced at reasonable risk.
For example, look at high volume parts where quality and variation in tolerances is less critical. These will be the best candidates for production in a lower cost, potentially lower quality environment.
How critical are trade secrets or patented IP to production? In the US and Europe there are strong protections for IP. However, these protections are not as strong in all countries. If production is outsourced to countries with poor IP protection, this may enable IP theft and create future low-cost competition.
Situation: A company that manufactures and sells components to a large corporation has a dilemma. This customer is throwing more business their way, under favorable terms. At the same time, the company wants to diversify to reduce exposure to a single large client. The challenge is that alternate opportunities are not as profitable as those from this customer. As the CEO puts it, should they use limited resources to chase copper when gold is readily available? Do you diversify or optimize current opportunities?
Advice from the CEOs:
It is always dangerous to have all your eggs in one basket. Dedicate resources to develop alternative business opportunities, knowing that at first the new opportunities will not be as appealing as current opportunities with this large client.
Think back – has business from the large customer always been this profitable? In developing new business opportunities, one often must pay dues to develop opportunities for future profits.
Invest in business development to find new business opportunities outside of this large customer. Do this sooner rather than later. One never knows when a large customer will change strategic direction.
What are the company’s options and choices?
Stay the current course and accept the risks of this strategy or diversify.
Put some resources into studying options to diversify. If there is no gold out there, then maximize the cash from the current situation and invest it in something that will provide a satisfactory long-term return. If the large customer closes the door, then just shut down.
How could the company diversify? Geographically? Additional products to other customers? Put together a diversification plan and test it for feasibility.
Make sure that company’s and owner’s priorities are clear and not in conflict with each other.
What is the optimal size of the company?
How many customers are needed to support optimal company size and how much diversification is required for this?
What is the owner’s exit strategy and timeline?
If the objective is to stay small and exit in one or two years, why chase diversification? Think about what would be appealing to a potential acquirer. Perhaps it is just access to this large customer.
Situation: A CEO is considering a new revenue model for his company. The existing model is profitable and stable, but not scalable. A new model, and perhaps additional locations may be needed to add scalability. How do you assess the risks of the model? What steps can be taken to reduce these risks. How to you evaluate a new revenue model?
Advice from the CEOs:
Project both the current and new models on a spreadsheet. What do profitability and return look like over time based on current trends?
Include assumptions about adding new customers within the model. Consider capacity constraints at the present location. Add start-up investment needed for the new model. Does overall profitability increase in the projections and will this adequately cover new customer acquisition costs?
Are performance standards for the current and new models different? Would it make sense to have different teams managing the models? What kind of experience will be required in the people who will build the new business? Account for personnel additions and start-up costs in the financial projections.
Critically evaluate the upfront financial exposure as new clients are signed up for the new model. Consider hybrid options which can be added to customer contracts. Examples include:
A variable flat fee model. Customers contracted under the new model will receive services up to X hours per month for the flat fee, with hours over this billed separately.
How do current time and materials rates compare with industry averages? If they are high, it is not necessary to quote existing rates to new model customers. Create a new rate schedule just for new model customers. Taking a lower rate under the flat fee model will not cover all costs and profit; however, it will at least partially cover utilization exposure and a higher rate for additional hours can make up the difference.
During the ramp up period of a new operating unit, client choice is critical. If, based on observations and responses in client questionnaires, heavy early work is anticipated, charge an initial set-up fee. Alternatively, ask for a deposit of 3-4 months to cover set-up exposure. If either at the end of the service contract or after a burn-in period some or all these funds have not been used, the client is refunded the unused deposit. This can both cover early exposure and make it easier to sign new customers for the new unit.
Draft contracts under the new model to include one-time fees in the case of certain events – e.g., a server crashes in the first 9 months of the contract, or an unplanned move within the first X months of the contract. These resemble the exceptions written into standard insurance policies. They can be explained as necessary because standard contract pricing is competitive and does not anticipate these events within the first X months of the contract. Most companies will bet against this risk. Those who do not may know something about their situation that they are not revealing. In the latter case you will be alerted to potential exposure.
Consider a variable declining rate for the new model. The contract price is X for the first year, and, assuming there are no hiccups, will be reduced by some percent in following years. This resembles auto insurance discounts for long term policy holders with good driver records.
Adding hybrid options may make it easier to sign new clients while covering cost exposure. The view of the CEOs is that most clients will underestimate their IT labor needs and will bet against their true level of risk. Provided that the new model delivers the same service that supports the company’s reputation, once clients experience the company’s service, they will be hooked.
An additional benefit to hybrid options may be faster client acquisition ramps within new satellite units and faster attainment of positive ROI.
Situation: A professional services company is constructed as a network of members. The company’s contract specifies that if a member of their network goes to work for a client – even a client that the member brought to them – the client owes the company a fee of 50% of either the member’s salary or the annual consulting revenue paid to the member. This is onerous. What is the best way to respond? What is a fair revenue split?
Advice from the CEOs:
This does seem like an onerous provision. It is unclear whether the bite is as fierce as the growl.
Consult a lawyer. If you quit the network and go to work for the client, what is the level of risk that the company will successfully sue, and what you can do to mitigate this risk?
If the offer from the client is appealing, quit or avoid using this company’s services. Given their cut to your revenue you will see a net gain in your own pay for services rendered.
If several members agree that this stipulation is onerous, team up and start your own network with better terms. This can provide you and the others with an annuity revenue stream.
Integrity in professional circles is everything. Whatever course you decide on, be up front.
Situation: A company buys several important components from a single US supplier. They are considering an offshore source for one of these components which makes up a large portion of what they purchase from the supplier. Does off-shoring make sense in this case, and how do they mitigate the risk? How do you change suppliers for a key product?
Advice from the CEOs:
The key consideration is the off-shore partner’s ability to reliably make the component at the price promised. If they can, why not outsource offshore?
The decision depends upon two additional factors: the amount that you stand to save by off-shoring your source, and the potential cost to you of inconsistent or unreliable components from the off-shore supplier.
If the cost of failure is high, a modest savings is less valuable. You may want to wait until you have higher volume and higher potential savings before looking at off-shore sources.
In the US, we assume – with some security – that a pilot run predicts a large run. Historically this has not been shown to consistently apply to offshore suppliers.
Can you afford to invest and potentially lose the amount that it would cost you to secure your first production order from the off-shore source?
If the answer is yes, invest the time and effort to visit the supplier, and secure resources to monitor their production – your own or a trusted partner’s. Your presence and interest are very important.
The principal challenge will be quality and consistency of raw materials, and varying age of production equipment used to produce your components.
Are you concerned that your current supplier might cut you off?
The CEO is not sure, but has identified this as a risk.
If this is the case, start now identifying second sources for other components made by this supplier – if only to keep them honest in price, quality and delivery.
Situation: A software company is evaluating its distribution network. Historically they have worked with resellers who aggregate software services into packages for larger customers. Recently they were approached by a reputable distributor seeking a master distribution agreement with favorable payment terms. Is this an option that they should pursue? How do you evaluate distribution alternatives?
Advice from the CEOs:
There are at least three objectives to consider: market coverage, margin to the producer, and market risk.
For market coverage, evaluate the alternatives in terms of their ability and commitment not only to serve your current market but to expand into adjacent markets.
Regarding price and margin, there are two alternatives:
Decide what price you want, and don’t worry about the reseller or distributor’s final price to the customer, or
Establish a floor price for your product and ask for a percentage commission on sales.
Run models on each and decide which will provide the best return on sales.
Market risk is more complex. These are different approaches to the market.
In evaluating the reseller option, insist on terms in reseller agreements that the reseller disclose the terms of their sales.
Sharing of customer databases is another factor. Siemens, for example, considers their customer database as IP and only releases portions of their customer database selectively to resellers.
A master distribution agreement has different risks. It puts all of your eggs in one basket. If the distributor adjusts focus away from your software during the term of the agreement your sales and revenue will suffer.
Are there conditions where a master distribution agreement may make sense?
If the distributor is willing to sign a multi-year agreement with sales guarantees at favorable pricing this mitigates the risk.
The central issue is risk and guarantees. If you see the option as a low risk – high return proposition, it may be worth considering.
Situation: A Company has a key customer that wants to upgrade the Company’s status as an approved supplier. This comes with a catch – the customer demands that the Company reduce the amount of its total revenue represented by its business with the customer. The customer doesn’t want the Company to be overly dependent upon them or their business. One option that the Company may explore is purchasing another business. When does it make sense to buy a company?
Advice from the CEOs:
The Company may be working under a false premise.
If the Company is truly a critical supplier, the customer is not likely to go away just because they don’t like a single ratio on how the Company runs its business.
The risk that the Company takes on buying another business is that this distracts the Company and ends up jeopardizing current business both from thus customer and others.
It makes more sense to explore acquiring another company if the Company’s broader goal is to become more diversified, or if new business commitments are forthcoming from this or other current customers.
What about this strategy makes sense?
Provided that the purchase of another company makes strategic sense, it may be feasible to finance the purchase of that company through a leveraged buy-out.
Be sure to build an earn-out with incentives contingent upon the seller staying on and helping to maximize long-term value of business.
As an alternative to buying another business, it may be possible to build a new lower cost/price version of the Company’s current product or service and build a new customer base for the lower cost version. This is how automobile companies use the same or similar frames, engines and many of the same components to create different cars for different markets.