RSS feedsNo business ever runs smoothly. Every adviser knows that because they see businesses from the inside every day of their working lives. If someone tells you their company is perfect, they are detached from the truth. Trouble is inevitable: sometimes it is bad luck, sometimes it is your own fault. The true test is how you react to problems. You can throw in the towel, or you can work hard and with perseverance and a bit of luck emerge bloodied and unbowed, ready to fight another day.
The latter course of action is what happened to a client of mine after a poor decision meant it was sleepwalking into disaster. The managing director of an audio-visual engineering business based in the north east of England had spotted a cracking opportunity. It meant a move into an adjacent market for the long-established company and could only be accomplished with a hefty and ongoing commitment to research and development.
The investors were a private equity group that backed the MD and other key members of the management team in a management buyout. It was a classic deal with the buyout company geared up as far as possible plus a demanding business plan, which had to be met to pay the bank.
The deal was completed before PE deals went off into the stratosphere and so, in comparison with other investments, the AV and sound business started to slip down the private equity firm’s priority lists.
Certainly the business was doing nothing to enhance its reputation with its shareholders. It was showing a profit at earnings before interest tax and depreciation (EBITDA) level that the stakeholders and the management took as a rough and ready measure of cash generation. However, once the interest payments were taken into the account the business was falling firmly into the red.
The MD saw the new product area as a way to transform the fortunes of the company, turning the loss into a profit and keeping the company in the black. But first it needed some R&D investment. Over the space of a couple of years the MD oversaw an R&D programme of several million pounds, which was a substantial undertaking. By the end of the planned investment period the company was actually no nearer to entering the promised land of the new market and, to make matters worse, was in dire financial straits.
Misplaced judgment
The heart of the problem was that the management team and the investors had been looking at EBITDA and assuming that the finances, if not brilliant, were acceptable. However, the hefty R&D investment had resulted in a large and sustained cash outflow, which had been masked because the R&D had, correctly enough, been capitalised and was rolling up on the balance sheet as a growing fixed asset.
While the core business was cash generative, the high level of capital expenditure (capex) combined with the interest payments had brought the company to a cash crisis and the edge of collapse. The problem was only discovered by chance. First, a new finance director was appointed and sensibly set about conducting a business review on his arrival in a bid to understand the business better. He probably learnt things he would rather not have known. Two items of particular significance landed on his desk within a few days of his arrival. First, an unexpected and large VAT bill arrived. That was swiftly followed by the bank ‘reminding’ the FD that a tranche of capital payments on the part of the MBO financing was soon due.
It was clear from a cursory look at the books that neither creditor could be satisfied. Sensibly at this stage the FD called in the auditors, who confirmed the FD was right in his snapshot assessment. They both agreed that bankers and investors had to be told the bad news. The business, which had a long-standing relationship with one of the main clearers, revised its cashflow and then went to the bank to ask for facilities. The company’s lack of clarity and confidence in its own figures was apparent revisions to the cashflow calculations were frequent and, perhaps not unreasonably the bank, definitely unnerved by this stage, decided it wanted to find out what was happening.
By this time the bank was querying the very survival of the business as whole. But rather than act precipitously by calling in the receivers the bank opted for some turnaround help. The bank manager called me in to work with the finance director with the request to make a calm assessment of the cashflow over the next quarter. From a review of the business and from the financials a sensible course of action was quickly established.
It may have been the MD’s pet project but it was obvious that the R&D spend had to go. It was a project that the company could simply no longer afford. While the VAT payment could not be avoided for long we all know the ladies and gentlemen down at HMRC the bank could hardly claim to be surprised when it was asked to wait for its capital repayment.
It was partly persuaded by the fact that after the VAT debt was settled and the capex programme frozen it was possible to demonstrate that the company was returning to a position where it was actually generating cash rather than haemorrhaging funds.
While the management still has plans for entering a new market with this product, those plans have been scaled back to more realistic levels. Instead their time is being taken up on focussing on core products and developing new products for the AV markets they know best. And this is creating a virtuous circle: the new products are finding success in the marketplace and so the sales team is encouraging further investment in new products they believe they can sell.
The company has not escaped unscathed; these episodes do have long-term repercussions. While asset-backed finance does work, it is clearly not as flexible as an unencumbered overdraft. And the company does now have less room for manoeuvre. With its assets pledged it can’t afford to make any more financial mistakes because there is little left to offer as security.
However, the PE firm seemed to be re-engaged and re-energised by the threat of losing its investment completely. It may not be the most successful investment it has ever made but the indications are now that the company is on a path that will secure greater profits in time.
Learning the lessons
In many ways the company described here was lucky. It was only by accident that it was saved from going out of business completely. Once the danger had been spotted the company worked with its advisers – auditors, bankers and investors – to find a way through the problem. The management team, while clearly not happy with the situation, also managed to carry on working together. They did not resort to blaming each other either for the failure to break into the new market that held so much promise, nor for the financial management failure that failed to flag up the funds outflow taking place.
The management is now focused on the core strengths of the existing business. And the private equity investors are looking at re-incentivising the existing management by establishing revised incentives.
As for the financials, the company is producing ever-increasing positive cashflow and look set to meet the repayment of the banks in the end. For the bank this is much better than the substantial write off it was facing if it had decided to take precipitate action.
Perhaps it is only human nature that every so often we take our eyes off the ball. But the way in which management teams respond under pressure will set one business apart from others. The management team and their advisers learnt their lesson quickly and their speed of response ensured that the company was able to get back on track. They saw the light. Talk to the directors and you get the impression that they have learnt one lesson about business – at the end of the day it is all about cash.
Peter Charles is a member of The Institute for Turnaround and runs the consultancy firm Peter Charles Limited
