According to Slee’s research, the United States economy experiences a recession (or other economic downturn) during the first three or so years of every decade.  The capital supply to the private markets becomes restricted, primarily because lending is restricted, which reduces the leverage a buyer can achieve and lowers valuations as well as limiting access to working and investment capital.

This begins to transition around the fourth year as companies improve profitability which leads into a period of free-flowing capital into the private market.  Humans are creatures of habit, so we quickly forget the recession we recently survived and continue to spend and invest until we are over leveraged and over invested.  At this point, parts of the economy begin to feel the strain and the economy as a whole is affected by the end of the ten year period.

Why will such a cycle be expected to continue?  Because the nature of people, namely, the private business owners, bankers, investors, and politicians in America, is to be overly optimistic in the good times and overly pessimistic in the bad times.  We also take a predictable amount of time to adjust to changing conditions and we can be counted on to react in certain ways.

Today, the catalyst for our recession was sub-prime mortgages followed by complete financial system meltdown, bankruptcies, and major fiscal policy changes.  Impending commercial mortgage uncertainty will help us to remain in a deal recession for the next several years.  Business values will remain flat or fall further as we struggle to adjust.  But adjust we will (or go bankrupt) and the survivors will profit again.

In my last post on business value, I mentioned that you can expect to achieve the highest return when selling your business at the right market timing.  If the transfer cycle holds, the best time to buy a business will be any time from now through 2013 or so.  The best time to sell a business will be toward the end of the prime selling time, or roughly 2016 – 2018.  Obviously, businesses will continue to be bought and sold every day, but a savvy business owner will look to exploit this cycle to his or her advantage.

Melissa Knutson is Relationship Manager with Chase Business Banking RM Channel in Colorado Springs, CO.  Melissa can be reached at (719) 227-6497 or by email at melissa.j.knutson@chase.com.

What Happened

After several successful tech companies, Al Davis started a company that developed a software product aimed at assisting engineers with calculating the optimal mix of features in a product. After four years and several investment rounds, the company liquidated, paid its remaining debts, and returned pennies on the dollar to its shareholders. So what went wrong?

What Went Wrong

According to Davis, the company’s most visible failure was the late addition of a qualified marketing & sales executive. His company went through three marketing/sales directors, each with a dramatically different focus and with varying levels of understanding of both the company’s product and its customers. The first involvement from marketing wasn’t until 6 months after the company was formed and by the time they found a marketer with a deep understanding of their customers and technical knowledge of the product, it was too late. Davis’s hindsight advice is to involve a professional marketer at the very beginning, along with the rest of the skill sets generally considered critical to your success such as financial, management, and legal professionals. Make sure this person understands your customer and your product and knows the appropriate sales methods to utilize.

Another failing was the attempt to create a complete “Cadillac” solution right out of the gate. The software product they developed contained all the bells and whistles they could think of and was priced accordingly. They had trouble selling the product because their customer didn’t even realize their need for all that software. Davis calls it a “solution looking for a pain”. Instead, they ended up stripping many of the features and selling an entry level tool at an entry level price.

Starting with a simple product has several advantages:

1. It is less expensive to develop
2. It is faster to develop, allowing you to reach your market sooner
3. It is easier to explain lowering the average time to close a sale
4. You can add the more complex features your customers really want by soliciting their feedback
5. It brings cash in the door today

Finally, spend according to your means. Davis developed a detailed business plan for his company that included targeted levels of investment at each round and expected uses of that capital to meet growth targets. When one of the investment rounds brought in less than projected, Davis chose to continue hiring personnel according to the plan to drive growth. Looking back, he recommends scaling growth investment to the level of available capital, especially if sales are less than expected. In addition, the company was renting Class A office space, and he had personally guaranteed the lease, when their customers rarely visited headquarters. A much less expensive location would have met their needs and freed up cash for reinvestment.

What Went Right

Al Davis has actually been quite successful over his career and the reason he attracted investment in the first place was because there are many things he did right. In fact, a major contributor to this particular failure was the market downturn in 2001.

My favorite positive feature is his employee and investor friendly equity structure. Davis reserved 1/3 of the equity for the founders, 1/3 for future investors, and 1/3 for his employees. Nearly everyone to whom he presented his plan applauded his balance of employee motivation and investor reward.

Davis went even further for his employees and removed nearly all symbols of hierarchy in his company, down to maintaining the same size offices for all employees (including himself). He also went out of his way to keep them informed, even as the company was on its way down. This style of management kept panic to a minimum and employee involvement high which turned what could have been a precipitous plunge into a quiet exit.

Another powerful decision was for the principals to personally invest in every round. Other investors will ask you two questions and personally investing allows you to truthfully answer both questions correctly:

Question: Am I the first investor?
Answer: No, you are not.

Question: Do you have skin in the game?
Answer: Yes, I do.

Finally, and probably most importantly, Davis organized powerful external boards to oversee his company. Not only did he find a qualified board of directors with a variety of useful experience (except marketing, of course), but he also developed an external advisory board in addition. The combined experience and knowledge of these individuals might have prevailed even as the company learned the lessons above had the market not also contributed by reducing the capital expenditures of their customers.

Thanks to Al Davis for his frank and humble commentary. If we are wise, we will let his experience teach us how to become more successful entrepreneurs.

Resources:

• Colorado Springs Gazette Article

Being a CPA, I always read the fine print attached to the asterisk and these offers are just never as good as they initially sound.  I thought I’d take the time to calculate exactly how much interest a business would really end up paying if it utilized this “line of credit” under a couple of scenarios.  I’ll give you a hint: the hidden killer is in the fees.

Let’s take a look at the fine print.

…For each check posting to your Account, we will assess a Promotional Discount Transaction Fee (FINANCE CHARGE) equal to 3% of the check ($5 minimum).

Well, that’s not so bad, you say.  A little transaction fee will at least be offset by the low, low interest rate, right?  Maybe, but probably not.  A 3% fee sounds an awful lot like an additional 3% interest and since this offer is good for exactly one year we can just add the two together to get a real rate for borrowing money under this program and paying it off as late as possible (before the rates rise, of course).  If a business borrowed $1,000, paid $30 in fees (3% * 1,000) and paid it off in a year, there would be $39.90 in interest (3.99% * 1,000).  If you’re paying $69.90 for the privilege of borrowing $1,000 for a year, that’s equivalent to a 6.99% real interest rate ($69.90 / $1,000).

Still not a terrible interest rate for a line of credit, but what if you pay it off sooner?

If you paid it off in 6 months, that $30 fee turns into the equivalent of a 6.00% interest rate (3% / 0.5 for half a year).  Now you’re paying 9.99% annual interest when you add back in the 3.99% interest already being paid.  That sure grows quickly.

Let’s max this program out and assume you borrowed the $1,000 and paid it off in just one day.  3% paid for the privilege of a single day’s worth of credit is a staggering 1,095% annual interest rate! (3% fee * 365 days in a year)  That means if you were to borrow that same $1,000 each day and pay it off a day later for one year you would pay $10,950 to essentially borrow $1,000 for just one year.  And that isn’t even counting the fabulous 3.99% interest they’ll charge you on top of those fees.

Businesses are faced with these kinds of hidden interest costs on a daily basis.  Discounts for paying vendors early and penalties for paying vendors late are among the most common examples.  Overdraft fees due to poor cash management, payday and bridge loans from loan sharks, points and closing costs to refinance, and profit sharing with investors are all components of the real interest cost of borrowing money for a small business owner.  If the real cost of capital is more than what you can get somewhere else or, God forbid, more than the profit you’ll make, it isn’t worth it.  Make sure you do your homework with your accountant before accepting the next “deal”.