Private companies exist to create and grow value for their shareholders. Some of the ways to achieve this core mandate is by growing the business operations through expansion to new markets, developing new products or services or through mergers and acquisitions. When seeking new avenues for growth, most companies conduct outward looking feasibility studies that focus on external factors such as political stability and value chain risks in their target markets. What is often overlooked are internal key aspects of the business that are heavily affected during business expansion drives such as operational capacity and cash flow efficiency.
Managing Financial Risks
Companies face significant financial risks when expanding their operations since they require additional resources to enhance their capacity to deliver to their new target markets. To finance their growth strategies, businesses often seek external funding to bridge their funding gaps from internally retained earnings. The external funding comes in form of debt or equity instruments; depending on the desired ultimate capital structure, and the cash flow generation capacity of the business.
Expansion through equity investments tend to be a preferred route for startups and Small and Medium Enterprises (SMEs). This is due to the fact that they often lack the necessary assets on their balance sheet to secure a loan; and lack sufficient cash flows to meet monthly interest payments and principle repayments on debt facilities. However, equity fundraising takes longer to close (typically 6 – 12 months); and this delays the expansion strategy of the business if they need an immediate capital injection.
Companies can also use debt capital to steer their growth plans. Unlike equity, debt capital comes with immediate cash outflow obligations after the grace period ends. Before pursuing the debt option to fund their expansion, businesses need to assess their capability to generate sufficient free cash flows to pay the interest and repay the principle amount as per the agreed upon installments. Growth is a gradual process and it is likely that the projected revenues from the new target markets will not be attained within the initial years of expansion. Taking this factor into consideration, businesses should be very conservative with their cash flows projections, and assess their ability to meet their debt obligations under their worst case scenarios. Expansion drives funded by disproportionately huge amounts of debt tend to fail due to the cash flow strain from debt repayments before the cash inflows projected from the new target markets materialize in full.
A leading mobile phone company in the US faced insolvency in the 1990s as it had expanded its product line using debt. However, these products were not selling as fast as the company had expected; and interest payments on the debt kicked in way before revenues from the new product lines could cover the interest payments in full. The result was a liquidity crisis and failure of the new product line for the company. It is therefore crucial for companies to have conservative projections on their expansion revenues and use aggressive estimates on their costs to determine if the free cashflows in the initial years would be enough to meet their debt obligations. One of the recommended practices is to stress test the cashflows within the firm to validate whether the company can survive in a worst-case scenario.
The safest way for businesses to avoid financial risk when expanding is to rely on their own internally generated cash flows to fund their gradual growth. However, retained earnings are in most cases not sufficient to fund an ambitious growth strategy, hence the need for businesses to source for external funding. In the event the business ends up sourcing for debt capital, it is prudent to ensure that there are sufficient cash flows to meet the debt obligations as they fall due. In addition, if a company is raising funds from external lenders, then it should only begin implementing its expansion plan after securing the funding. An organic food producer in North America, began expanding after agreeing with a local high net worth individual that they would receive funding. However, months later, the financial crisis affected the investor and they were unable to meet their commitment. This ended up putting the company in a negative cashflow position as they had spent money budgeted for other activities which they were not able to reimburse. The liquidity crisis could have been avoided had the company been patient enough to wait until the funding was transferred to their bank account.
Managing Operational Risks
Besides the financial risks, operational risks also tend to be overlooked during company expansions. These risks stem from companies putting an additional strain on their internal human, technological and physical resources. For example, a business could be expanding to a new market without bringing in new employees to meet the additional operational demand. This could lead to a high employee turnover due to employee burnout. Subsequently, the turnover will lead to additional costs to the business including training costs for new employees and reduced output as the new employees go through the learning curve within the company.
A recommended practice is to review the production levels that the company has met with the current operational capacity. If the existing operations are already optimally utilizing the internal human, technological or physical resources, then the company has to invest in new equipment, enhance its technology capacities and hire new personnel as part of the preliminaries in its expansion drive. Due to the fact that expansion tends to involve all departments within the organization, company boards should engage all levels of management when making decisions to expand. For example, accounting departments should be analyzed if they have the required knowledge of the accounting standards and tax regimes in the new market; or the different taxes that a merged corporation would be subjected to due to a change in its management or shareholding structure. The company could also be expanding into a new market and its existing sales team do not have the knowledge and capacity to convert sales in the new market. Building a sales force for the new target market should therefore be an operational priority before the expansion; in order to ensure sales forecasts are met and avoid cash flow challenges down the road.
Managing Keyman Risks
Finally, companies can face keyman risk when growing. This is the situation where the expansion of the company is dependent on a particular individual who often happens to be the founder or an influential C-Level executive. The key risk here is the individual could be exposed to a situation where they are not able to perform their duties or they are poached by a competitor. Asset management companies tend to face key person risk whereby once the key personnel in their portfolio management leave, the performance of the fund tends to be affected negatively. A major asset manager in Europe ended up closing one of its high performing funds after its senior portfolio manager left to start their own practice. To avoid this kind of eventuality, company management should invest in cross training and capacity building among the entire organization. Knowledge share programs where key individuals with more experience train those under them should be structured and continuously supported by the board.
Author: David Kageenu