Will the business survive?: 7 Leading Indicators

Specific business indicators can be analyzed to determine whether a business is a good candidate for surviving another generation. Some business are better suited for a transition strategy than others. It’s usually helpful to test the business against a variety of different indicators. Obviously, if a review of the relevant business indicators suggests bleak prospects after the exit of the parents, a sellout may be the best alternative.

First Indicator – Is the Business Strategically Based or Relationship Based? The strength of some businesses is primarily attributable to keep personal relationships that have been developed over many years. The relationships may be with suppliers, customers, key employees or all three. These relationships give the business its advantage and make it possible for the business to succeed. In contrast, there are other businesses that are strategically based. They’ve identified and filled the market niche that is not dependent or tied to personal relationships.

The business succeeds because it is strategically situated to competitively deliver goods and services in an identified market niche. Obviously, a strategically based business has a better chance of surviving a second generation. Relationships often are difficult, if not impossible to transfer. The child may develop a friendly interface with the crucial vendor but that interface will never match the strength of the personal relationship that the father had with the vendor.

The challenge becomes even more difficult when the vendor’s successor takes charge. The reality is that over time, the strength of personal relationships often break down and fizzle out as attempts are made to transition relationships. As this occurs, there’s a substantial risks that the business activity between the parties will diminish unless both parties identify a strategic business advantage for maintaining the relationship.

Sometimes a business owner misreads the situation by assuming the business is strategically based when in fact the basis of its success is personal relationships that have been developed over many years. Similarly, there are some businesses that appear to be propped up by relationships but that could be strategically strengthened with some careful analysis, some restructuring, and some very good public relations. The challenge for the owner is to identify key personal relationships, assess the importance of those relationships to the overall success of the business, and evaluate the capacity of the business to enhance its strategic base.

Indicator 2 – Is Institutionalization Possible? A central challenge for many businesses is to begin the process of institutionalization. In this context, an institutionalized business is one that is bigger than any one individual. Its operations and growth do not primarily depend on the person that started it all. It has developed systems, personnel, management structures and expertise to allow it to function like an institution.

The contrast is the business that is operationally dependent on one person. That individual is the key to everything that happens. Without that person’s daily presence, that business lacks direction and suffers; the system, support personnel, and expertise are not present. An institutionalized business has a much better chance of being successfully transitioned than a business that is primarily dependent on its leader.

Some owners do not want to invest the time or capital required to build systems and personnel that will allow a business to effectively function on its own. In some cases, it takes a financial commitment that the owners are willing to make. In others, it’s kind of a control ego obstacle. The owner enjoys the importance of his or her invaluable presence. A smart owner will always be trying to fairly assess what steps should be taken to help institutionalize the business. Usually these steps are critical if the business is going to survive a second generation.

Indicator 3 – How Much Margin Tolerance? This indicator relates to price and margin flexibility. The question is whether the business can survive and prosper if it is faced with some serious price competition. Ask this: What would be the impact if the business was forced to cut its gross profit by 3% or 4% to remain competitive? If the responses is a roll of the eyes and a “No way!” explanation, this may suggest that the business will struggle trying to survive another generation.

In most businesses, price competition is intensified. Others have found better ways of producing the same products or delivering comparable services at lower prices. New techniques on operating systems are being developed to allow businesses to operate more efficiently. Businesses are right sizing to cut out the fat and to have the capacity to operate on lean tough margins. New players are not tied to all systems and old investments.

Often a business finds itself at an intense competitive disadvantage as bigger and stronger players, perhaps from foreign lands, enter the market. It does not have the capital or the sales volume to justify the development of the economies of scale, new technologies and operating systems that would allow it to remain tough on price. Many business owners sense or know that they’re operating the old way and that their market share is being challenged by new players who have better ways of better ways of competing.

If this situation exists, the better alternative may be to consider selling while the company’s market share is still intact. If the sale opportunity is missed down the road, the owner may be forced to sacrifice or eliminate profitability by cutting margins to preserve the business. This has been the fate of many businesses that have been unable to survive a second generation.

Indicator 4 – Asset Base. The asset base of the business may be an indicator of whether the business can successfully survive another generation. Some businesses have a unique substantial asset base that cannot be readily duplicated. The assets have been developed over a long period of time. The key asset may be a unique custom manufacturing capacity that gives the business a competitive advantage in the market place. In some cases, there may be valuable patents, trade names, or intellectual property rights that protect the business. When such an asset exists, the business has a better chance of surviving a transition.

In contrast, the asset base of many businesses is not unique or significant in many respects. It can be readily duplicated by any new player entering the market.

Indicator 5 – Is the Business Low Tech or High Tech? A low tech business is one that does not rely heavily on new technology to sustain its position in the marketplace. It does not have to keep coming up with new technology concepts to support the viability of its market mix. It offers a group of products that are readily recognized as non-technical. In contrast, a high tech business is dependent on its ability to create new ideas and new products. Often the success of a high tech business is tied directly to the talent of the individuals that work in the business.

From a transition stand point, a low tech business usually offers a stronger position than a high tech business. A high tech business today can quickly end up being a defunct no-tech business of tomorrow. The competition in high tech business continues to grow to rapid pace as players throughout the world enter the market place. This low tech/high tech distinction is an important factor to consider in evaluating the transition capacity of any business.

Indicator 6 – Other Barriers to Entry. What are the barriers to getting into the business? Some businesses have very substantial barriers that make it difficult for a competitor, a new entry into the market. The barriers may be tied to customer relations, brand strength, government regulation, product technologies, historical market positions, intellectual property rights or financial commitments. If the barriers to entry are high, the chances of successfully transitioning the business go up. If the barriers to entry are low and others can easily access the same market, the prospect of the business succeeding a second generation is reduced.

Indicator 7 – Capital Structure. The capital structure of a business may influence the parent’s attitude regarding the need to sell or transition the business. Often changes in a business capital structure may cause the parents to look at the transition plan very differently. A common scenario is the family business that has done everything in its power to reduce or eliminate debt. The parents determine a long time ago that the business had a better chance of succeeding with little or no debt.

As a result, the parents have taken steps over an extended period of time to reduce or eliminate all debt in the business and in so doing have committed substantially all of their assets to the business. This situation significantly increases the stakes, the Sell vs. Keep decision. If the business is sold, the parents free up their capital, are able to diversify their holdings, and are in a much safer financial position. If they choose to transition the business, often it is advisable to consider restructuring the capital base of the business in order to enhance the strength and diversity of the parent’s total capital. This can be done by having the business take on an appropriate amount of debt that is secured by the assets of the business and that is funded over time through the business’ operation.

As the business increases its leverage, the parents are able to implement diversification strategies that allow them to pull funds out of the business. These funds can be used to develop investment portfolios, fund life insurance programs, and accomplish other financial planning objectives that are not tied to the business.

There are other collateral benefits that may surface if the company has an appropriate debt/equity ratio. The parents may be able to make larger gift tax-protected equity percentage transfers to the children because the value of the business equity will be reduced. Interest paid on the business’ indebtedness will be tax-deductible. Children who are targeted as the successors will begin to develop valuable relationships with financial institutions and gain a much better understanding of the financial markets and how they work.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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