Rise and Fall

Posted by on Jun 14, 2013 in Blog, Featured, HR | 0 comments

The following is a fictionalized version of real events at one of Ken’s businesses.

Rise and Fall

By Ryan Carter

It was a hot, dry day in California’s central valley.  Steve was skateboarding with his friends on a Saturday afternoon.  While sipping on sodas, they sat down on the curb.  “Steve, when are you going to get a real job? It’s been two years since we graduated high school,” one of his friends inquired.

“Actually, I just heard about a beginning job with a local electrical company. I think they install the large pumps to irrigate the valley,” he responded.  “I am supposed to meet with a guy on Monday.”

Steve, though young, was enthusiastic and driven.  He had a certain charisma about him that was hard to ignore.  Catching the eye of Bob, the regional manager, he was hired on the spot.  He reported for work the next day.  The work was hard, the days were hot, but he liked it.  It was rewarding to see the water flow through the fields and he felt like he was learning a meaningful trade.  Under the tutelage of a more seasoned journeyman, Steve quickly learned the ropes.  He absorbed new information quickly and had a knack for figuring things out.  After two years he was promoted to a technician and could perform work from his own truck without any direct supervision.

In his new role Steve excelled even further.  He liked having the extra responsibility and did well under pressure.  He understood that the business relied on getting the company’s name out in the public and he did well at finding new customers.  The regional manager started to hear good things about this budding star in the company.

“Tom, how is Steve coming along in his new position?” Bob asked his branch manager.

“Bob, he is doing great.  We took a bit of a risk on him in the beginning, but I think the potential we saw in him is starting to show.  He has already brought in 3 new jobs this month,” Tom replied.

Four years after Steve started, the branch manager decided to leave the company to take another position.  Despite having the least experience, the other employees in the shop expected Steve to take his place.  They’re assumption was correct and the regional manager called on Steve to take over.

“You know, there will be a lot of weight on your shoulders.  You have shown that you care for the company and I believe you have what it takes to be a leader,” Bob told Steve.

Along with his new responsibilities as branch manager came a healthy pay increase, which Steve was glad to receive.

During Steve’s first year as manager things were going great in the company.  The economy was good and there was a lot of work to do.  The branch even had to hire a couple of extra people to keep up with the demand.  Steve’s charisma helped him motivate the crews and he was well liked by the other employees.  They started having company barbeques on Friday evenings after work.  Steve treated everyone like family.

Steve continued to bring in new customers and bid on even bigger contracts.  He successfully completed several large jobs, netting the company some healthy profits.  Bob was pleased with his choice of branch manager.  Shortly after his first year, Steve had a meeting with Bob.

“Things are going pretty well at the shop and I feel like I am helping the company make quite a bit of money.  I think I deserve a raise,” he told Bob.

Bob recognized that Steve was doing well, but he also recognized that Steve’s compensation was already very competitive in the market.

“I think you are doing a great job, I think it’s time we talk about some type of bonus structure and profit sharing,” Bob stated.

He then went on to explain that a certain percentage of Steve’s compensation would be tied to volume and profitability at the branch.  With the way things were going in the company, Steve was very happy with the amount of money he would be making.

A year later, the economy began to slow and the branch began losing profitability.  Bob met with Steve to show him some of the numbers.  An investigation in the accounting books showed that the number of billable hours had declined, yet the employees were still taking home full paychecks.

“We need more billable hours to support the number of staff we have.  Either you find some more business or we will have to start cutting back hours,” Bob said.

Steve was dismayed by the fact that some of the employees might have to reduce their hours.  He was also frustrated that his compensation had diminished due to the falling profitability.  He had difficulty understanding why he was being paid less because the branch was not doing well.

As time passed by, things did not improve.  The economy and the subsequent amount of work continued to plummet.  Steve was not able to find enough customers to create sufficient billable hours to keep all of his employees busy.  Rather than cut hours, Steve would put two or three people on a job that only required one person.  This would result in going over budget on large contracts and the company would lose money.  Additionally, he would bill smaller customers more hours than necessary because the extra manpower was inefficient.

A series of monthly meetings convened between Bob and Steve.  Bob was very concerned about the financial state of the company.  During one meeting he said, “We are losing a lot of money.  We just can’t keep all these employees.  In order to cut cost we need to lay off the part-time secretary.  One of the secretaries from the other branch can take over her duties.”

Nearly infuriated, Steve shot back, “We can’t lay her off!  She is like family.  What will she do now?”  Steve understood the situation, but he was starting to feel a lot of animosity towards Bob.

Unfortunately, things at the branch went from bad to worse.  The poor economy had all but halted any new work from coming through the door.  Likewise, the company was losing a few of their valued customers from the overpriced labor charges.  Steve reluctantly reduced some of the hours among the employees, but he had not completely done away with all of his questionable managerial practices.  Things came to a head when Bob informed Steve that the company was losing too much money.  He had to lay off a particular employee that was underperforming.  This employee was brought on by Steve himself, and happened to be his roommate.

For Steve this was the final straw.  He did not want to see another employee let go.  Steve knew that there was no one else in the branch that could take over as the manager.  He also knew that his knowledge of the branch and its customers was extremely valuable.  His rapport with certain high-dollar customers was understood and Bob knew it would be tough to replace someone like Steve.

Steve called Bob into the office for a meeting.  Putting all his chips on the table, he looked Bob in the eyes and said, “If he goes, I go.”

Bob had no choice but to call his bluff.  Steve and the company parted ways.  The company eventually moved on and made it back to pre-recession volume.

About a year later the secratary answered a call.  “Michelle?  Hi, this is Steve.  How are things going at the shop?  Are you guys looking for extra help?”

 

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Free Cash Flow and Financial Ratio Quiz

Posted by on Jun 10, 2013 in Blog, Featured, Finance | 0 comments

This is a selection of True/False questions from a corporate finance course I took.  The questions are designed to be tricky, so read them carefully.  If you dont recognize certain terms, use this as a good opportunity to learn what they mean and how they can be used.  I have found Investopedia.com to be a good reference for this.  You might want to start with what ‘free cash flow’ is.  In future articles we will try to explain some of the answers and how these ratios are important to your company and general investing.

1. (T/F) An increase in ‘accounts receivable days outstanding’ will reduce free cash flow to the firm (FCFF).

2. (T/F) Reducing debt balances will decrease free cash flow to Equity (FCFE), all else equal.

3. (T/F) An increase in dividends paid will reduce free cash flow to the firm, all else equal.

4. (T/F) An increase in ‘accounts payable days’ will reduce the length of the ‘cash cycle’.

5. (T/F) An increase in interest expense will reduce the Return on Invested Capital.

6. (T/F) Comparing two firms with identical operating performance and size, the company with the higher debt ratio will experience greater variability in its Return on Equity, all else equal.

7. (T/F) Holding other factor constant, if a company increases its accounts payable balances and uses the cash to repurchase its own stock, the Return on Invested Capital will improve.

8. (T/F) The Return on Assets is unaffected by a company’s financing choice of debt versus equity.

9. (T/F) If two companies have the same level of current assets and current liabilities, the Quick Ratio will identify the company with more inventory as having lower liquidity risk (greater liquidity).

10. (T/F) A problem with using net income as a performance measure is that it is likely to lead to over-investment.

Answers: (1. T, 2. T, 3. F, 4. T, 5. F, 6. T, 7. T, 8. F, 9. F, 10. T)

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Business #11 – Art of the Appraisal

Posted by on May 31, 2013 in Blog, Featured, Finance | 0 comments

Business #11 came to us in a roundabout way.  We were advertising for drafting employees to meet the needs of our cell tower engineering customers.  A young lady came in to apply for the position.  We asked her why she was leaving her existing job and she said her employer was retiring.  We took that information and called the owner to find out about his business.  Sure enough, he was selling his business.    He was old, tired and ready to move on.

I contacted the business broker and we started in on the negotiations.  The first thing I received was a copy of the appraisal, which the owner paid a lot of money for.  Historic income statements showed declining sales:  2001, $1,119,655; 2002, $716,131; 2003, $439,599.

The appraiser then developed a risk factor model:

Build-Up Model, Risk Factors:

Risk-Free Rate                                     3.97%

Market Equity Risk Premium           6.92%

Small Business Risk Premium         20.00%

Total Discount Rate                       30.89%

The appraiser then capitalized the earnings with a weighted average:

Capitalization of Earnings            Normalized      Weighting        Weighted

                                                            Earnings           Factor                Earnings

Fiscal 2001                                             401,135                  1.0                  401,135

Fiscal 2002                                             239,774                  2.0                  479,548

Fiscal 2003                                             80,132                    3.0                 240,396

Sum of Weighted Earnings                                                                          1,121,079

Divide this by Sum of Weighting Factors                                                              6.0

Weighted Average Earnings                                                                        186,847

Divided by Historic Capitalization Rate                                                              30.89%

Total Equity Value                                                                                           604,877

It is important to note that business appraisals are part art and part science.  There are a lot of assumptions to be made and the combination of those assumptions can change the value wildly.  In this case, the appraiser weighted the last 3 years of earnings, giving more recent years a higher weight.  This is a common method, but past performance does not predict the future.  If you follow the trend line, the sales will hit zero in a matter of a couple years.  Stating that the company will generate free cash flow of $186,847 in perpetuity is wishful thinking at best.  The new owner needs to pull the business out of a nose dive, which could cost even more capital.  For this reason, its important to appraise a business in at least a few different ways to get a good idea of what’s at stake.  We plan to cover some of these ways in future articles.

With an appraisal in hand, the owner opened negotiations with a sales price of $600,000.  We told the broker we were not interested at all at that price.  His expensive appraisal was only looking at past results and did not forecast the most likely scenario going forward, which was a continuation of 2003 results.  We just stayed in touch while the broker tried to find other buyers.  The seller and broker came to the realization if they wanted to sell his business he needed to lower the price to a reasonable number.  We entered serious negotiations and the business sold for 25% of the appraised value.  I negotiated my usual 50% down, 50% financed over 5 years.

We were able to stream-line the operation and this became a very profitable branch office, even at historically low volumes.

Keys To Success

  • Business appraisals are just assumptions, if yours are different, don’t buy
  • Do not be put off by the initial asking price
  • Be observant and look for opportunities everywhere

 

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Mind Readers

Posted by on May 23, 2013 in Blog, Featured, HR | 0 comments

The ability to read another person’s mind has been a fixture in popular movies and books for at least a century.  Characters like mutants, aliens, vampires and mad scientists are usually portrayed using this power for evil.  People are rightly uneasy with the notion of having their most intimate thoughts plucked from their minds and exposed for others to see.  Likewise, you can understand how these inner-most-thoughts could easily be exploited.  I would like to inform you that a mind-reading device was invented over a decade ago and its use has recently exploded in the last 5 years.  Stalkers, news organizations, global corporations and even the government have access to this device and will use it on you if you are not careful.  Strangely, the device of which I speak does not extract thoughts through compulsory means, but rather, individuals reveal their thoughts voluntarily.

Twitter, Facebook, and to a lesser extent LinkedIn, are broadcasting our collective thoughts 24 hours a day.  I find it funny, and at times disturbing, how often I see news of a celebrity apologizing for some Tweet they posted while tired or utterly inebriated.  It’s even more unbelievable when they are perfectly coherent.  Does your iPhone need a breathalyzer? Do we need a driver’s license for social media?  Maybe not, but your company does need a solid policy for social media.

We all have crazy thoughts, but some people just can’t keep them to themselves.  In the past, this would have only caused an awkward moment at a social gathering, but today, thousands of people will know about these unfiltered thoughts in a matter of seconds.  This poses a huge risk for your company.  Your hard-earned reputation could go down the tubes because of an off-color joke or socially insensitive remark carelessly posted by one of your employees to all his followers.

It’s obvious that anything coming from the official company account needs to checked an rechecked before it gets posted.  This type of work should not be pawned off on the volunteer intern.  This is your company’s image and you should take great care in making sure it’s correct.  There are tools available that will delay a social media post for a predetermined amount of time just in case you want to retract your words before its too late.

What your employees post in their personal time is an entirely different beast.  Your policy on such behavior should be clear.  There are many legal and privacy questions around this subject.  Many companies have policies that limit what high profile employees can say on their personal accounts.  Some companies even state that their executives are not to have personal social media accounts at all.  The bottom line is that you need to mitigate this risk to your company by implementing a policy that makes sense for your industry, your business and your customers.  Once something hits the Internet it is impossible to erase it.

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Business # 10 – On The Lookout

Posted by on May 16, 2013 in Blog, Featured | 0 comments

Business #10 was flat out a business of opportunity.  My mentor had seamless gutters put on his home and during the process he asked the installers about the business.  The foreman explained that they pull a trailer from job to job that extrudes rolls of flat aluminum into gutters of custom lengths.  These gutters are then installed on the spot.  One crew can do two jobs a day and bill out up to $2000 a day.  This seamed to be a low overhead, easy-to-operate business.  After that discussion with my mentor, I was on the lookout for a gutter business.

Not long after this, I was given a tip that someone was interested in selling his gutter business.  I was not told the identity of the potential seller so I had to cold-call some businesses in the area using information from the contractor’s licensing board.  I eventually identified the owner that was thinking about selling his business. His response was, “Maybe, but not yet.” He wanted out of the industry to pursue something else, but his new venture was not up and running yet. I stayed in touch with him for many months, calling occasionally to see how his new venture was developing.  I even had him replace gutters on my house and I was impressed with the crew and the quality of the work.

After 8 or 9 months, the owner called and said he was ready to sell his business.  Given that our relationship was now quite strong, the negotiations went smoothly. We did the typical 50% down, 50% over 5 years at 6%.  The matrix was 65/0/15/20.

At the time of the acquisition we did installations directly for home owners and also teamed up with roofers to sell new gutters with the new roof.  I hired my new son-in-law to manage the business and he landed Home Depot as a customer, which increased sales by 30%.  We added another gutter machine and a second crew to keep up with demand.

Things were going well until the housing market crashed.  With falling home prices, people were less motivated to make improvements to their homes.  Home Depot started to put the squeeze on their wholesale contractors, which left us with little or no margins.  Things looked pretty grim for a while, but the market is recovering and things look much brighter for East Bay Gutters.

Interestingly, after my son-in-law moved on to go to law school, the old owner came back to work as a manager.  His venture did not turn out as he planned and he was looking for a job.  He worked for me for a few more years before finding another job.

The business has had its ups and downs, but it really turned out to be a neat little businesses that can be expanded.  We are looking to reinvigorating the business even more with a new marketing campaign.

Keys To Success

  • If you can, take the business for a test drive
  • Patience will save you money
  • Quality relationships always prove to be valuable
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Business #9 – Putting the Pieces Together

Posted by on May 9, 2013 in Blog, Featured | 0 comments

My mentor always kept an inventory of the skill sets and interests of people he knew so he would have certain pieces in mind to put together his next deal.  This networking tool came into play for me on business #9.

I found business #9 on BizBen.com.  In many ways it was a perfect fit.  It was 10 miles from my home, highly profitable and a great niche.  The seller was running the business at 52/0/10/38 and, like so many other of my deals, he was burned out and motivated to sell.  The only problem was that the company was a civil engineering firm, a discipline outside of my expertise.  The owner was the only licensed engineer, so the new buyer (ideally) also needed to be a professional engineer. Upon learning this, I realized how I could use this fact to my advantage.

The business was priced very high, but finding a buyer with the capital, skills and engineering license would be difficult for the seller.  My brother-in-law proved to be the first piece of the puzzle.  He is a licensed engineer and was looking for a new opportunity after being in city government for 20 years.  He was immediately onboard.  I also added an additional investor to spread out the financial risk.  The seller was tough, but he liked our team.  Knowing his business was a hard sell, he started to move on price. However, the terms turned out to be another obstacle because the seller was not willing to follow my usual 50% down 50% seller-financed model.

The second puzzle piece was financing. We went back and forth many times, struggling to find middle ground.  In the end, we got our price and he got his terms, 70% down, 30% seller-financed for 54 months at 6% with a personal guarantee from my brother-in-law.  I had avoided personal guarantees up to this point, convincing the owners that the business is the seller’s security.  For my brother-in-law’s experience and personal guarantee he was named president in charge of daily operations and issued 1/3 of the outstanding shares of stock.

The final piece of the puzzle was a collection of things I try incorporate into all the businesses I buy, strong accounting practices, efficient operating systems and sufficient working capital.  Luckily, business #9 was the cleanest, neatest business I had ever owned.  The engineering business has minimal inventory; we sell designs and drawings.  It is a great business provided you have work.   We took over the business in the middle of the cellular tower construction boom and we did millions of dollars of cell tower designs.  Fortunately, the seller’s niche paid the business off quickly.  Since then, the company has had to adjust to changing market conditions.  The cellular business became super competitive and dried up with the 2008 crash.  We were blessed to segway into solar and wind energy projects, but that market is developing slowly . The business will need to reinvent itself to continue to thrive.

cell_tower

Cell Tower

Shiloh_wind_farm

Shiloh Wind Farm, Solano County, CA

 Keys To Success

  • Business deals are like a puzzle, the pieces need to fit.
  • Look for great businesses, regardless of your skills.
  • Focus on running the business and leave the rest to the right talent
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