Why the organisational balance sheet is as important as the financial one
What is a balance sheet?
You are, of course, very familiar with financial balance sheets and how they relate to on-going activities (think P&L) and concrete outcomes (cash). Likewise, you know about the category of intangibles, i.e. assets you cannot touch, see or count easily such as software, algorithms; consumer brands; patents and copyright; ‘goodwill’.
But if we define balance sheet in broader terms to include all things which have absorbed time and cost to create with the intention that they create value for a business over a sustained period of time then we can identify other significant assets of interest to investors and executives. Those can include supply chain configurations, supplier and client relationships, or distribution channels. For a manufacturing business, machine calibrations and certifications fall into this category. In a call centre, well-honed customer management scripts might count, while for a user of SaaS systems, the time and money invested into tweaking configurations are all valuable.
Those are all assets in that broader balance sheet sense. But there are liabilities too, for example technical debt where the way software has been written creates on-going bugs, need for adjustments for individual clients etc. Like any kind of debt, there is an on-going cost to the business – paid in cash and management time – and a significant effort is required to get rid of it.
Does an organisation have its own balance sheet?
This balance sheet metaphor applies to organisations as well. You may naturally turn your mind to the quality of ‘management, management, management’, see here for discussion of that by some of our experienced friends:
On the asset side, workforce skills and culture can drive productivity. Embedded routines, practices and commitments can underpin quality and customer service. Organisation structures and communications can create agility and efficiency. The existence of strong second-tier capabilities can liberate top team energies for higher value-added activities. Likewise, a strategy which does its overriding job of guiding managers and staff on how to allocate their time and attention can create huge value. But note several things:
Firstly, that achieving any of those things is generally expensive in money, management bandwidth, and elapsed time. Managers tend to be busy with business-as-usual stuff – client questions, staff problems, checking performance, internal coordination etc. and so strong organisational balance sheets can take years and unusual levels of commitment to create.
Secondly, in consequence, the hope that gaps in those balance sheet items can be redressed in parallel with ambitious new initiatives is often over-optimistic. Either time and bandwidth need to be painfully carved out at the (temporary) expense of growth or else there needs to be a realisation that growth will hit constraints before long.
Thirdly, the value of a strong organisational balance sheet already in place is a rare and valuable thing. It creates options for strategic manoeuvres which most companies do not possess, regardless of whether they have grown quickly for the last few years. So, spotting the strength of weakness of organisational assets and liabilities pre-investment is pretty fundamental because the delta it provides for subsequent value is very high.
Why do we tend to under-invest into this area?
Like many intangibles, the costs of creating organisational assets appear up-front and hit the P&L quickly (they often look like overheads) but those assets produce value only over a longer period of time, and that value is often hard to calculate. That makes them vulnerable to relegation into the ‘nice to have’ category.
The shame of that tendency is that evidence about investments into organisational assets suggests that they can generate unusually high and sustained returns once they have been created. Rather than citing studies on that point, consider a thought experiment. Imagine a reorganisation which raises productivity by say 10% and that the benefit falls mostly to the bottom line. At a typical EBITDA multiple for mid-market companies, that is likely to be worth a lot to the company and its shareholders. The cost of achieving it is likely to be substantially lower than, say, bringing in new clients.
There have been various surveys over the last 20 years where investors have been asked to attribute blame for under-performance in investees. The top category in almost all of them is ‘management’. But I would argue that the executive team are just the visible part of the real cause which is the attempt by to grow companies with weak organisational balance sheets which cannot support scaling, clever strategies or shocks. That makes finding ways to make those assets and liabilities an explicit part of decision-making a genuine priority pre- and post-deal.
War Stories
The risk taker
One of the dilemmas in life and investing is how to appropriately balance optimism and caution. We need both, of course, but most people are aware that going too far in one direction or another can lead to painful surprises or stagnation. Super-optimists, a bit like people who have drunk too much, can be colourful but also reckless and dangerous. Take the case of Graham whom I met in the context of what looked like a hurriedly put together management team to help a vendor take advantage of the buoyant M&A market in the mid-2000s.
He was amused to recount some exciting moments in his life. For example, in the property boom of the late 1980s he re-mortgaged his house to indulge in speculation – without telling his wife – and then lost everything including the wife. A few years later, he became involved with a franchise opportunity which collapsed due to fraud by the owners. Later still, and immediately after being appointed to a leadership position in Europe for a US business, he invented a buy-and-build strategy (something he had no experience of) on a plane trip and ‘winged’ his presentation to key decision-makers. He subsequently struggled with gaining the confidence of his European colleagues but a stroke put him out of action before he could try to execute the strategy.
When I met him, he was the salesy CEO of a business being offered for sale at around £32 Mn. to our clients. It soon became apparent that the valuation was way-off and discussions ceased. A few months late a restructured deal was done with another buyer for about £23 Mn. and they also supported two bolt-ons. A somewhat larger business was sold within 18 months to a very optimistic foreign buyer for about a 3x return, despite making almost no profit. The business itself didn’t prosper thereafter – shrinking and losing money - and Graham exited after another year, with the business sold on for a rumoured £10 Mn.
All in all, Graham’s risk-taking style had made money for some people and not others – and valuations seemed to depend more on hopes for the future than demonstrated value.
The frog and the scorpion
It’s always a problem when people don’t turn out as ‘nice’ as they first seem. The apparently good businessman who, yes, may well be good, but only for himself. The team player who is happy to be in his own team of just one. However, sometimes the evidence is staring us in the face and we still don’t act.
RepairCo specialises in repairing high-performance engine parts and appeared to be performing well but needed investment to grow. The main shareholder, Chris, had worked in the sector for many years and seemed – on the face of it - well qualified for leading what was intended to be a steady rather than spectacular plan. The top team needed filling out, notably with a CEO (allowing Chris to become exec chair) and an FD. Candidates for both had been identified and looked strong.
Unfortunately, Chris had a dark side. He had led a previous business into administration and been disqualified. In informal comments during the DD process, he described amusedly how he had essentially defrauded the MOD. When it came to referencing him, he had a few fans but, on the whole, the more people had had the opportunity to work closely with him, the more they appeared to dislike and fear him. Various lurid stories emerged regarding threats he made against people who might reveal his unsavoury practices.
Faced with these revelations, the investor concluded that financial incentives and the involvement of the new appointees would probably neutralise any negative influences. Indeed, initially, the business grew its scale and profitability due to various actions to professionalise sales and operations. But the CEO had had enough after a year and the FD followed him a year later. As Chris regained influence over the business its performance deteriorated and newly appointed managers also came and went. The company continued downwards into a full crisis.
The remedy involved a change in the investor director, the appointment of an independent Chair, and a new CEO – and the side-lining of Chris into a pure board observer role. Since that point, performance has recovered step-by-step with activity now back above the starting position although EBITDA is still lower than seven years previously.
The management hypothesis here was that a known rascal could be managed to do the right thing by the ‘good guys’. Unfortunately, this ignored the fact that narcissists and fraudsters have developed specialised skills to run rings around most of the rest of us. Ignore that and one can end up as their next victim.
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