Hibernation is NO Fun and How to Think About Expanding Your Business

I had an uplifting, sunshine filled experience yesterday, which I am pleased to share with you.  It’s been a long time, too!  A long time.  I telephoned a prospective client about their accounting and tax work.  The woman I spoke with is the office manager.  I already knew a bit about the company.  My first observation is how lucky the business owner to have as clear and perceptive a thinker as the office manager.  Really, she humbled me.  But, back to the reason for the call.  Their current accounting firm has not been proactive in providing general business guidance.  From the sound of it, they’re order-takers not order-makers.  The office manager said, “What I want you to do is tell me how a business like ours should be thinking about expanding”.  Music to my ears!  After two years of client cost-cutting and lay-offs, her request was like a fragrant, spring breeze. 

The economic times we’ve just lived through have certainly taught some lessons.  Regrettably, they’ve been imparted via the swift end of a two by four.  I suppose I could dust-off the product of previous thinking on the topic.  But, the times have changed me.  I need to put new ink to paper (or whatever the electronic equivalent is). 

I know I’m stepping out on the ledge a bit, but I think I’d like comments from those of you who read this.  Don’t feel bad if you decide not to.  But, it might be interesting if you do.

Anyway, here’s my first shot at “How To Think About Expanding Your Business”.  My purpose is to stimulate thinking on the subject.  Here’s my challenge: When asking yourself the questions I’ve posed and considering the statements I’ve made, on what side of the ledger do your responses fall?  Moving ahead?  Or, giving it a rest?  Some of the queries are either non-issues for you or already accounted for.  It’s the one’s you haven’t thought about, that resonate as important, that may provide value to the following.

You’ll notice I’ve written this in outline form, as if I were making a list.  Well, I’m a firm believer in the value of lists, especially those made in a hierarchical manner, which I’ve attempted to do here.  As you begin thinking about your expansion project I urge you to start making lists organized in a way that reflects the correct progression of events leading to a decision. 

What follows is rather lengthy.  To help you focus on the areas of particular interest, here’s the “table of contents”.

  1. Is this what you want to do with your life?
  2. What’s the idea?
  3. Making the Investment Decision
  4. The nature of demand
  5. Looking at the numbers and building analytical models
  6. Financing the expansion
  7. Exit strategy

HOW TO THINK ABOUT EXPANDING YOUR BUSINESS

  1. Is this what you want to do with your life?
    1.  As the business owner, what do you want to do with the rest of your life?  Expanding a business comes with risk (of course, I suppose failing to expand does as well).  There’s a gestation period before the seeds that have been planted take root.  You need to have the physical endurance, not to mention financial, to endure the ups and downs.  The time it takes for your new venture to take root is a function of the general business climate, the industry, your familiarity with the incremental business and the complexity of the business plan.  Here’s something to consider: Managing a business that’s sprouted down the hall from you is a lot easier than managing the same business located just far enough away it makes you think twice before traveling to it.  Imagine the complexity if it’s in another state, region, country, continent, different culture, language, laws, and so on.  What I’m trying to say is, is this really what you want to do?  Is your heart in it?  If it isn’t, better start thinking about plan “B”.  It’s easy to daydream the good stuff.  If you really want a taste of the stress you’re about to live with, make it a point to spend a few minutes in the dark quiet of the early morning thinking about all the things that could go wrong.  If you think it’s still a good idea after a few nights of this, you’re probably onto something.
  2. What’s the Idea?
    1.  The easiest idea is “more of the same”.  Often, expansion is driven by customer demand; legions of hardcore consumers beating on your door to sell them more products or services.  What a nice problem!  The nature of other ideas is more subtle: recognizing complementary products or services and similar skill sets or channels of distribution.  Some ideas are even further from one’s expertise but hang around your day dreams as something you always wanted to do.
  3. Making the Investment Decision
    1. What’s the basis upon which you’ll make a decision?
      1. Much of what follows is my recommendation of a process for evaluating your idea.  It’s obvious that to fully analyze the opportunity requires a significant amount of time.  I suppose there are those among us who have such a clear vision that additional pondering is unnecessary.  I know that’s not me.  It’s probably not you – especially considering what’s at stake.  Look, buying a new computer for the office is not the type of project I had in mind.  A new computing center might be, however.
      2. Objective or subjective?
        1. You can do it any way you want.  But, for my money I’ll take objective analysis as much as possible to minimize the risks such analysis is suited to uncovering.
      3. How much analytical detail do you want to commit to?
        1. There’s a cost/benefit to all this.  What’s your thinking?
          • Avoid the mistakes that are avoidable, or
          • Make hay while the sun is shining. 
    2. What’s your objective?  There’s a presumption this idea is going to result in something you want.  Make sure you have a pretty good idea of what that is.  In performing the analysis you should have some basis for comparing why you started pursuing the idea and the possibilities should you make it a reality.  Here are some things to think about:
      1. Make more money?  How much more
        1. When you examine the results of your projected financial analysis, what do you want to see?
          • In terms of sales, profits and cash flow?
          • In terms of liquidity and leverage?
            1. In one year, two years, four years?
      2. Improve the operations of your company to require less management from you?
      3. Make your company more marketable to others?
      4. Pursue an idea that’s been an itch you’ve wanted to scratch?     
      5. Have more fun?
      6. Spend more time at the office thereby staying out of the line-of-fire of your spouse?     
      7. Other??  (To the reader:  What are the other motivators prompting a decision to expand?)
    3. Do you include others in the decision-making process?
      1. Naturally, including others will come at a cost, but
      2. Time-to-market may dictate you get some help
    4. Stakeholders
      1. When making decisions about where your business is headed remember not to forget your stakeholders:
        1. Employers
        2. Family
        3. Vendors
        4. Customers
        5. Others ??
      2. Some groups will win; some will lose; some will win in certain ways but lose in others.
      3. Who do you need support from?
      4. How will you mitigate the loss of support
      5. Is there a scenario where the loss of support sinks the idea?
  4. The nature of demand.  I guess we’re getting into the realm of detail.  You’re planning on expanding due to customer demand.   The nature of the demand is to produce or provide services along lines similar to your existing business.
    1. Quality of demand
      1. Is it blip or is it long term?
        1. Something’s going on out there that’s increasing demand.
          • What is it?
          • Is it regional or national?
          • Is it momentary distortion of the supply chain
          • Will the demand be sustained long enough to make it worth your while
          • The macroeconomics of the decision is incredibly interesting.  There’s probably more than one source that can weigh in on this.  One particularly good source is the industry group to which you belong (or should belong!).  This won’t be the last time I say this, but ultimately you’re on your own in weighing the evidence you uncover.  Ultimately, the buck stops with your judgement
      2. Price elasticity
        1. I wonder how easily it will be for you to pass price increases to your customers?  Whether it’s labor or materials, the ease with which you can get your customers to absorb price increases may be the pivotal issue weighing on the success of your expansion. 
          • Are there alternatives to your product or service?
          • Where are your competitors located?
          • Are the competitors’ costs the same as yours?
          • Do the competitiors source their raw materials and labor as you do?
          • Is your competitors’ strategy the same as yours?
            1. For instance, do they use the product or service as a loss leader?
    2. Availability of “raw materials” (i.e., Cost of Goods or Cost of Sales)
      1. Materials availability and the demand curve
        1. Are materials widely available?
        2. Are there many sources or only a few?
        3. Is the local materials distribution point relative to your location an advantage or disadvantage?
        4. If materials are primarily sourced abroad, is the political climate friendly in those locations?
        5. Are material costs a large or small component of cost of sales?
        6. Does your inventory have many SKUs or few?
        7. Will the additional demand arising from your expansion impact the cost of materials.
      2. Labor availability and the demand curve
        1. Is your labor force highly skilled, trained or educated?
        2. Is there a reasonably easy access to labor?
        3. Is the educational infrastructure strong or weak in your community?
        4. Is labor a large or small component of cost of sales?
        5. Is the labor function susceptible to automation and technology?
        6. Is the skill-set in the labor force you will employ in high demand?
          • Does your region have other employers seeking the same skill set? 
          • If so, how will that influence the availability and cost of labor?
    3. Geography of demand
      1. Is it in your back yard or on the other side of the world?      
      2. Does where the demand comes from make it more or less expensive or more or less risky to do business?
    4. Condition of the economy
      1. Is the economy healthy? 
      2. Is your business sector healthy?
      3. Is your business sector trending up or down?
      4. Any bubbles out there?
      5. To what extent can demand be influenced by the economy?
      6. Where are interest rates going? 
        1. To what extent will an increase in interest rates impact your plan?
    5. Condition of customers
      1. Are your customers in good financial shape?
      2. Trending up or trending down?
      3.  Does the expansion expand your customer diversity?  Shrink it (i.e., create greater customer concentration)?
    6. Condition of suppliers
      1.  Are your suppliers in good financial shape?
      2. Trending up or trending down?
      3. Do you have a broad selection of suppliers?
      4. Can any one supplier cause trouble?
        1. How bad?
        2. How difficult is it to shift suppliers?
          • What’s the preliminary plan?
  5. Time to look at the numbers and building analytical models.
    1. Building analytical models using Excel to do the heavy lifting
      1. I like Excel.
        1. I’ve been using it for a long time. For doing the sort of analysis envisioned here it’s a great platform. The way I use it is to first develop the format (such as an income statement or project cost).
        2. Some items in the analysis are known and unlikely to change. By themselves, their numbers aren’t big enough to be worthy of additional consideration. However, there are other items that are so significant to the outcome they require special focus. These are the variables I want to manipulate.
        3. I will then create a companion worksheet within the file to serve as the index for the model where the variables (assumptions) are listed in individual fields. It’s a beautiful thing to play with the variables and see how the outcome changes.
        4. Other inter-connected analyses can be created that draw from the original (such as a statement of cash flow that will draw from the income statement).
        5. Additionally, you can perform multi-dimensional analyses by creating variables within the variables. For instance, within the cell representing labor cost are numerous factors you deem important to consider. And, within some of these factors may, in turn, be other factors to specifically account for. The result is that the single item on the analysis, “Labor” is built from numerous assumptions, which, themselves, are comprised of multiple assumptions.
      2. Beware of the Tower of Babel!
        1. There’s a tendency to create so much complexity the analysis loses its usefulness. The more variables built into the model, the less the user is able to take the output and use it intuitively. There’s a limit to how much the human brain can wrap itself around multiple variables and still make sense of it all.
        2. In addition, the complete flexibility of Excel is also its danger. One mistake in programming the Excel worksheet can lead to erroneous results that prove damaging.
      3. Using “if-then” statements to create a more meaningful analysis
        1. An “if-then” statement works like this:
          • If “sales” increases by greater than “x%” then increase “rent” by “y%”.
        2. The ability to program a level of sensitivity to activity level provides the opportunity to more closely model reality.
      4. Naturally, you’re not looking at a single point but rather a range of points which you, the decision-maker must decide best represents the likely outcome. As you change the variables take note of how the model changes. After you’ve made as many changes to the variables that makes sense, settle back with a cup of coffee (or whatever you happen to drink) and look at the results. Here’s where judgment comes into play. Where do you think reality lies in all of this?
      5. These sorts of analyses also allow you to evaluate risk. As sales declines, for instance, at what level is the business in serious trouble? Consider creating “low water” benchmarks that will signal if trouble is at your doorstep.
    2. Cost of the project
      1. This is really fun! It’s the first step in translating your plan into reality. Everybody likes to buy stuff. Here’s where we start thinking about it in concrete ways. You have a sense of what you want to accomplish. The question remains, what tools do you need? How much are they going to cost?
        1. Create a project plan.
          • What’s got to happen?
          • Who’s got to do what?
          • When is it going to happen?
      2. Costing the project
        1. The project plan doubles as the format for costing the project AND creating a budget.
        2. Here’s a great example of how Excel can be applied in the manner I’ve described above. A single cell in your main cost analysis can be supported with detail by as many subsidiary schedules as you deem appropriate.
        3. Identify what the idea will look like for purposes of understanding the components.
          1.  Describe the process of creating and distributing the product and/or service
            • Identify equipment and technology needs
            • Identify real estate needs
            • Identify suppliers
            • Identify staffing needs
            • Create a marketing plan
      3. Who’s going to do the research and analysis?
        1. You probably can’t do it all yourself.
          1. Who’s going to help?
          2. What are they going to do?
            • How much time will it take?
          3. How are you going to keep track of the progress of the project?
      4. Timelines and timing of investment capital needs
        1. Part of organizing the project is determining when things are supposed to happen. Often times A can’t happen before B. You need enough detail in this analysis to know when a problem arises during the course of the implementation.
        2. The timeline will also be useful in understanding when project costs need to be paid for. Forewarned is forearmed. Additionally, this analysis can be presented to a source of financing so they better understand the project and your needs. It also demonstrates your commitment to careful planning and cost control, which is music to a banker’s ears.
    3.  Projections
      1. Profit projection
        1. Obviously, there’s a range of responses you want to consider.
          • Optimistic
          • Realistic
          • Armageddon
        2. Through a certain activity level (i.e., sales volume) fixed costs remain unchanged except for inflation. What are the inflection points?
        3. Merely using current-year performance may not be an appropriate starting point. Each item on the income statement needs to be evaluated on the basis of “current reality”. This is particularly true for sales and cost-of-sales.
      2. Cash flow projection
        1. I can’t remember who told me this. My recollection is it was a pretty smart person who’d heard it from someone even smarter. The idea’s stuck with me. The question he asked is this:
          • “Do you know the reason why businesses fail?”
          • I had a bunch of reasons none of which was correct. Here’s the right answer:
            1. “They run out of cash”
            2. So true!
        2. There’s a difference between doing a cash flow projection for the next 90 days and one for the next year to three years.
          1. Predicting the actual cash balance at a point in time is an unsatisfying affair. It’s very difficult to do.
          2. Like so much of this analytical process, we ultimately weigh the actual results against our best judgment of realistic expectations. Those expectations can certainly be influenced by hard-core spread-sheet analysis but you have to be prepared for actual results that are broadly different.
          3. Maybe some thought on “why the difference” turns up more useful information for going forward than the projection itself.
          4. I think the more useful cash flow analysis is the longer-term one.
  6. Financing the expansion
    1. Who to go to?
      1. I’m presuming that despite your success you haven’t accumulated the capital necessary to finance this yourself. Frankly, debt capital is a lot cheaper. One of the points of extraordinary clarity to come from the economic crash of the last few years is the notion that banks were taking risks more appropriate for equity. Certainly, knowing what we now know, the banks failed to adequately charge for the risk they assumed. As the memory of the debacle begins to fade I sense a renewed appetite for risk on the part of banks. I wonder how long before we forget how poorly we matched risk and return and the acquisition of debt financing, once again, requires nothing more than proving you have a pulse.
      2. So, here are your choices:
        1. Banks (my first choice for small businesses)
        2. Private equity.
          • There’s lots of money out there chasing deals.
        3. Friends and family.
    2. What to expect?
      1. Debt and equity investors are simultaneously suspicious and greedy. I’d also say that under most circumstances they are, as we all are, optimistic. If you have a history of unbridled success investors will be falling all over themselves to give you money. If, on the other hand, there’s a stain or hiccup in your business past, their enthusiasm will be much, much more cloudy. The greater your successes, the more flexibility you have. The more problems in your past, the more locked-down and restricted will be your options, if any at all!
      2. Obviously, at least to me, you need competing options to consider. This process also provides an interesting benefit. I’m forever surprised at what I’ve learned about the lending/investment climate, about deal structuring and about the splendor of your business idea (or lack thereof) from speaking to third parties whose only interest is getting their money back and making a profit. It can be humbling.
    3. Assuring adequate capitalization and access to working capital.
      1. You need more than you think you do! Don’t kid yourself. Something’s going to go wrong.
        1. How much?
          • How lucky do you feel?
        2. How much more will your financing source go along with?
        3. Minimize the cost by having access to an additional amount on a line of credit specifically for this project.
          • Other than a commitment fee for making the money available, the cost is incurred only upon take-down of the funds.
    4. Term loans v. revolvers and fixed v. floating interest rates
      1. Here’s a maxim which makes a lot of sense to me: “Finance long-term assets with long-term liabilities and short term assets with short term liabilities”.
      2. That means if you expect the asset to last more than a year, finance it with a liability (or equity) commitment possessing a commensurate life.
      3. This applies to interest rates too. Lines of credit intended to finance accounts receivable are appropriate for floating interest rates. Lines of credit intended to finance assets such as equipment and real estate are appropriate for fixed interest rates.
      4. The interest rate yield curve reflects the nature of the risk. Interest rates rise as the repayment of the principal extends into the future.
      5. Don’t be lured into floating rates merely because they’re lower!
      6. Always ask for pre-payment rights. Work hard for rights without penalty. For many banks, it shouldn’t be a problem.
  7. Exit Strategy
    1. What’s your exit strategy?
    2. How does the new business affect your exit strategy?
      1. When does an exit strategy need to be implemented?
        1. Does the implementation of the new business conflict with the timeline of your exit strategy?
        2. Do you have enough time to implement your idea?
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