InSight

Exit and Growth Strategies for Middle Market Businesses

Not the Time to be Under-Capitalized

By George Walden | Nov 25, 2008

During the last period of economic boom many companies expanded through debt financing. The logic was if one machine is making money then adding three machines will make three times the money. As long as the economy was strong and margins remained high this was viewed as good thinking. After all, even if the economy dropped, the value of the equipment, even leveraged, would be equity that could be used to raise capital in a downturn.

Then just like the housing market, the phrase “mark to market” enters the valuation. Suddenly you find you’re upside down in the market. Whether you borrowed money to expand your organization, equipment, or inventory; all have suddenly become less valuable in a down economy. The true value of the equipment is the value of the goods produced by the equipment, not the intrinsic value of the equipment itself. The inventory values have declined. There is too much equipment on the market at the same time and suddenly the value of your asset has been cut in half. Your people are being paid a premium especially when compared to foreign markets but they are refusing to go along with your cost cutting measures.

The dictionary defines under-capitalization as follows:”A business has insufficient capital to carry out its normal functions. Of, relating to, or being a firm that has insufficient long-term equity to support its assets. An example would be a rapidly growing company that finds itself financing its operations primarily with short term loans may be considered undercapitalized.

The common business owner mantra, “I feel like I am working for the bank”, is never so true a when you are undercapitalized. With this downturn business owners should expect sales to decline, margins to tighten, profits to shrink and capital to become more expensive and more scarce. Most business owners will not make the changes needed and risk everything on the belief that they can just get by until the next upturn. Some might even be purchased out of foreclosure.

There are things you can do to mitigate the current situation.

1. Begin cost cutting measures immediately: Don’t wait for the economy to affect your business.

2. Try to convert short term debt to long term debt: While some banks are cutting back their business many are still lending or are being mandated to lend. Be first in line and present a plan as to why converting the short term debt to long term debt makes the business a stronger entity for the future. Advisory firms can help you with this process.

3. Let go of marginal people: Most businesses run with the axiom of the 80/20 rule. Twenty percent of the people produce 80% of the business. Be honest about who is producing for the company. No one likes to release people but if reducing overhead protects the company, better to lose one or a few than lose the company and put everyone in the unemployment line.

4. Reduce excess inventory: Most industrial companies have inventory issues. Scrap what is not useful and sell the rest. Cash is king during a down economic period. Inventory that is lying on your floor or rusting outside doesn’t do you or your business any good.

5. Return or sell excess equipment: Just getting off of a note can be a victory for a company in an economic downturn.

6. Convert debt to equity: Good companies still attract investors even in a down economic period. Consider giving up some equity to raise cash or reduce debt. Finding the right type of capital while the company is still relatively strong can very effectively set you up for the next economic upturn.

These are just a few ideas for implementing strategies for a slow down. Those owners that accept the situation and make the necessary adjustments will probably fare very well over the next cycle. I am not saying all businesses will diminish in this economic setting. Some will excel. They are the flexible companies that attack situations as an opportunity.

If you need an analysis of your current situation speak to an experienced firm that has successfully helped others in previous downturns. Now is the time to work out a plan with your advisors. Waiting until it is too late benefits no one.


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