RESOURCES

Turnarounds

Turnarounds involve companies that have fallen on hard times. Someone - often a third party but sometimes current management - sees value in the business beyond recent performance and takes on the challenge of turning the business around. These opportunities are fraught with risk. Typically, if the company continues on its present course, it will not be able to remain a going concern. This is all the more true if the transaction that starts the turnaround involves debt financing. Against that backdrop are the twin challenges of accurately diagnosing what is wrong with the business and quickly developing and implementing a turnaround plan that addresses those problems.

This section looks at the most common problems and most common fixes in turnaround situations and then discusses the types of financing available to those undertaking a turnaround.

While there are as many types of business problems as there are businesses, areas that give rise to the need for a turnaround can be placed into three basic categories: poor management, uncompetitive cost structure, and declining market position.

While these may be very broad and over-simplified categories, they are helpful in thinking constructively about whether a particular situation can be turned around. In the following discussions, the basic assumption is one of a company that has seen a decline in profitability reach crisis proportions.

Poor Management

It is always easy to second-guess the decisions of current management. There are, however, certain circumstances in which management can be evaluated and problems created can be identified. In a sense, the incentive structure of the management team is the critical issue. If management does not have incentives aligned with the bottom-line profitability of the enterprise, the company might have a problem with its management team. A disparity between trends in executive compensation and company performance confirm the existence of the problem. The management team in this situation is using the company to support their lifestyles and not taking direct, personal responsibility for the business' problems.

Issues with management may also be evident active yet incorrect decisions that have led to the decline. Analyze the profitability of the business by product line over the preceding five or ten years, paying particular attention to margins and business mix in the period immediately prior to and during the course of the decline in profits. Forays into unprofitable lines of business can be reversed provided the core - and formerly profitable - business is still intact.

Problems traceable to bad management can be easily solved by firing the individuals in question and hiring new managers. It is axiomatic that good management is central to a successful business. But all investors must be prepared to fire a management team, and therefore, all investors must be confident in their ability to source good replacement managers.

An investor presented with a turnaround business plan in which the centerpiece involves replacing inept management can make reasoned guesses as to what the future will hold under the new management team based on an assessment of the track record the new managers bring to the enterprise. Have they turned around similar businesses with similar problems? Are they investing cash equity in the business? Is there a credible turnaround strategy in place or are the new owners simply hoping that the new manager will change things merely by not being the old manager?

Cost Structure

Poorly managed costs can strangle a business, all of which must be closely examined for savings opportunities. From an investor's perspective, cost savings are often more readily believable profit enhancements than the introduction of a new manager or a fundamental shift in the business plan. It is easier to accept that if last week there were five people in an office and this week there are four, the company's costs are likely to be lower and everything else being equal, the business is more profitable by that difference.

However, there remains the question whether the remaining four people will be able to take on the responsibilities of their former colleague. An alternative to eliminating the fifth position is to reduce the compensation of all five employees, in this case by 20%, and granting each employee equity in the company commensurate with that wage reduction. In a successful turnaround, this approach can align incentives throughout the entire workforce, increasing productivity and leaving the company with a loyal and incentivized workforce to manage future growth.

Labor costs can be reduced through the elimination of positions or the reduction of cash compensation levels or both. Another approach, often combined with an ESOP structure, is the implementation of a profit-sharing program in lieu of some portion of fixed salary or wages. This turns a completely fixed cost item into one that is partially fixed and partially variable with the profitability of the company. As an overall goal in a turnaround, transforming fixed costs into costs that vary with profit is an important one.

Another major area of costs saving opportunity is purchasing. Many businesses limit their purchasing to sole source vendors, even when multiple sources exist for the goods or services being purchased, on the belief that it is better to give up the opportunity to negotiate a more competitive price for more consistent quality or service. This may be a close call, but in a company with diminishing profitability, every penny counts. Unless there is a clear and demonstrable gap in quality or reliability among vendors, a good first step in a turnaround is to open bidding to multiple vendors. The incumbent may retain the business, or at least the lion's share of the business, but more likely than not at some discount to the company. We are living in deflationary times, and top line pricing has declined as a result. Pass that trend on to your vendors.

The key to cost reduction is quantifying and justifying each element of the savings - and recognizing hidden costs. If you are presenting a turnaround business plan to an investor, describe cost savings as concretely and in as much detail as you can. Another manifestation of cost control is better pricing and more selective sales. A company can grow sales rapidly by underpricing business. While this is not strictly speaking a cost control issue, it is certainly a problem involving the relationship between costs and top line revenue. Like cost cutting, this problem can be fixed in a turnaround situation through actions of management - eliminating unprofitable business - without necessarily depending on forces beyond the company's control.

Declining Market Position

Many turnarounds involve companies that have fallen on hard times because of factors other than the two described above. These failures stem from circumstances beyond the control of the principals of the business, and are therefore likely to be largely beyond the powers of a new group of principals to fix. Take, for example, a company beset by declining revenue. This company is either selling fewer things or at lower prices, or as is often the case with companies sliding into oblivion, is selling fewer things and in an effort to stop that decline, at lower prices.

There are a host of problems that give rise to turnaround situations that fall into this general category of top line erosion. Each is driven by a different change in the company's marketplace. Examples include the rise of a new or previously weak competitor, the introduction of substitute products, declining demand or a shrinking marketplace. Investors tend to be wary of situations like these because the chances of success are hard to figure and rest in the hands of decision makers outside the four walls of the subject company.