Three Reasons for Failure

For over 25 years, former senior NAB banker Neil Slonim worked closely with many HNWs and entrepreneurs. Some were hugely successful whilst others were less so. Based on this experience he has identified three types of reasons why investment decisions go wrong – People, Financial and Environmental.

PEOPLE

Some investors pay large sums for goodwill only to see it dissipate through their own actions that disrupt the company’s capacity to produce the results that justify the goodwill paid.

When buying or investing in a business, HNW’s/entrepreneurs can struggle with the balance between the role they play as shareholders and managers/leaders particularly alongside an incumbent management team which includes co-shareholders.

Conflict can easily arise between management who have usually started and grown the business and the investor who brings cash to the table but has other expectations. The classic example of this is the wealthy individual who invests in a business either to buy themselves or more often their children a job. Whilst the capacity to inject new capital into a growing business puts the investor in a strong bargaining position, neither party should proceed with any transaction unless both are totally comfortable with the ongoing role the investor or their family members wish to play, especially if this involves day to day management.

When they do become actively involved in the business, investors can come unstuck because they lack the management, leadership or industry experience required to be make a meaningful contribution. They might assume (wrongly) that being an owner entitles them to be a leader but injecting new cash into a business gives the investor ownership but leaders gain traction and respect from personal conduct not personal wealth. A self aware investor knows if he/she has the ability to define and articulate a vision and to inspire people to join them on the journey. Unfortunately not all investors have this level of self awareness with their attitude more akin to “I am an owner and therefore I am entitled to be respected”. These situations usually turn out badly for all concerned.

Finally, some investors are just not suited to be in partnership situations so rather than try to work through these challenges, it is perhaps better to accept this upfront and structure any investment accordingly.

FINANCIAL

There are no new ways why businesses fail and the oldest and most common cause is lack of equity or “hurt money”. HNWs/entrepreneurs are optimistic by nature and accordingly don’t always take into account all the things that could go wrong. Thus the business could lack a strong capital base which is needed to weather the economic storms which play out from time to time. In the event Plan A falters every business needs a Plan B and even a Plan C. This invariably involves access to more funds albeit possibly only for a short period. Businesses need to be appropriately capitalized in the first instance and also be able to access a contingency fund in the event the need arises.

Similarly, when preparing forecasts, owners should undertake best case, most likely case and worst case scenarios and ensure that even under the worst case scenario the business still has access to sufficient funds to ensure its survival.

When considering the worst case scenario, investors should assume Murphy’s Law applies ie anything that can go wrong, will go wrong. More often than not businesses fail due to the occurrence of more than one unrelated adverse event.

HNWs/entrepreneurs generally prefer to minimise the level of their financial commitment by leveraging their reputation and standing with the banks to access the maximum level of bank debt without the need for a personal guarantee. This reduces the weighted average cost of capital, provides a better return on the capital invested and also minimises and caps the absolute amount of funds at risk. Everybody is happy when things go well but if the business hits turbulent times and breaches banking covenants, the situation can rapidly deteriorate. HNWs who previously assured the bank that “my word is my bond” can be placed under immense pressure by banks which are longer placated by words and instead insist on additional tangible support. And when the pressure is on, banks will always look to protect their balance sheet ahead of any individual client relationship regardless of the borrower’s standing.

Along with lack of equity, inadequate due diligence (“DD”) is another common cause of failure. Some investors simply pay “over the odds” for a good business whilst others completely misread the situation and end up investing in a “lemon”. Either way, the root cause is lack of or poor DD. Investors might be put off by the cost of external and/or specialists conducting DD whilst some believe they possess the necessary skills themselves. Often they will rely on their external accountant who whilst relatively inexpensive may lack the technical or industry experience of larger or specialist professional firms.

The costs of external DD even if it is to review the work carried out by the investor invariably outweigh the losses incurred from a bad decision. Whether it is ego, time pressure, complacency or any other factor, there is no substitute for proper DD.

Having a solid understanding of the business and knowing the owner might encourage an investor to dispense with a formal DD process but in fact DD is even more critical where there is existing knowledge and especially an existing personal relationship. Investors should work on the principle of “Trust but Verify”.

ENVIRONMENTAL

Looking at the broader environment in which businesses operate, perhaps the biggest error HNWs/entrepreneurs make is failing to properly recognise the impact of technological change. There are countless examples where technological change has substantially reduced the value of an investment for instance the shift from vinyl records to cassettes to CDs, the DVDs and now digital. Companies which don’t quickly adapt to such change eg Kodak will struggle to survive.

Secondly any industry which is reliant upon government incentives involves risk which can be difficult to quantify because governments do not make decisions on the same basis as businesses. Classic examples include home insulation, solar energy, gaming and the motor vehicle industry. Many investors have been brought undone by the stroke of a pen of politicians and bureaucrats.

Finally, the compliance burden can have a significant impact on investment profitability and returns. HNWs/entrepreneurs can easily overlook the impact, not just in terms of cost, of meeting changing regulatory and compliance standards. Perhaps the best example of this is the financial services sector.

Neil Slonim established Slonim Consulting in 2008 to help growing businesses grow profitably and safely by applying the lessons learned in a career in corporate and business banking. He sits on a number of boards and advises several family businesses on issues as broad as investment decisions and succession planning.