A RELEVANT CASE STUDY

The Background - A very successful product design consultancy business which had been established for over three decades had been enjoying an approx £5/6m annual fee income, a highly-qualified team of approx thirty chargeable professionals, plus an excellent support staff, a broadly-based blue-chip client list, and a very handsome (indeed) net profitability track record over many years

Sadly, at a certain point, and well before the impact of the current recession / depression, a number of major client contracts were not renewed when those came up for review, and as a result, gross fee income dropped sharply – and, most importantly, stayed down - and the business subsequently got itself in to all sorts of most unpleasant financial difficulties, both on the P & L account, and then with cash flow

The company’s bankers were unwilling to help, there was no significant internal funding available and the directors were loathe to shrink sharply their lovingly-developed professional teams, and so they turned eventually to a firm of regionally-based Venture Capitalists – also to a local Business Angel – to try to work through positively, with the relevant extra funding, the effects of the downturn in contracts, and to assist them in expanding significantly once again their client portfolio and the gross fee income of their business  

Sadly, the directors were unaware completely of some key and most relevant issues which face business directors and shareholders when considering working with (most) VC’s and Angels

The problem - The said directors / shareholders had done an absolutely amazing job in starting up and then building and developing this significant and very successful and much-respected enterprise over nearly three decades, and with their having put in to place during that time the most excellent and absolutely state-of-the-art technologies, in terms of both equipment and people, but sadly they were totally non- worldly-wise when it came to the subject matter of business financing models

What the directors / shareholders had failed to appreciate and to take seriously on board, at any time or at any level of consciousness was that to work with VC’s or Angels was actually and perversely putting at serious risk the future survival and prosperity – and, most importantly, their ownership - of the business

The directors / shareholders only woke up to the critical importance of this state of affairs when they came to realise after some two years plus that the involvement of the said Venture Capital firm and its funds was not making any improvement of any real significance to the growth or financial performance or value of their business, and that the said VC firm was within that process taking over steadily vast rafts of their shareholdings

The action - At this very sad moment, the directors approached and appointed a highly-experienced OMSG Group Non Exec to assist them in the planning and implementation of that which they hoped might be a successful rescue operation, to take them away safely from this very nasty predicament    

The said OMSG Group Non Exec was aware immediately and fully so of the very serious nature of the problem, having encountered before on several occasions over the years the said very similar predicament with other businesses, but his analysis was speedy and quite clear, ie that everything had already gone far too far down the line over the first two years plus of VC involvement to make any serious rescue from the situation a sensible / practical option, but that maybe just some form of damage limitation might be considered, in the form of possibly taking the business in to Administrative Receivership, and then attempting to buy back the Trade and Assets of the business, ie without its debt, out of the back of the said Administrative Receivership, ie what would nowadays be termed as an attempted “Pre-Pack”       

It was agreed between all concerned that the above route was the only option left realistically, and it was therefore implemented post haste, and this not least as the VC firm had by this time lost any serious interest in the project upon which they had ventured, and had effectively washed their hands of the whole thing  

The outcome - Sadly for the original directors of the firm, they were outbid in the Administrative Receivership process, by a competitor firm, and that was that, ie they had lost everything. Also, most of their professional staff, and all of their support staff were not taken on by the new owners, so a total disaster all round, for everyone 
 
What should have happened - The OMSG Group Non Exec should have been called in at the beginning of the saga, rather than at the effective end !

And he would have then worked with the directors to check out primarily that all realistic professional efforts had been proved absolutely to have been made to replace the approx 50% of lost top line fee income, and that such efforts had been proved absolutely to be unsuccessful

Then, if that were so genuinely to be the very case, and in the absence of any significant funds being made available internally, to be working with the directors to plan with them and to implement with them, a marked shrinking of the business costs / fixed overheads by approx 50%, to ensure the survival of the business, and taking into account that in most businesses, there is an approx 10/15% per annum element of natural wastage, so it could very well be that compulsory redundancies might be avoided, given of course that zero recruitment be brought in at early enough stage

Health warning ref (most) VC’s and Angels - And, in which general regard, it should be noted, in most cases, that the OMSG Group Non Exec would not normally be recommending any client firm to be going down the Venture Capitalist / Business Angel route, unless in absolutely total extremis, if only because to do so ends so often (but not always) in tears, as the above example demonstrates so vividly

The key underlying problem here is that there is in most cases a woeful lack of clarity and understanding between the two parties as to what exactly is going on – and not going on - within such VC / Angel deals – and to be fair, that is the fault in most cases of both parties, rather than just that of the VC’s / Angels. However, having said that, the VC’s are the professionals in this regard, and their clients are usually the very clear amateurs at same, so in our view, it is the VC firms who are by far the most culpable in this matter of lack of mutual clarity and understanding

In this case, the VC firm should have spelt out far more clearly than they did, and with absolute maximum verbal as well as written clarity, that the key (usual) elements of a VC deal with a client business are –

• The VC firm will want absolutely to exit (sell) within 3/5 years, (with potentially very difficult personal / professional situations then impacting on the original business directors / shareholders at that point) 
• The VC firms see themselves – not unrealistically, it has to be said – as the Lender of Last Resort, and that is just how they should be seen
• They look to see a return on their investment of some 30/40% per annum – and compound  ! – and that is on the increasing value of the (shares in the) business each year, an incredibly difficult challenge in most circumstances
• They expect to see only one, maybe possibly two, successes emanating from any given portfolio of ten investments, with maybe two to four failing totally, and with maybe two to four, maybe six, surviving but not succeeding, (but, most importantly, with, in the cases of the last element, their (as VC’s) ending up owning all or most of the Ordinary Shares in the client business rather than the original business directors / shareholders) 
• The VC firms will almost invariably use Cumulative Redeemable Convertible Preference Shares (CRCP’s) via which to make their equity investment in the client business, which means in essence that if the (annual) performance-increase targets (of please note / repeated some 30/40% per annum compound of the moving valuation of the business) are not met, then the VC firms do indeed steadily acquire over time all or most of the Ordinary Shares in the client business
• Suffice to say, that this type of deal / process is not for the faint-hearted !  - nor most definitely for the ill or non-advised   !

 
The moral of this story / case study - Having a strong-minded, independent detached objective and highly-experienced and expertised Non Exec on board right from the very beginning of the saga could and would have made all the difference to the original business directors / shareholders, in order to be able to be analysing clearly with them all of the relevant problems and opportunities, and to be discussing examining - and validating and proving appropriately - the relevant and workable alternative strategies and tactics with which to deal successfully with those problems and opportunities

And for the said Non Exec to be willing to commit to stay with and support the client firm and all of its people throughout the whole of the three or four years involved / required

And, Yes, we would say all of that wouldn’t we ! – but it’s true, nonetheless

More next month, with another case study highlighting a topical issue for SME business owners / directors / senior managers

December 2011

©OMSG Non Exec Group Ltd – 2011