THE STORY
Last night, I was going to visit someone whose house I had
never been to before. The directions to the house went something like this: Travel
down road “X” and take a right on the last residential road before coming to
the intersection with a stop sign.
At first, that sounded like pretty good directions. But then
I started thinking. How am I supposed to know when I come to the last
residential road prior to the stop sign? It was dark out, and there was no way
of seeing if there were addition residential roads between where I was and
where the stop sign was.
The only way to find out which was the last road prior to
the stop sign would be to go past the road I want and go all the way to the
stop sign. Then I would have to turn around and go back to the first road I
find.
I guess those directions weren't as good as I originally
thought.
THE ANALOGY
Knowing when it is time to turn is not always obvious. Like
in the story, sometimes you have to go past your turn before you can be sure of
where you should have turned.
This same dilemma can occur in business. There are times you
should turn away from a business direction, because it is no longer the right
strategic place to be. The business is moving towards becoming obsolete and out
of touch with the changing marketplace. You need to divest.
Ideally, you’d want to turn away from the declining business
before it is too late. That way, you can divest of the business more profitably
and preserve your cash flow before it plummets.
However, how can you know when the time is “just a little
bit before it is too late”? Like the
story, you almost have to drive past the best time to turn and wait until you
get to the point when it is too late to know exactly when “just a little before
too late” occurred.
Unfortunately, by that time, it really is too late. Unlike
the road in my story (which you could turn around on), you cannot turn around
time. Once time has passed, you cannot go back.
THE PRINCIPLE
The principle here is about timing. There are optimal times
to invest in a business and optimal times to divest in a business. Usually
these optimal times occur just prior to a change in the inflection point on the
industry lifecycle curve. I’ve talked
about this concept before, but it is worth repeating.
As you can see in the figure nearby, the best time to invest
is just prior to when the market turns up (Point “A”). The reason why this is a
good time to buy in is because the current trajectory is still low, so you may
be able to buy in cheaply. Yet, when the trajectory soon turns, the value of
the business will increase dramatically, so you make a quick gain. If you wait
to buy in until after the inflection point beyond point A, the market will have
already reacted to the change in direction, so you will probably have to pay a
lot more to get in with little additional upside potential. All that upside is
already baked into the projection, and you have to give the seller a price
which includes that upside potential.
Similarly, the best times to divest are usually at Point B
or Point C. These are points just prior to a downward changing inflection
point. Here, the idea is to sell while buyers are still projecting a value based
on the higher valuation. You sell it to them at that higher valuation, just
before the valuation drops due to the coming inflection point.
Of course, the problem with this theory is the same as the
problem in my story. It is difficult to know when “just before an inflection
point” occurs. You almost have to witness the change in the inflection point
before knowing when “just before” occurred. And by that time, it is too late.
And if you wait until it is obvious that the inflection
point is near, then it is as if the inflection point has already occurred, because
both sides of the negotiation will know of the certainty of the upcoming change
and bake it into their projections, so you don’t get an advantage.
Ideally, you want to be far enough in advance of the change
that it is not obvious to the person you are dealing with that the change is as
close as it is. And being that much smarter than the person on the other side
of the negotiating table is not easy to accomplish.
Why this is
Important
If this is so difficult, one might say that it is not worth
trying to figure it all out. And maybe,
a few decades ago, I would have agreed with you. But in the modern economy, I don’t think we
have that option anymore.
In today’s economy, most of the value created in a business
no longer occurs though the annual activities recorded on the income statement
or cash flow statement. Instead, most of the value is created (or destroyed) at
the point when the ownership changes hands. I’ve spoken about that in more
detail here and here.
Think about all the modern dot-com and social media business
that are being created. Many of them never show a positive cash flow (or a cash
flow large enough to justify the money invested in it). Many cannot even
explain exactly what a path to profitability would look like. Yet, with every
new round of private equity funding, a new value is created based on the nature
of that round of funding. The changes in
ownership define the value, rather than the current income statement.
Then, when the startup goes through an IPO or sells out to a
bigger public entity like Google or Facebook (think YouTube and Instagram), the
really big change in value occurs.
Whether the startup lives up to that valuation is questionable (think of
all the stock drops and balance sheet write-downs). But the point is that if
most of the value is created or destroyed at the point of ownership change,
then determining the optimal time to make that ownership change is now more
crucial than ever.
How to Improve
Your Odds
So how do you find those ideal points prior to inflection points
before everyone else? I have three suggestions.
1. Look for
Leading Indicators. Lagging or concurrent
indicators are like the stop sign in the story…by the time they tell you where
the inflection point is, it is too late. What you need are leading indicators—factors
which help predict future directional change. For example, in the social media,
mobile, and digital worlds, future activity can be determined by the amount and
quality of top tier engineers and designers flowing through the business. If
many bright engineers are entering the business, better times may be
ahead. On the other hand, if engineers
are leaving the company, the trend may soon be getting worse.
2. Watch how Other
Ownership Changes are Affecting Valuations. If the biggest value changes take place when
firms change hands, observe how similar companies are being evaluated at their
ownership changes. This may be the best way to gauge how your company would be
valued at its next ownership change (if you act quickly).
3. Stick to What
You Know. The closer you stick
to businesses for which you have intimate experience, the better you are at understanding
the nuances in that space. This should
help you to see the more subtle changes that novices would miss and give you an
advantage in understanding the inflections.
SUMMARY
Since valuation in today’s economy is ever more dependent on
what happens at the time of ownership change, it is critical to time ownership
changes more precisely. This is difficult, because the best timing is usually
prior to inflection points. To help find these prior moments:
1.
Look for Leading Indicators
2.
Watch How Ownership Changes are Affecting Others
3.
Stick to What You Know
FINAL THOUGHTS
If I would have had someone up in an airplane when I was
looking for that house, I probably could have found my turn sooner. The airplane could see the big picture and
provide better data. Similarly, a
strategic planning department which monitors the big picture can help companies
better find those ideal moments.
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