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.
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 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.
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
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.