Last month I had a very lucrative, but sad day.
I spent nearly four decades in the same private employee-held service sector company, the final eleven years as its CEO. Over my career, I witnessed it achieve world-class status in its focused sector of global water infrastructure. Three years ago, I left the management for an independent consulting practice but, as did other senior retirees with large holdings, retained a stock position in a multi-year sell-down allowing the company continued use of my investment capital.
Since I left the management team, the firm repeatedly told its employees of its exciting future as evidenced by its ever-growing record backlog, strategically enhancing acquisitions and improving internal efficiency. They credited much of the success to the dedication and care of employees who were also the sole owners.
But last fall, the Board quietly self-initiated a structured sales process with about a dozen self-chosen firms and sold this spring to a public company—to the surprise of its shareholders, employees and the industry. When the deal closed I benefited through my residual stock’s escalation, but it was a depressing day for me. Another mid-sized, privately held, services company was gone…this time; it was the firm to which I had dedicated my career.
As a result of the acquisition, many of the latent ambitions of both individuals and the company’s leadership, that was not possible before the sale, may now be achieved with the new configuration. The buyer is an established public company in the infrastructure space with proven leadership and better accessibility to growth capital. All this may be true, but sadly, the merger results in the rapid evaporation of my former company’s enterprise legacy and independence. And that change is irreversible. There is no warranty or a ‘try out’ period.
Why is it that private companies often do well in their earlier years, but start to stall and then sell when they get to mid-sized? I am sure there are many reasons, but my theory is that when they get big enough, they start competing against larger public companies and decide that copying them is the more appropriate strategy. As a consequence, their growth stops and they can’t raise the stock price or pay the bonuses required to keep their investors or management happy.
Private companies have many distinct advantages and disadvantages compared to public companies. Private companies do not have the pressure of making forecastable quarterly earnings or non-controllable stock market volatility, so can be more patient in developing new and transformational initiatives that take time. Yet, if the private company has no transformational initiatives, this advantage is worthless. Private companies can be much more agile and less bureaucratic, but do they really exploit that advantage?
On the other hand, public companies have much more capital to complete acquisitions, can de-emphasize organic growth and still grow. If a private company copies that strategy, it is doomed to eventually make a fatal acquisition mistake with limited capital. Public companies require more legal caution and discipline in governance, but if a private company tries to mimic this practice, they lose employee-owners’ investment trust. The examples go on and on.
So many private companies fall into the trap of thinking that there are advantages to copy publics, instead of emphasizing strategy that exploits their advantages or the public companies’ disadvantages. If it were a military battle, one would attack the other’s weakness rather than copy it. In the end, if private companies don’t position to their strengths, the public companies will have the capital to buy out the troubled private companies, but not vice versa.
Today I consult for private equity companies and sit on a public company board, but I have a very soft spot in my heart for employee-owned, private companies. This spurred me to ask—with what I have witnessed in my 40 years of business life, and in studying the sale of some 10 other private firms, how would I advise an employee-held private company if they want to sustain private ownership and control?
Here are my thoughts on creating sustainability for employee-owned private companies:
Governance and Employee Investors
- Employee-owned private companies are really quasi-partnerships of family investors under the legal umbrella of a corporation. As corporations, they have boards that are representatives of the family partners that should not operate in total isolation. There should be some set terms rotation of internal directors to emphasize that they are not representing their management assignment, but the total shareholder population. Outside directors should have terms and non-negotiable term renewal limits to avoid getting too cozy with the CEO and key executives.
- There are no adversarial or activist shareholders in an employee-owned firm. Therefore, private boards should have an open and transparent governance system. The company needs employee trust to sell stock over their financial advisors’ advice not to put retirement, employment and investment under one roof. Secrecy is the enemy of trust. Therefore, open the boardroom to shareholder guests and distribute board minutes that reflect the board’s real conversations/concerns. It should be transparent to all owner inquiries and, on big decisions like sale, get some significant shareholder input outside the board.
- Getting a sustainable stock valuation formula is critical. It needs to hold up over time under different economic conditions, liquidity requirements and equity adjustment through acquisitions. Private companies’ stock valuation formulas should be conservative. They should be at least 30 to 40 percent lower than comparable public companies. On the other hand, a stock valuation formula that is too low, which vastly underestimates the company’s true value, is too tempting to not exploit a sale by senior executives (probably on the board) ready to retire and at the peak of their power to influence.
- Private companies need to pressure current employees to step up to the accumulation of significant stock ownership over their career. There needs to be an employee buyer for every seller of shares over successive generations and this has to be a cultural expectation of consequence. This is getting increasingly difficult, as most financial advisors will recommend against doubling down on your employees’ compensation with their family wealth investment. But employee investment is essential in all private service businesses unless they are extraordinarily profitable.
- You should not allow any owner over 60 years old to carry greater than five percent of the total shares. Make your buy-back rules flexible enough to work out special win-win re-purchase arrangements with your largest shareholding retirees, if necessary.
- Once a private company gets to mid-size, it cannot be successful with a ‘cost leader’ strategy. Private firms need to be ‘value leaders.’ At mid-size, private firms have entered the competitive arena of public company competition due to project scale. Public firms are larger and thus can play the ‘low cost leader’ game far better. Private firms must be more focused and deserving of differentiation by specialty expertise, relationship and innovation to justify a higher value pricing point. As a ‘value leader,’ if the field operations claim that clients are saying that you are too expensive, hear that as the market saying you are not adding enough customer value to justify your price. React by creating more differentiation, rather than just cutting costs. If you are the ‘value leader,’ not everyone is a potential client.
- Private companies that are in more than three or four sectors are probably very small market competitors in each, but with a larger company’s overhead structure. Too many sectors create a defocused company that does not create internal synergy. It is only the sum of units, each lacking differentiation against other smaller firms that focus on one or two specific segments or publics that have huge divisions.
- Private companies should discipline themselves not to over-commit to booming sectors that historically have high volatility and are cyclical like commodities, catastrophes or war zones. Private companies require a stable profit/cash flow from a balance of reliable sectors. Trying to capitalize on a temporary boom can drive the stock value too high for normal times.
- Due to limited resiliency of private company balance sheets, private companies need to avoid “bet the company” risks in large lump sum projects that they do not control just because their public competitors do. Avoiding joint and/or several liability or parent guarantees at all costs is critical. A private company’s risk profile needs to be far lower than that of a public company. The company needs a high sophistication relative to structured risk management: from project selection to contract negotiations to risk mitigation techniques is a strategic imperative.
- Private companies are often dabbling in the public-client sector of ‘red’ corruption countries. I would argue they should avoid these completely. Competition for ‘red’ countries’ work is lower for a reason. They are alluring for employees who want to ‘do good’ in poorer countries or want intriguing foreign experiences, but all violations, or even accusations, with the Foreign Corruption Practice Act (FPCA) or EU Corruption laws have catastrophic impact. For field personnel, it is very difficult to determine the blurry line of facilitation or illegal activities; and domestic practice usually doesn’t align with the U.S./U.K interpretation. ‘Red’ country profit is usually minimal to nil after absorbing long-distance project oversight, paying the ‘dumb dividend’, installing compliance training and realizing the huge payment risks within immature legal systems.
- Private companies should shift their product development investment to automation, solution bundling and intellectual property initiatives. The digital and connected world will remake the labor-based, hourly rate playground faster than one can imagine. You need to be obsessed in how you are using technology to gain competitive advantage and always thinking how to disrupt the industry earnings stream through solutions, not selling hours.
- Private companies need to emphasize organic growth with occasional smaller acquisitions in the newer strategic frontiers. You can’t compete with public firms’ capital, so don’t try. An acquisition mistake for a private company can be deadly, while public firms have 10 years and financial scale to absorb them. A better strategy is to target smaller firms that are not in the public companies’ gun sights and who want to stay private.
- Realizing that there is current generational decline of employee ownership interest, a private company’s survivability is dependent on a strategy of predictably high profit margins. Private companies should set a strategy to be in the top quartile of profitability of their industry to take some pressure off employee stock purchasing. Liquidity comes from free cash flow and it is best obtained by profit rather than increased personal investments.
- For a private company it is always preferable to have internal CEO succession, but insider grooming requires structured—and uncomfortable—executive sorting, rotation, training and testing. Otherwise, success is just luck. An insider will never have proven CEO experience until they are made one, and then the complexities of the job require monumental and sudden jumps in skills growth. The advantages of an insider are that they know the ethos of the firm and own its history and traditions. Many firms find cause to sell when they realize that there is no existing visionary succession and they have not allowed talented outsiders in. To avoid this, when a sufficient number of promising internal CEO candidates is lacking, it is important to import outside executive talent at least five years before CEO succession is planned so you have more alternatives and time to evaluate. When they arrive, support them and let them speak their mind, as there is a tendency to run new executive talent out of town by the incumbents.
- It is an essential cultural characteristic for the top leadership of an employee-held company to be non-hierarchical and much more personally biased. Building trust and corporate transparency go a long way in employee investment confidence. An executive of a former iconic private company that was sold, told me: “Our company really died when the last great partner-leader left and was replaced by a CEO.” Since ‘his last great partner-leader’ was also entitled CEO, I think he was talking about approachability and empathy of a senior partner-type, rather than a title. Private employee-held companies are really a partnership with its employee-families that invest and risk both salary and equity. There are probably safer investments employees can make other than in their employer, but I have always believed in investing in the businesses I know best. You need to convince your employees of this through trust and setting an example.
- With private companies especially, a new CEO leader must be a leader with a vision and consistent philosophical foundations that match the company’s historical ethos. Every company will name the wrong CEO at some time. When that happens, private companies have difficulty making timely leadership change. Private boards are often stacked with conflicted inside subordinates to the CEO; the wrong CEO can be fatal due to slow action. The private company needs to have strong enough outside directors to correct the situation before it is too late. A private company should never name an unproven CEO to the roles of both chairman and CEO, as it destroys proper CEO accountability.
- Private companies should not just analyze short-term financial results, like month-to-month or even on a quarterly basis. Use rolling year-over-year quarters for five years to see the long-term trends of ascent or decline. Avoid the ‘frog slowly boiling’ syndrome that happens by measuring only against an annually reset budget. Executive management should look at the longer-term trends of the enterprise. Unless a catastrophic loss is experienced, private companies usually die over time rather than by a single event.
- For a private company free cash is vital and, as such, total accounts receivables should be under 80 days. The company needs to choose a strategy, clients, geography and sectors that allow that. Private companies cannot afford to act as a bank for their clients, as cash equals liquidity.
- Private company managements should not be lulled into thinking about backlog as just ‘revenue resupply,’ but look at backlog as a barometer of profit (free cash flow) health. Many companies have several different services combined in backlog, each with a different predictable margin. Don’t assume all revenue has the same profit. Private management needs to reduce focus on revenue and measure backlog in terms of profit potential. Pace that potential over a 12-month period to see if it really supports near-term profitable growth. If the next 12-month authorized backlog does not predict 80% of your profit budget, you are probably in trouble.
- Large project losses wreak havoc with a stock formula and they need to be avoided. Private companies need to invest in technical/project internal audit capacity in addition to the normal financial and control compliance audits. This is a great use of content knowledgeable retirees. A project manager resigning at the 75% completion point is a significant red flag. Don’t fail to detect large overrun project disasters before it is too late to save/mitigate them.
In closing, there are really good reasons for a private company to turn to public ownership, or re-capitalize themselves with outside investors; or even to sell to a larger public company. I would not advise all privates to stay employee-held and private at any cost or risk, especially if they have a visionary dream that requires significant capital or takes increasing enterprise risk. But it is a shame to lose a private company due to poor planning, strategic positioning, failed succession or low profit growth. Employee-held private companies have a valuable place in the service industry but require visionary care, leadership and planning to stay sustainable over generations.
© 2016 Robert Uhler and THE UHLER GROUP. All rights reserved.