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For someone building a house, it is logical to invest in good materials for a durable foundation. It would not be smart to build up walls, install a roof, and decorate before the foundation is solid. However, when small businesses get started and experience high growth, building a sturdy foundation is not really what happens in the real world. Usually, start-ups achieve early commercial success with limited resources and significant inefficiency. These businesses focus on proving that they should exist and not so much on how long they will exist. The mindset is geared toward keeping high growth rates and attracting investors. On the other hand, large public companies are in a constant struggle to keep up with investor growth expectations. Therefore, there have been instances of large companies paying high multiples on the revenue of small businesses even if their profit margins are low or negative.
Unquestionably, small businesses drive economic growth and are primary targets for acquisitions. In the United States, businesses with five hundred or fewer employees represent 99.9 per cent of all enterprises. With their innovation and flexibility, small businesses drive 44 per cent of economic activity and have been the source of 62 per cent of new jobs created between 1995 and 2020.
(1) However, more than 20 per cent of small businesses do not survive for more than a year and about 50 per cent go out of business in their first 5 years.
(2) Large companies looking to acquire smaller firms know the risks entailed, and despite significant due diligence efforts, it is common for many acquisitions to fail or never reach financial expectations assumed at the time of purchase. For this reason, a 2019 article on business valuation, made the following observation: “In general, smaller businesses (with transaction values between $10 - $25 million) are worth less and have lower multiples of between 5.0x to 6.0x, and larger business (with transaction values between $100 - $250 million) are worth more and have higher multiples of between 7.0x and 9.0x.”
(3) This reality should be enough to convince small business leaders to adopt a forward-looking risk management approach to their investment decisions, which is key to sustainable growth and maximizing potential acquisition value.
Forward-looking risk management can be described as a proactive investment strategy that identifies foundational investments required for sustainable growth. In other words, instead of waiting until a business is struggling to keep up with customer demand and is facing employee dissatisfaction because of unbearable workloads, forward-looking risk managers anticipate and proactively invest in capabilities with a sustainable approach. This is not easy when multiple commercial growth opportunities appear more important than investing in foundational capabilities. However, the reality is that it is quite common for small businesses to fail at implementing all their great ideas because of underestimating what it takes to make things happen. This lack of understanding leads to wasted resources in proverbial wild goose chases driven by pet projects and unattainable ideas.
As a business grows, the availability of reliable information to make asserted decisions becomes increasingly critical and harder to achieve. If the business has not structured its systems, processes, and people to manage real-time information to support customers and make informed business decisions, the leaders of these companies fly blind and make decisions disconnected from reality. What are foundational investments that must take place to enable sustainable growth?
For successful businesses with long futures, it is critical to invest time and resources to carefully choose effective Enterprise Resource Planning (ERP) along with scalable transactional and analytical systems. Given the cost and complexity of the implementation of any system, a forward-looking risk management approach keeps into consideration a 5-to-10-year growth strategic plan to avoid wasted resources and ensure sustainable growth. Effective research and expert advice to identify the right systems considering business needs just makes sense because of the high-cost and inherent implementation risks.
One of the common mistakes experienced by small businesses is to customize systems based on the personal preferences of certain individuals, who may or may not remain in the business for an extended period. A governance structure that requires the documentation and expert review of system customizations pay off dividends because it reduces the overall maintenance and upgrade costs over the life of the system. Without any doubt, investing in internal expertise and proper training for all employees should not be negotiable when a company devotes significant resources to foundational systems.
However, what are the goals of any system and process? First, the existence of a business depends on effective and efficient customer service. Therefore, forward-looking risk managers view the foundational systems and processes that allow consistent delivery of goods and services to customers in line with their commitments as must-have capabilities that require proactive investment. Secondly, knowledge is power. Reliable master data and timely analytics on the performance of the business, related forecasts, along with visibility to risks and opportunities are essential to make asserted business decisions. Finally, especially in the current labor market environment, if a company does not enable each of its employees to be productive and feel good about his/her contributions to the success of the business, the likelihood of employee retention is low. An experienced and well-trained workforce provides a significant competitive advantage that leads to customer satisfaction at a lower cost, which in turn creates sustainable profitable growth. In conclusion, forward-looking risk management is essential to proactively invest in foundational capabilities that maximize the value of high-growth emerging businesses.