10 items entrepreneurs must work on to bulletproof their business
Most startup businesses are little more than an “incorporated job”—a vehicle for the owners to earn a market-rate salary with the hope of future growth. Once a business can pay the owners a market-rate salary and have significant profits remaining, it becomes an asset. This marks the time when entrepreneurs must begin working on their business, not just in their business. When they stop working harder and begin working smarter, they will yield significant dividends by making the company more profitable, more durable and, ultimately, more valuable.
Over the last 30 years, I’ve worked with hundreds of businesses and I believe there are 10 items entrepreneurs must work on to bulletproof their business.
- Benchmark company results against the industry for valuable information that will lead to improved results.The relative value of a business is determined by comparing its performance to those in its industry. For example, gross margin should be examined to make sure the company is being efficient with its production costs to meet or exceed industry standards. Similarly, employee costs should be analyzed to make sure the company is both paying a market-rate wage and receiving market-rate output from its employees. A company’s net income percentage should compare favorably with the industry if it’s carefully monitoring general and administrative expenses.With regards to the balance sheet, it’s critical that the company carefully manage the working capital (current assets minus current liabilities) deployed in the business. Too much working capital is generally the result of receivables getting too old or carrying too much inventory. Some businesses tend to overstock inventory in order to guard against the dreaded stock-out, unaware of the fact that the carrying cost of inventory is prime plus 20 percent (almost two percent per month!).Though often overlooked, determining a company’s return on equity is critical. I’ve seen cases where the return on equity in a small company was below five percent. This rate of return, in a more typical stock market environment, would be fairly easy to achieve with a diversified basket of blue chip companies with far less risk than operating a business. Developing standards through benchmarking is an excellent first step for entrepreneurs who are establishing their company’s initial financial goals.
- Create a short-term compensation plan. Initially, the owners must conduct research to determine market salaries for the key positions in businesses of their size in their region. Owners must also decide where on the scale of “fair” they want to be. For example, does the company want to be in the top quartile of businesses its size or should it be in the 50th percentile because of its standard profitability? This sort of information is available not only to owners, but also to employees, which make these decisions particularly critical as owners seek to attract and retain the best of the best. Similarly, the company’s bonus plan should be linked to individual performance, as well as to company performance. There should never be a time when employee bonuses are forced to come directly out of the owner’s back pocket.
- Define an effective longterm compensation plan that’s linked to the company’s appreciation in value. This is particularly critical if a non-family employee won’t have the opportunity to own real equity. Top-notch employees will want a wealth-building opportunity in addition to their retirement plan. The long-term compensation plan should be competitive with the industry and linked to long-term company goals, which should be indicators of the company’s value. (Example: A company continues to increase profit percentages even as revenue grows.)
- Carry appropriate insurance coverage.For some reason, companies often get stuck in the “mom-and-pop era” when considering insurance matters. A company’s policy should include business interruption coverage (talk to the Gulf Coast businesses if you doubt this). Inappropriately low limits on this coverage are the number-one reason a company doesn’t resume business after a loss.The best property coverage insures the company’s property, building and equipment at appropriate values. Generally, it’s better to insure for replacement cost than fair-market value. During poor economic times, employee dishonesty is much more common, making covering this risk a critical addition. Consider purchasing an umbrella policy, which provides an extra layer of protection over the company’s primary liability limits.General liability coverage should also be considered. This coverage is inexpensive and worth looking into, considering the potentially significant value of the company’s assets (think British Petroleum). Similar to employee dishonesty, employment practices coverage becomes more critical in a tough economy due to wrongful termination suits. Having a competitive health plan is also essential, as costs can be somewhat controlled when employees have a chip in the game via a health savings account (HSA).
- Maintain an appropriate information technology system. This is a common area for deferred maintenance, particularly in a down economy. The information a company needs changes as products and services change. An effective IT system should deliver timely information that is management ready. Often, companies will demand their IT system produce a “dashboard,” which provides the key numbers management must monitor to ensure profitable growth. Part of a quality IT system is its ability to maintain adequate internal controls over the company’s cash. Once again, especially in a struggling economy, some employees’ fingers get sticky.
- Adopt an effective retirement plan. An effective plan needs to benefit people at the right level. There is no business reason to provide an outsized benefit to employees who don’t stay with the company. Plan design can ensure the efficient use of the company’s contribution. Plan features, which include vesting, eligibility, cross testing and integration, can result in a higher percentage of contributions going to the owners and other key personnel. The owner, as the fiduciary, is responsible for plan assets to be appropriately invested. Investment policies and investment performance criteria are essential aspects of an effective retirement plan. They also fulfill the sponsor’s fiduciary responsibility.
- Establish both an operating and capital budget.To do this properly, the company needs an appropriate budget process. (Taking last year’s number and adding five percent is not an appropriate process.) Once adopted, the budget should first be used to compare last year’s actual performance to this year’s budget and determine reasons for any variances.As part of the budget process, companies should challenge their sales and marketing teams to generate significant new revenue, while the administrative staff continues to cut costs so the company can drop a higher percentage of earnings to the bottom line each year. In addition, using a capital budget, companies should plan for all significant capital expenditures and complete a detailed analysis of the return on these investments. It’s also important that the company’s bank agrees with the company’s future plans (in terms of both the capital and operating budgets), as banks are particularly unresponsive to last-minute requests.
- Develop a comprehensive short- and long-term human resource plan.Many firms hire too fast in good times and fire too slow in bad times. That’s why it’s important to analyze the adequacy of the company’s current team. Once again, benchmarking is critical, and perhaps even forced ranking may be required to ensure a top-notch workforce. Many employers use standardized tests to screen out candidates and determine who should be promoted within the company.It’s also important to hire for a specific need, as opposed to simply hiring the “best athlete in the draft.” Few companies are large enough to absorb people with the idea that they are going to be valuable at some point in the future. Once a company has spent the time hiring the best talent, creating an employee handbook—with clearly stated expectations —is critical. Since each hire is made privy to elements of the company’s proprietary “formula,” it makes sense for key employees to have employment contracts including a non-compete covenant. It’s also important to note that such contracts are often one of the first items buyers request when it comes time to sell the business.
- Outline a growth plan. Management teams love targets and need to know where they are taking the company and how to get there. The plan may call for expansion of the company’s products or growing through acquisitions, or perhaps a geographic expansion. The ultimate goal should be sustainable and profitable growth, which, once achieved, creates true value.
- Create a succession plan. The owners must analyze their buy-sell agreement to make sure it continues to make sense in light of their current personal and economic circumstances. The company should also do an assessment of its executive team’s readiness to take over. If owners have been diligent in their grooming efforts, there may be an internal group that’s ready and able to buy the business. Since it’s likely that, as part of a management buyout, this group is going to be issuing a note to the owners, it’s critical they be able to handle this all-important responsibility. A well-thought-out succession plan can help ready the business for sale at the correct price—an appropriate reward for the smart business decisions entrepreneurs have made.