Failure IS an option

"Why should I trust a word you say?"

I'd only been in the room 30 seconds. This was my first meeting with one of our lenders since I’d taken this new job.

He was p*ssed. My honeymoon period lasted about a week.

I knew there was a lot to do, but it had set in just how broken this business and its relationships were.

EBITDA had halved in two years and was still falling fast. Debt levels had exploded (hence the angry investor). The business would run out of cash in a few months without drastic intervention. Thousands of people would lose their jobs.

The stakeholders of the business had lost confidence. Creditors and shareholders were furious. Suppliers were pulling credit. Any talent the business had was jumping ship.

I wanted a turnaround CFO role. Now I had one ...

I wondered why the hell I was doing this.

I liked fixing things…and this was a thing that needed fixing.

Even the board was squabbling like siblings.

What a f*cking mess.

There was something worth salvaging. A diamond in the rough. But it was going to take a long time to extract.

There was so much to do, but focus was the name of the game here.

I boiled my responsibility as CFO down to one thing…

Buy time.

Maybe we could save this thing, maybe we couldn't. But without time, the fate would be sealed.

Time meant cash.

I set to work on doing whatever I had to do to increase cash reserves. Asset sales, capex freeze, payment plans with suppliers, and early settlement incentives for customers.

All of these things would cause some level of long-term damage. But at least we'd survive long enough to work out how to make it right.

I couldn’t convince that big investor to retain his patience, though. He sold at the bottom, and let someone else ride out the bond price rally that followed as the turnaround took hold.

I don’t blame him. I would have done the same in his shoes.

This season we will dive into turnarounds:

• Week 1 - Why businesses fail

• Week 2 - Principles for turning around a business

• Week 3 - The 7Cs of successful turnarounds

Why businesses fail

We’ll start from first principles.

What is a turnaround?

A turnaround is the process of fixing a business that is on the path to failure. There is a real and present mortality risk.

There is finite cash, or maturing debt, with no obvious solution. And there is certainly no VC waiting to extend the runway.

A turnaround is the process of fixing a business that without intervention will fail. Soon.

So why do businesses fail?

Fundamentally, one reason: they run out of cash.

Unprofitable businesses can survive a long time with access to enough cash.

Likewise, profitable businesses can die in a heartbeat if they don't have the money in the bank to pay the rent when due.

When is a turnaround necessary?

If a business doesn't have the cash needed to pay its creditors when they expect the business eventually will be unable to continue. Because creditors will not allow it to continue.

At the extreme end:

• the landlord will padlock the doors

• suppliers will stop delivering

• employees won’t turn up to work if they go unpaid

• banks will call in loans

• customers will stop ordering as they lose confidence

At this point (or maybe before), you are into technical bankruptcy processes (Chapter 11 and international equivalents). The law is complex here, but exists to protect directors and creditors. We touched on it in January’s board of director series. But getting the right legal advice is critical.

How to spot the risk

In practice, if things have gotten that far, it’s often too late. A turnaround is about intervening before it reaches this point - while the business still has options, even if none are perfect.

And with good cashflow forecasting, you should be able to spot the risk of running out of cash early.

You should be running base case, upside case, and sh*t case cashflow forecasts (13-week weekly rolling, and 12-18 month monthly rolling). This will ensure you have a good picture of the risk that the business is unable to pay its debts when they fall due. And can act accordingly.

Why do businesses run out of cash?

There are a million reasons.

Some are within management's control, some are not:

• Lose a major customer

• Cost inflation

• Interest rate increases

• Suppliers pull credit terms

• Regulatory fines

• Overtrading with 'positive working capital'

• Your best credit controller leaves

• Poor margin management

• Lack of cost control

• Bad debts

• Overdraft gets pulled

• Warehouse fire

… the list goes on

But these are all symptoms of a bigger problem.

The root cause could sit under one of three following headings:

1. Bad business

2. Bad management

3. Bad balance sheet

Identifying which one (or more) of the above is the root cause problem becomes vital to ensure the correct fix is administered.

Let's take each in turn:

1. Bad Business

In this context, a bad business is one with no fundamental competitive advantages. Enduring businesses need access to something that allows them to operate cheaper or better than others.

Like if a manufacturer can produce at 20% per unit cheaper than anyone else in the industry or it owns a brand that gives built-in pricing power.

These are also called ‘moats’ (we’ll cover moats and strategies in a future series).

On the flip side, a bad business has no intrinsic defensibility.

A bad business is not to be confused with a good business with a bad strategy. The latter is a failure of management, while the former is not.

Bad businesses with good management and a good balance sheet can survive a long time.

Think of a brick-and-mortar retailer. It can be optimized to within an inch of its life by a brilliant management team. All while being slowly eaten year after year by e-commerce competition.

Bad businesses will either:

a) die slowly over a long period of time as they are eaten by competitors fueled by megatrend tailwinds. Think Macy’s.

b) Evolve an unfair advantage using a combination of good management and opportunism. Maybe that retailer uses its strong supply chain to build a second life with a well-executed e-commerce strategy. Walmart and Target did this well out of necessity during COVID.

Warren Buffett once said, "When a management team with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact."

2. Bad Management

There is plenty of bad management out there. Turnaround pros are licking their lips.

15 years of ZIRP has bred a generation of weak managers.

Let's get specific.

Bad management could be:

a) Poor in strategy selection

b) Poor in execution of that strategy

c) Both

The distinction is important because they present differently.

Management who are good in execution but not in strategy are good at winning battles, but bad at picking the right battle.

They aren't capitalizing on the business’s inherent advantages properly. Or perhaps they aren’t seeking ways to extend or develop new advantages.

On paper, this might look a lot like a 'bad business'. The difference here is that the business does have inherent advantages, it just doesn't have a management team that recognizes them.

Unaddressed, this is a slow death. But it’s certainly easier to fix than a bad business.

Then there is management who are good at setting strategies but poor at execution. These guys expose themselves much more quickly.

You've seen them. The plan looks great on paper. The financial model works. The PowerPoint slides are beautiful. But it just doesn't happen.

Capital market investors are really bad at judging execution risks in management teams. Largely because most institutional investors have never run businesses. So don’t know what to look for. As happened to the poor old bondholder who'd been left holding the bag in the opening anecdote.

Execution risk is harder to model into an investment case. I see analysts get this wrong again and again.

Whilst management teams who execute badly are hard to quantify, they should be easy to spot.

Things don't happen when they say they will. Businesses aren't run on PowerPoint or in spreadsheets. They are run in factories, on sales calls, and in product quality reviews.

Execution is hard. When you see businesses doing it well, it's like magic.

I worked in a huge global megacorp early in my career. It allowed me to witness a famous battle between two industry giants, firsthand. The business I was in trampled all over the competition. But at face value, both businesses had the same core assets and the same strategy.

Yet over a decade, one doubled its market share, and the other shrank.

The difference was the quality of management. Nothing to do with me… I just got carried along by the tide and learned a bunch on the way.

The business I worked for had mastered the skill of execution. What we could execute in days or sometimes hours others would spend weeks doing.

The real skill was in the C Suite. They had built the organization and culture across the organization to execute complex things at speed.

The compound effect of that over many years was seismic. Tens of billions of differential value creation.

So if great execution can unlock a competitive advantage, the opposite can certainly be true.

I have been consistently surprised throughout my career by the impact a management change can have.

3. Bad Balance Sheet

Sometimes there is nothing wrong with the business itself. It is just saddled with a cr*ppy balance sheet. That means too much debt. Or the wrong type of debt. Or insufficient liquidity.

Bad balance sheets can take many forms:

• Inadequate liquidity levels, impacting growth and investment

• High Net Debt: EBITDA

• Interest rate exposure on debt (rolling off of fixed debt)

• Short debt maturities, exposing the business to the market at an unfavorable time

• Over-collateralizing good assets

There are plenty of businesses dealing with this out right now.

Businesses who took out fixed coupon debt in the ZIRP era, now have to refinance a similar level of debt with rates 4% higher.

For a business that is 4x levered, that is the difference between being refinanceable and not being refinanceable.

There are a lot of highly levered businesses staring at ‘before’ and ‘after’ P&Ls that look like this right now:

Businesses with bad balance sheets get flushed out by the economic cycle. While money is cheap and abundant, often they’ll limp on. But when the tide goes out… they get found out quickly.

The Chapter 11 process exists to spare fundamentally good businesses with bad balance sheets.

There are a lot of nervous PE funds right now who took a good business, installed good management, and levered it up during ZIRP. And now the interest cost of that debt could gobble up their equity case.

You might ask, is a bad balance sheet not the product of bad management?

At some point in the past, yes, that could be true. But there are good businesses, with good management, saddled with the legacy of previously bad management. And those historical sins end up on the balance sheet.

Story time…

Back to the turnaround story I started this post with. The business had strong fundamentals, with good moats in an attractive sector. But it had had awful management. The strategy was wrong, and it couldn't execute. And years of the resultant underperformance had led to a terrible balance sheet.

I learned a lot from that sh*tshow. But this was something that will always stick with me…

In the first few weeks of the turnaround role, I was reviewing the modeling for downside cashflow scenarios. The team had identified 3 things that could go wrong. Each with a probability of approximately 30%, and an impact of $50m (I’m simplifying the example).

They’d worked out an expected value downside risk of $45m ($50m x 30% x 3). And therefore a $50m emergency fund would suffice.

When I looked behind the numbers and into the business issues that sat behind them, there was a clear flaw in this thinking…

They had assumed the three issues A, B, and C were mutually exclusive (i.e. independent of one another).

This was not the case. If issue A materialized, then B & C were almost inevitable.

So it was not three independent risks of $50m with a 30% probability. It was actually one $150m risk with 30% probability.

The modeling had assumed a $150m shock to cashflow was a 2.7% probability event (30% x 30% x 30%), when in fact it was a 30% probability event.

Once I discovered this, we adjusted our plan to require $150m of emergency headroom instead of $50m. And I'm glad we did. We ended up needing it.

The takeaway? When things go badly, there is rarely one rat in the kitchen. It’s like compounding in reverse and can get away from you quickly.

As the CFO in a business that is heading to a bad place, you are catching a falling knife and with a business that is dependent on you to forecast the bottom.

It’s lonely and tough.

Anonymous from Tennessee asked:

What are things CFOs can do ahead of starting an M&A process? We are ~2 years from a position where we could sell and I don’t have a good grasp on how to get ready over that period. We should be a $100m ARR tech-enabled service in the healthcare space at that point.

Good timing. For a business of your size. 2 years is the right sort of planning horizon.

First up, you should identify the investment bank you are going to engage to sell the business. The sooner you can get them involved, the better. They will help you in ensuring you are doing all of the things necessary to maximize value. They will also help you better understand the buyer universe.

Secondly, you need to plan the business for consistency. A business that is growing consistently 10% quarter on quarter is more valuable than one that grows by 20% one quarter and declines by 10% the next. Buyers will pay for the consistency of cashflows.

Smooth curves demonstrating growing sales on leading and lagging indicators, coupled with improving margin conversion. You need to build all of this into the top-down targets for your FP&A cycle for the next two years.

Third, you then need to measure relentlessly against those targets. That comes back to the reporting and FP&A cycle again. Very clear bridges. Making sure variances are understood. This will be valuable for two reasons: 1) to keep performance on track 2) it gets you a head start on the analysis you will need to provide into a confidential information memorandum

Fourth, you need to ensure that the business management team can ‘stand alone’. A business with a ready-made management team that truly stands alone is better than one with gaps to fill on day one. This all goes to value.

Finally, there is lots of background work you can be doing to assemble information that will be useful for the data room when the time comes. Starting that sooner rather than later gets you a head start.

Maximizing value from a sale is all about building a story in what I call the ‘zone of believable fiction’. You can read more here.

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Next week we'll start a brand new series on turning around business performance.

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Stay crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director, or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need.