The current economic crisis will severely challenge many businesses as supply chains and customer relationships are disrupted and revenues drop along with cash flow. While periods of severe economic grief are not new, each crisis may be different in origin or intensity, and they most often impact thinly capitalized young companies. Such firms fight to survive by cutting operating costs to conserve cash.
I want to call attention to the “quality” of this effort, which will largely determine the future of the business when better times arrive – as they always have done. And as I found in years of private equity investing, many young enterprises managed by outstanding teams lived through a bad crisis to emerge winners.
What I mean by “quality” in this context is management’s ability to zero in on the core value proposition of their business and protect those resources that will provide the building blocks for realizing their unique value creation in the future. The easy part of cost-cutting is letting go of elements in the business that can be replaced in the future. Excess rental facilities are one example.
Regarding staff, the place to begin cutting are people added to the company as it grew because of anticipated skill needs in engineering, administration or marketing. Such people are not needed until a later time, when growth resumes.
The core rationale for cost-cutting must therefore be to protect those parts of the business that constitute its competitive advantage. Sometimes this means a drastic temporary reduction in business scale as the company rethinks it strategy while conserving cash.
Two examples come to mind that emerged as big winners after going through a drastic business-plan change. Both were Warburg Pincus portfolio companies.
The first example is Level One Communications, a chip company startup that had developed a novel technology for transmitting high-data-rate digital signals on copper phone lines.
The business had grown on the basis of custom product development for office-equipment manufacturers. The founder’s idea was to become the exclusive communications specialty chip supplier to leading equipment companies. This idea worked until a recession led to reduced revenue opportunities and a contract cancellation by IBM. The company was going to run out of money, and there was no basis to encourage investors to put in more.
Then, under the leadership of a new chief executive officer, a new strategy emerged. He believed that the company’s technology was unique in quality and patentable. Therefore, the strategy should be to design and sell products only to industry operating standards – which then was set by Ethernet – and offering them to the general market in competition with others.
That meant giving up custom work. To conserve cash while the new products were being completed, the company terminated all but the outstanding and creative core engineering team and a few applications engineers.
The strategy worked. The company emerged fast-growing, profitable, and one of the leading suppliers of Ethernet connectivity chips in the world. It had an initial public offering (IPO) and was eventually acquired by Intel for US$2.2 billion.
The second example from personal experience was Nova Information Systems, a startup in the credit-card processing business. The company’s founders were 11 specialists from the banking industry who aimed at the small-merchant processing business – a sector not well served by the large processors that dominated the business.
The competitive edge that the founders relied on was a technology-processing and merchant-access platform that that was unique in offering low-cost operations. The company’s challenge was to acquire customers in large numbers. It deployed salespeople to call on merchants and contracted with independent sales organizations.
The bad times came when the company found itself in a recessionary environment. While revenues grew – as did the staff of the company – cash losses kept growing.
The company was facing a round of financing without the prospect of reaching break-even any time soon. Analyzing the company’s cash flow, it became obvious that the cost of acquiring a customer was so large that it was not recovered over the life of the contract. The reason was that the independent sales organizations took too much of the revenues and the contract life was too short – mostly because small merchants did not last more than two or three years on average. Direct selling to merchants by Nova salespeople was equally uneconomic.
The conclusion of this analysis was that the business model was bad – another way of acquiring customers was needed. Then the CEO came up with a customer-acquisition solution that leveraged the problem of small banks that needed profitable revenues. The local banks had the merchant relationships and sold them credit-card services in addition to other financial services.
The new strategy allowed Nova to buy their merchant portfolios, do the processing and contract with the banks for future merchant contacts as they acquired new customers. The customers would be moved on to the new Nova processing platform seamlessly. But this required new Nova technology development. Most of the staff was let go, including nine of the original founders as the company focused on completing its technology platform and contacting small banks all over the US.
The end story was a huge success. The company became the leading US card processor for small merchants and reached over $1 billion in highly profitable revenues. After an IPO on the New York Stock Exchange, the company was acquired by US Bancorp.
What these two stories have in common is great management, supportive investors, and an important competitive edge that is identified and developed into a successful business strategy. These three elements allow successful businesses to be built even under conditions of deep adversity.
Dr Henry Kressel is a technologist, inventor and long-term Warburg Pincus private equity investor. Among his technological achievements is the pioneering of the modern semiconductor laser device that enables modern communications systems.