Learn what Rodney Davis has to say
Grey Matter is our financial thought leadership for enterprises and business owners. In our interview series, practice lead, Rodney Davis provides valuable insights into issues facing companies and organizations today through his CONVERSATIONS.
About Company Valuation
It may not seem like the right time to start planning an exit, but partner Rodney Davis talks about how, when and why business owners should start valuating their companies for a future exit.
DETERMINING AN EXIT VALUE FOR YOUR BUSINESS
HOW DO YOU DETERMINE THE VALUE OF A BUSINESS?
Interviewee: You should understand the assets that you have in the business because when someone thinks about the ultimate future income from that business it includes the proceeds on the sale of assets.
So you should understand your balance sheet and understand how the things on your balance sheet can turn into cash in the future. Whether that’s the liquidation of your accounts receivable, offset by the extinguishment of your accounts payable, whether that’s the sale of tangible assets in a manufacturing business that might be a much bigger number, than say, in a services business, which you still may have tangible assets in the business. So you should understand your balance sheet when you’re trying to determine your current and your future exit value for a business.
And you should understand, not only the sources of income for your business, but also the strength, and the likely continuity of those sources of income, in the event that you were to exit. So going down a checklist, you look at your balance sheet, you look at where does my income come from, you look at the underlying cost of delivering those services normally. Because often when you look at the exit value of your business and you’re looking to sort of see what are the normal costs going forward. Obviously, people look at the historical cost, to get a sense of what the future cost might be, but you have to remove from those historical costs, those things that are non-recurring in nature.
So you may have one time put some personal expenses through your business. You want to take those out when considering future operating costs of the business. You may have incurred things to solve a problem in a particular year that are not likely to reoccur. You want to take those things out when you’re considering the future cost of the business.
HOW DO YOU IMPROVE YOUR COMPANY’S VALUE?
Interviewee: So, some of the best things you could do, when you’re thinking about how do I enhance or maximise the value of my business, is try and ensure that there is a predictability to the future revenue of the business, there is a predictability to the cost structure of the business, there is a predictability to the working capital required in order to support that business. Because the more that that is predictable, and people have confidence that it’s reliable, the lower the risk premium they attach to the business, and therefore, the more they were willing to pay at the same level of earnings.
WHAT ABOUT THE VALUE THAT THE OWNER BRINGS TO THE BUSINESS?
Interviewee: Well, when we talk about the replaceability of the owner of a business, we’re talking about the difference between personal goodwill and business goodwill. People don’t pay a lot of money for personal goodwill, because personal goodwill isn’t necessarily transferable. So, if the business is totally dependent on you, then what good is it to me to come in and step into your shoes? If the clients are going to leave, upon your exit, then I’m not really buying that book of business.
So it’s really important that as a business owner, you try and establish business good will and you try and diminish personal good will. I mean, our egos make it hard to do, because the thought that our business could survive, or that we’re not the most important thing in our business, is something that’s hard to deal with, from an ego perspective. But it’s expensive to make your business continue to depend on you because other people aren’t willing to pay for that.
WHEN SHOULD OWNERS START PLANNING THEIR EXIT STRATEGY?
Interviewee: You want to consider the potential opportunities for the business. You may be at a point where you just started a new business and it hasn’t had a chance to come into fruition so when you’re checking off sort of what’s my business worth. What’s the exit value of this business? You want to give thought to what it might look like tomorrow, in addition to what it looks like today, because there may be some underlying value that you might leave on the table that you don’t go through that checklist.
Every business eventually is going to require its owner to exit because businesses generally live longer than people. So if you’re operating in a business, no matter what stage you are in that business, every so often you should give thought to when, if and how you might want to exit that business, and whenever that inflection point comes along, make sure to think about value and think about what it is it needs to be done and whether you are doing the things that you need to do to maximize the value of the business, because it’s inevitable.
They say we’re born, we live, we die. Well, your businesses don’t follow that pattern, there are businesses that will live forever. There have been businesses that will forever, there are businesses that have been around for hundreds of years, they’ve outlived every owner they’ve ever had. There will be a time to talk about exit value, so just prepare ourselves for it.
On Managing Your Bank
Your relationship with your bank is seldom a simple one. Hear Partner Rodney Davis speak about how business leaders and owners can strategically make the most of the complex relationship.
What’s the best way to establish a relationship with a bank?
Rodney Davis:Banks want predictability. Banks want confidence. Banks want transparency. And so, if you’re going to have a good relationship with the bank, you need to satisfy those three conditions and if you satisfy those three conditions, even in adverse times, you’re going to find it’s easier to deal with the banks.
There are inflection points in the life of any business, at which time, whether the cashflow suggested it or not, you should try to establish credit relationships that will serve you well, as you require them.
So, take a profitable business that suddenly started within the last few years. It generates positive cashflow all the time. Why would they go to a financial institution to establish relationships? Well, because if they’re growing, it’s very possible that you need resources to finance that growth, and it’s not necessarily the right source of financing to finance long-term growth with short-term operating results.
When you think about how you finance your business, if you’re financing your business entirely out of the profits of the business, then you should, as a business owner, consider that to be making additional equity investments in your business and a lot of owners don’t do that. If the business is financing itself, they consider that as they’re not making additional investments.
But the reality is, if you’re using only your operating profits to finance long-term sustainable growth, you may actually be missing the opportunity to better balance the capital, the total capital structure of your business, because you never know when you’re actually going to need financing. And the worst time to apply for financing is when you’re desperate for it and that goes back to predictability.
Why are relationships with banks often mismanaged?
Rodney Davis: The difficulty about the relationship between banks and their clients is we absolutely need banks. We have to have a repository for our funds. We have to have a vehicle of settling our accounts with our suppliers, with our staff, with our clients. It’s absolutely mandatory and so, sometimes as a client, we forget that we’re a client of the bank, as opposed to in desperate need of their services, and sometimes bankers like it that way. So, the relationship isn’t quite as balanced or set in the right method for it to be productive for both sides. It’s rarely not productive for the bank, unless there is a situation of default, but many times it’s not what it needs to be for the client. At the end of the day, you’re a client and if that relationship is going to work in the most efficient way for both sides, the supplier-client relationship should never be lost, and many companies find themselves not acting like a client with their bank.
How do I project whether I’ll need financing?
Rodney Davis: If you’re doing good business planning at the beginning or during your business cycle, which is your annual business cycle, it should give you a predictor of whether or not you’re going to need cash.
Now I will tell you, a lot of businesses do forecasting or do their budgets and don’t budget their balance sheet. In fact, most businesses don’t budget their balance sheet. But the way that you know whether or not you’re going to need financing is by carrying through the operating and capital requirements of your business through to a projected balance sheet. Because that will tell you if you’re going to have periods during the year where you might have cash crunches, and therefore puts you in a position to start to negotiate ahead of time to put facilities in place to meet those cash crunches.
Is it wise to use your own personal credit?
Rodney Davis: I think you should do as much as you possibly can to separate your personal life from your business in terms of intermingling the financing and the credit and anything else that puts your home at risk for the purposes of your business.
And I say that, in law, you may know that a business is a person. A business is considered an individual in the eyes of the law, for tax purposes, for litigation purposes and for any other civil matters and even criminal – a business can be criminally indictable. They can indict a corporation, however, not a sole proprietorship because a sole proprietorship is an extension of you.
Once you incorporate a business, that business takes on an individual existence of its own, separate and apart from you. And that’s done for a reason. The reason for that is to put you in a position whereby the actions of the business, which is typically governed by a board of directors, is separate and apart from the actions of an individual.
Of course, there are times when it is not only necessary, but not a bad thing, to put personal guarantees on the business, because that’s the only way that the bank will take the risk on you – on the basis that if you’re not willing to take a risk on your business why should they?
But when businesses get to a certain size, a certain predictability, it’s much easier for you to say to the bank, “Look, this business is predictable. I’ve been transparent with you. You can rely on where this business is going.” Therefore, you want to not need a personal guarantee. So, you should only guarantee your business as long as you have to. It should never be a choice. It should be something that’s necessary.
Is it important to have a financial advisor in these conversations?
Rodney Davis: I’ve seen situations where entrepreneurs have thought they could go at it alone and that same entrepreneur has seen the difference when they’ve had an advisor beside them.
I would recommend that if you’re in any kind of meaningful financial discussions with your bank as an entrepreneur, unless you have a financial background, I would think it would be wise to bring somebody who can speak bank-speak. The banker-client relationship is a very difficult relationship to navigate and often mismanaged. So the best advice I could give to anybody is understand from friends and colleagues who’ve had experience dealing with bankers over the years, and get some education on how you should manage your bank, particularly if your business is either going to go through a difficult period, go through periods of rapid growth or simply just needs to have the right capital structure.
It really is important that you take personal responsibility as the owner of business in helping to define what the relationship is going to be with the banks.
I know a lot of clients who don’t even know their personal banker, their business banker. They may have a passing relationship with that individual and they’re proud of it because they say they don’t need the bank for financing. You should always know who your banker is.
On Service Pricing
Is pricing services different than pricing products? Partner Rodney Davis speaks on how business owners and leaders can follow a better framework for setting prices on their service offerings.
How should a company price for services?
Rodney Davis: You know, people often struggle with how to price services, it’s something that in my career, I’ve been in the service space almost as often as I’ve been in the product space, so I have a very keen sensitivity to how you price services, and one thing I try to tell entrepreneurs all the time is, valuing a service is always down to how much time it takes to deliver that service.
And so, unlike a product where you set it, and the machine runs and therefore it’s very predictable, the time it takes to deliver that product, and therefore the underlying materials that go into it and associated costs. In services, you have to manage the resource to deliver that service in as efficient and way possible. So on pricing services, at the end of the day it’s time and then whatever else goes into delivering that service.
Well, what I tell clients or what I do when I price, is first you figure out what it’s going to cost you to deliver that service. Then you determine what margin you’d want to make on that delivery service, just like you would for a product. As in products, at the end of the day, you have to then compare that to what the market will pay.
So if you, and the reason why that exercise is good for many entrepreneurs is once you’ve priced what that product should cost based on your service delivery costs, you realize whether or not you’re efficient or inefficient, because it indirectly tells you you’re reasonably efficient. So I tend to price independent of the market first, internally, and then compare that to what the market rates should be for that service.
And if I’m way off on the market, either high or low, it might mean I’m either way more efficient than the market, or way more inefficient than the market, and then I have to go back and look at my service delivery model, but at the end of the day, the market dictates everything.
In some cases, if a person costs you $10 an hour, for example, it’s not uncommon for when using very simplified metrics to have that person charged out at a billing rate of somewhere around $30 an hour. If you’re paying somebody $40 an hour, it’s not uncommon to have a metric that says the billing rate for that person is $120 an hour.
So it’s typically a three to one ratio for most professional services, in terms of what that rate should be, but then again, you’re guided by the market and you’re guided by the level of efficiency in delivering the service.
What if the value of the service is worth more than the hourly rate?
Rodney Davis: That’s where the market prevailing rates are incredibly important, because I might deliver a service that takes me three hours in time, but my 40 years of experience in dealing with matters similar to that enabled me to do that in that amount of time, whereas somebody with far less experience who’s at a similar charge out rate might take three or four times that, because it might be a new industry to them, or it might be a new problem that they’ve not yet encountered.
And the important thing about that is that whatever it is you ultimately charge the client should be agreed upfront. When you’re in the service industry, you should not be trying to figure out what you’re going to get for a service after it’s been delivered, because once it’s been delivered, it’s gone. The benefit of it to the client is either already received, or the cost of lowering that service has already been incurred.
Is it fair for a client to pay for every hour of service?
Rodney Davis: The law profession, still is one of the few remaining professions that just bills by the hour and they expect to be paid for every hour. That they deliver regardless whether or not they’ve operated efficiently or not efficiently. There have been some firms that have come in with a block-based pricing for M and A activity, for financing activity or for particular corporate services that they provide, but by and large, the legal industry still does charge by the hour at the stipulated rates. It’ll be interesting to see how that’s evolved.
It’s evolved quite a bit in the last 30 years, I know, if you were looking at this question 30 years ago about the law profession, the accounting profession, to some extent the engineering profession, they would have all said, we get full billing for whatever we bill, in terms of hours.
In industries like I.T and marketing and advertising haven’t had that luxury, they definitely don’t get to do that for their clients, never have, and probably are better at pricing than the other three, so as competition has seeped in, I’ve known a few law firms that have really struggled with the idea of not being paid for every hour.
And in fairness, I think from the law side, it’s complicated for a client to understand what the scope of an engagement might be, it’s complicated for client or a lawyer to predict what may or may not unfold in a legal matter because of the amount of things that are outside of the control of the client. It’s very hard as a client to walk into a relationship where somebody says, I know where you want to get to, there’s a lot of moving parts in getting you there so I can’t tell you what it’s going to cost, but whatever it does cost, I need you to make sure you commit to paying me for that,
I mean, think about that as a consumer if you went to buy products, as opposed to services, how you would react to someone saying to you, I could sell you this ball, but I’m going to have to let you know later how much you’re going to pay for this ball, you’re going to be like, it’s still a ball at the end of the day, the service that I’m being delivered, it can be defined, and to the extent that it can be defined, you should expect a lot more or pushback from a client about unknown pricing.
During COVID, one issue that has been weighing on business owners’ minds is the financial implications of a work-at-home staff. Partner Rodney Davis wades in on that discussion.
Rodney Davis: This is very interesting, because a business has sort of the infrastructure implications and that is, how do I provide the infrastructure necessary for my staff to work outside of the office.
How do you maintain a workplace environment when people are never in the workplace? And so there’s a cost associated with that. You’ve got to buy technology that enables you to communicate more often and or effectively with your team. You’ve got to invest in measures that allow your team to still feel as if they’re part of an organization, and then there’s simple things like, do you keep your place of business?
How do you know you’re getting the most productivity from your employees?
Rodney Davis: The subject of out of sight out of mind, is a very difficult issue for some employers to grapple with. In other words, what the end product is that they need to get from their resources and their staff, have a much easier time with remote workers. So, how do I measure productivity in my business? I know what I expect my people at the various levels, on the various assignments to deliver within the specified timelines.
You have to trust a lot more. You have to put a lot of less emphasis on the how, and make sure that you’re measuring the what and the when.
So there are different productivity measures. But then I say to some employers who want everybody in every day, all the time, “Are you really getting more productivity because they’re sitting in front of you?
Are there financial benefits to having your company work remotely?
Rodney Davis: Travel costs. So employees who get travel allowances for traveling to and from the client premises. A lot of that has been cut out, significant savings across the board for travel and entertainment for clients over the last year.
Those are probably the biggest areas of savings companies have had, but something as simple as office supplies, when you’ve got 200 to 300 employees in a workforce and you’re burning through office supplies and everyone’s working from home, all of a sudden, there’s a lot less printing. There are two sides to that as well. I’ve seen some employees who, working from home means they never know when to turn it off, and so they’re actually working more time on their employers matters.
They feel guilty because throughout the day, they’ve had to tend to issues that they wouldn’t ordinarily tend to when they’re in the workplace, and so instead of calling it a day at four, they’re giving the kids dinner and spending another 45 minutes. And so as an employer, it’s only fair that you focus on the output, because if you focus on the time and set blocks of time, you really are going to put a lot of undue pressure on the people who work for you.
What have been the financial implications of hiring during this time?
Rodney Davis: I think that this issue will be a real issue for companies, because there is a financial cost of getting people to choose to work in different locations and so, think of the company that has offices in San Jose, where it’s very expensive to live, it’s very expensive to work and their employees say, oh good I can work remotely, and they move to Cincinnati or the outside of the suburbs of Cincinnati, where it’s a fraction of the cost to live and they’re delivering the same service. I think that there’s going to be a rationalization and a reconciliation of that. I think we’re going to see situations where people expect you to give them a workstation or whatever other tools are necessary for them to work in a work at home environment, to put them in a position where they’re not having to incur costs in order to do their jobs. I might get a desk or I might get the chair, or I might get monitors, or I might get compensated for using my own tools or workstation at home. Well in home environments, the level of comfort and the amount of space you have dedicated to working affects your productivity. We’ve got to create a situation where somebody can still be productive and there’s going to be a cost to that. I think employment agreements are going to start to reflect that.
I think a lot of those things are going to find their way into discussions with employees when you’re hiring, going forward.
Is there a financial impact on company culture?
Rodney Davis: One of the most difficult challenges companies are facing during COVID, is how do you maintain that sense of collegiality, and just empathy among your work staff?
I know many companies have hired a number of people who haven’t met their work colleagues. I mean, that becomes very difficult after a period of time because no matter how much we want to deny it, knowing someone gives you a predisposition in some situations to going above and beyond.
And so that work relationship can in fact change the way that people deliver services, the urgency with which people deliver services. So there is a value to that collegiality, that sense of belonging, that sense of loyalty that comes from interaction. I’ve seen companies try a lot of innovative ways to try and recreate or to provide an alternative to that. I’m not sure I’ve seen it done in a way that yet replicates the simple benefit of people actually interacting with people directly. The thing I would say the most about working from home is, I think it’s here to stay. I think we’ve been doing remote working long enough that it’s become a habit and it might be very different to rebottle this.
The all important budget. Every organization has one. But as a business owner, do you take the right strategic approach? Partner Rodney Davis outlines what leaders should look at when creating their budgets.
Q: How should a business create a budget?
Rodney Davis: There’s two ways people look at budgeting. Some people like to do zero-based budgeting, which assumes that you’re starting from zero and what would happen from there. I think there are circumstances where that makes sense. I’m not a big proponent of zero-based budgeting in isolation. There are elements of your budget that you can take a zero-based approach but if you’re an existing business that has a track record and history, it’s incumbent upon you to look at the budget as a progression of your business. A business like a person has a life, a lifespan and a life cycle.
When you’re budgeting, if you take into consideration your history, you have a better chance of understanding where you’re likely to go. But if you’re a brand-new business without a history, then you have to consider what you’re trying to achieve, who you’re trying to reach, and what things make it a viable business. Then break them down and try to get an idea of where you’re likely to end up.
I often say to businesspeople who really struggle with this, it’s your best guess. There’s nothing wrong with guessing and being wrong, as long as you’ve put the right amount of thought into it. You’re going to be better for it, no matter what the outcome is.
Q: Why is planning and benchmarking important?
Rodney Davis: I don’t advocate flying by the seat of the pants. I get that sometimes it’s a time crunch. I get that sometimes you can’t do the exhaustive process. The challenge I have with some people who resist planning is the all-or-nothing approach. I either do this incredibly elaborate, super detailed plan, or I don’t do a plan at all. There’s always a balance and there’s always time for planning.
There’s a conversation theme that comes up time and again. And that’s benchmarking. On the question of marketing, or on the question of how much I should spend on any other attributes of my business. If you’re not looking at the whole, it’s very hard to answer that question because the business where the product cost is 50% should probably spend less on marketing than a business whose product cost is 10%. However, what comprises the remaining 50% will dictate what they have available to spend on marketing and still make a profit. And likewise for the company that only has a 10% product cost. The effectiveness of your marketing is equally important when you’re determining how much you should be spending, If you’re spending 15% of your budget on ineffective marketing versus spending 15% of your budget on effective marketing, that’s a very different outcome. So it can’t be looked at in isolation.
The marketing budget is a good example for measuring how effective you are at budgeting. If you said, if I spend 15% of my marketing budget, I should be able to attract a certain number of clients with a certain amount of spend. When you finish the period and you look at how many people purchased and you look at what their average spend was, you can compare whether or not that was the right amount. Or if I had spent a little bit more, I may have gotten more out of it, or if I spent a little bit less, would I have gotten the same result?
It’s a journey and it’s an iterative process. You shouldn’t assume you’re going to get it right the first time.
Q: How do you measure the success of a budget?
Rodney Davis: Getting a good budget is understanding the drivers of your business. So if you’re a service business that has a client base that’s easily identifiable, you should say, do I need 50 customers to spend $50 to get to my revenue number of $2,500? Or could I do that with 10 customers spending $250?
If you know the drivers, you’re in a much better position to budget. Budgeting isn’t about top-line. Executives might give you a top line number, “We did $10 this year. We’re going to do $15 next year.” But do you know what gave you the $10? If you’re going to approach budgeting with an intent to get budgeting right, you should know what drives my costs, what drives my revenues.
Rodney Davis talks about one of the more difficult issues facing business leaders – downsizing. He offers insights into better strategies, how to seek other solutions and how to find
the right way to downsize.
WHY IS DOWNSIZING SO DIFFICULT FOR BUSINESS LEADERS?
Rodney Davis: You know, probably the most difficult decision in any businesses is the decision to let go staff or to reduce the size of your workforce and that decision, I would imagine more CEOs have laboured over that decision than almost anything else, with the exception of shutting down entirely and no, it shouldn’t be your immediate reaction when things tighten up, but it definitely has to be a consideration, depending just how much of a service delivery, versus a product based business you are. But when you start contemplating the decision to downsize, you’ve got to understand what the implications are, fewer bodies or fewer resources are to the ultimate delivery and quality of service delivery to your customers.
It may not be the answer. It may be that you are experiencing the decline because it’s a quality issue in the service that you’re delivering and therefore, maybe you need to possibly throw more resources that in order to get that quality where it needs to be. To get that revenue back to what it could be, if you’re delivering at the level that people expect, it could be that technology, rather than a revenue decline is probably more of a factor in what should determine the size of your workforce.
ARE THERE OTHER SOLUTIONS THAN LAYING OFF PEOPLE?
Rodney Davis: Absolutely. You might change your footprint, you might re-examine the workforce company relationship, there possibly are things within your labour contracts that some changes to that those could address some of the shortfalls you’re having as a result of your belt-tightening. And sometimes I’ve seen that very successfully discussed, where you actually negotiate with your workforce to make a few compromises and then you don’t have to let anybody go, you can manage through that with your group as a team and come out stronger on the other end.
Rodney Davis: Companies shouldn’t get caught by surprise, in terms of optimizing their workforce or optimizing their product and or service delivery. In a previous conversation, we talked about benchmarking. I’m a big believer in benchmarking. I’ve seen benchmarking translate in one-to-one cause and effect or one-to-many cause and effect, in terms of improvements to the bottom line. And if you’re in a business where you are serious about it for the longer term, if you’re not considering what it costs for you to deliver your service or to drive customer growth, as it relates to what it costs your competitor or your peers, then you probably are going to run the risk of getting caught off side at some point in the future
HOW DO YOU KNOW IF YOU’RE OVERREACTING WHEN DOWNSIZING?
Rodney Davis: Things like that should not be a surprise. If you’re constantly refreshing your understanding of how the key drivers of your business are working within your business, it’s going to come out of the numbers for you. And there are going to be early indicators, whether there’s going to be a tightening of the revenue because of fewer clients, reduced demand, increased competition, or whether there’s going to be the advent of new technology that your competitors have put in place that put them in a better position to deliver the same service, greater access to suppliers. You should be aware of your environment.
IS THERE A RIGHT WAY TO DOWNSIZE A COMPANY?
Rodney Davis: Firstly, you have got to do it humanely, and that means you have to communicate effectively, when it is time for you to communicate and you can’t do it with a broad brush.
I see companies do it, where they universally just go equal parts across the organization, or they offer blind, voluntary downsizing without having a good idea of who’s going to accept that and then find themselves in a situation where people that they had hoped wouldn’t accept it, have accepted it and people that they hoped would accept it, have not accepted it. And then they’ve got a workforce that’s smaller, but far less effective than either they anticipated or than they had before.
Rodney Davis: The normal approach I’ve taken to downsizing and one that I’ve advocated with a lot of senior executive teams and often with great success is you take your organization chart, and you remove all of the names and you build the organization chart that you expect to emerge with. Once you’ve done that, then you put the names in boxes. In many cases, it’s obvious who goes in which boxes and in some cases, it causes you to really contemplate who goes in those boxes. But essentially, you build an organization chart, independent of the people who are in the organization.
Once you’ve gone through that exercise, you realize you’ve built the organization that you think you need to have, and then you take that and overlay your existing organization chart over top of that and it’s very revealing what you come out with. It sounds cold, but it’s actually very cognizant of who works for you, because in order to do that well, you should know what the skills are, what the habits are and what the strengths and weaknesses are of the people that work for you if you’re going to do that effectively.
On Business Expenses
Partner Rodney Davis shares his thoughts about how business leaders can be more strategic in their budgeting when it comes to expenses, what metrics to consider and where to focus resources when times are tough.
Q: All businesses have expenditures. How you determine the value of an expense?
Rodney Davis: You can’t outright assume that an expense because of its size is good or bad. What you have to understand is when I incur that expense, what are the outcomes that will be derived from that expense? Albeit, whether that be incurrence of that expense might set a precedent that could cause a problem somewhere else. Is that expense going to generate revenue in a day and a month and a week? Is a dollar spent going to generate $10 of revenue? Is $10 spent going to generate a hundred dollars in revenue or is $10 spent going to generate $8 in revenue.
The disconnect that sometimes happens that finance is meant to bring to the table is because they are supposed to understand the knock on effect of all expenditure decisions to actually give an accurate representation, or at least a forecast of what that truly should translate into, based on all the inputs from sales, from marketing, from creative, from technical and from the banking or so, the source of funding, they’re supposed to be able to say, if I spend that dollar, yes, I can translate that back into $3 within X amount of time and therefore, that’s either acceptable or not
Q: Is determining an expense a subjective call?
I think it’s really important that the finance person resist offering their subjective opinion on these things. They should first present the objective, get the objective understood, have the conversation objectively and then they’re welcome to weigh in their subjective opinions. That advice then allows them to look at the results or the, one of the best things that we do for clients is we project. So, we take those metrics, we look at the historical results of those metrics combined, and then we take those exact same metrics and project what would happen if different components of those metrics where to change and show the entrepreneur if you’ve got more sales leads and this is your conversion rate, this is what your revenue would be. One of the tests I do with a lot of entrepreneurs is I take those metrics and I say, tell me what you think the outcome would be, change the metrics and what do you think the outcome would be? And many times they think they know the answer and instinctively they’re typically in the right direction. The advice allows you to be a bit more precise in your prediction, and a bit less invested in those predictions emotionally.
Q: How do you determine what expenses to cut, especially in challenging times?
My approach, when you are faced with a series of circumstances, where a great many of them are outside of your control, step back. Identify what’s within your control and focus on that. Don’t try to change what you can’t change. So, it takes a whole lot of control and discipline to recognize what you actually have the ability to change. So, I say to entrepreneurs, when you’re in survival mode, don’t try to rewrite your business, understand which parts of those things that are affecting you are outside of your control, try your best to understand where that control lies.
So, whether that’s protecting your existing cash reserves, fortifying your product or service to be the best that they can be, wring out efficiencies that you’re able to wring out of your product, serve your clients better for those clients who still are doing business with you, but focus on the things that you have the ability to control.
Q: what happens when cutbacks affect the mission or even culture of a company?
Changing your core is changing your business and so you’ve got to understand like, so the great example is the metamorphosis of Netflix, from being a mail order video business. They quickly realized that they could change the way that they do the exact same essence of their business. The mission is still the same, convenience, view movie or content when you want to view it, where you want to view it and when you’re finished, it’s not difficult to get rid of it. It’s the same mission, they just translated how they did it.
So what I say is, they pivoted without changing their core. They didn’t change their original reason for being. They didn’t change their purpose as an organization, but they pivoted to take advantage of a new way to deliver the promise that they gave to their customers. So don’t change your promise, you know what I mean? Pivot to deliver that promise in a way that’s suitable for the current circumstance.
On Entrepreneurs And Too Many Ideas
Rodney Davis was interviewed about the folly of many entrepreneurs and their temptation of pursuing new business ideas without a clear plan. Hear what he has to say about how they can work with finance to set up clear metrics.
Rodney Davis discusses the folly of many entrepreneurs – too many ideas. He provides an understanding of why ideas are not enough for a successful business and how to use KPIs to measure an idea’s success.
Q: Why Ideas Are Not A Business
Rodney: Entrepreneurs have ideas a mile a minute, they think and I used to, I remember I was working in China, probably five or six years ago, and I had a CEO who had great ideas, very poor execution, couldn’t quite translate those ideas into effective operating models for the business and I remember sitting with him one day saying, an idea, no matter how good, is not a business. A business is the implementation of ideas into an operating model and marrying sales opportunities around that and effectively executing against those opportunities, and so, what I try to tell an entrepreneur is, you can only do so many things and you only have so many resources available at your disposal. Good reporting focuses the entrepreneur on the most effective throttles within their business and so, what I try to do for entrepreneurs is build them a framework within which we can discuss the business that keeps them focused.
I’ve seen entrepreneurs who bet the farm every time, the bigger the business, the greater the risk when they take those challenges, if it’s a small business, they can rebuild. If it’s a big business, it’s really hard to rebuild and you’re affecting a whole lot of lives and so, you have to be very careful about making decisions at the farm, because you have a staff that you got to think about it. You’ve got stakeholders and legal obligations you have to think about. Finance’s job is to make the entrepreneur aware of what they’re putting up, when they’re making those decisions, and then let them be entrepreneurs.
Q: On The KPI of Ideas
Rodney Davis: My first job is to make sure that they trust me. How do I gain that trust? I gain that trust by repurposing or reshaping the way that they look at their business from a financial perspective and then rinse and repeat. So, by creating the habit of looking at financial information on a regular basis, that’s prepared in a useful way that focuses on cause and effect. It’s amazing how six months in or eight months in that entrepreneur can at least pause, because they’ve had enough visibility of those drivers that when you bring up this conversation that might otherwise have had fallen on deaf ears, because you don’t understand, you’re just the finance guy. You always say no, or please, you don’t think like we do, we know what the opportunity is.
That habit of looking at KPIs in the context of the business that you’re evaluating with the entrepreneurs and decision makers of that business is so fundamental to having them pause and walk with you as you take them down the scenario building of what the steps that they want to take are likely to lead to and when you have that, and you’ve already got that routine, you’re halfway there, you’re not always going to win, but you’re halfway there.
On Business and COVID
Rodney Davis speaks about how business can adapt to the uncertainty and fallout from COVID, and how they can prepare for future challenges.
How can businesses adapt to these COVID times?
Rodney: In a previous conversation we talked about sort of the cultural impediments to change, COVID is a classic example. Organizations that were not culturally built for change, probably had a worst time dealing with COVID. They probably had far more difficulty in adjusting to the new reality. But the reality is probably the number one driver for everything you do and that’s a cultural thing and that comes from the top. If you have that, you’re putting in place things constantly to enable you to respond to what the customer needs, and if you don’t, it’s harder.
Finance isn’t really the custodian of the customer relationship. Finance is the custodian of the outcome of not taking care of the customer, which is the financial implications of losing customers – the financial implications of service delivery that’s more expensive than the benefit you receive from a customer.
They are the monitor that says you’re losing customers or you’re gaining customers or your service delivery costs are too high or your product costs are too high. So finance, all of that has an effect on the customer relationship, because if you’ve got that customer relationship in a particular place, you can put through those changes, with less impact on the business and if you don’t, then you may have a much more difficult situation.
How can finance help prepare businesses for future problems?
Rodney: Yeah, the short answer is, in a time like that, where you have a sudden change to your business, that was completely unexpected, completely outside of your control, and it affects your customers and, or your ability to do business, the more variable the costs associated with your business are, the more resilient you are. And there are businesses in our eco society that have costs that are 80 to 90%, before you get to making a penny. So the gross margins are very small, The thin gross margins means you’ve got to generate a considerable amount of revenue before they cover those fixed costs. I would be willing to bet you that a lot of businesses that are in that situation, have looked for ways to reduce their fixed costs because that makes them more resilient during a difficult time. If I’m going to deaden or lessen the impact of the unexpected, then I’ve got to know what I have available and also what it’s going to cost to continue to operate.
Why it’s important to stay close to the money?
Rodney: You have to understand what the actual money impact, real money impact is of decisions and so, when I talk about costs, I’m not talking about notional costs when I’m making a management decision. I have to know how a decision to pursue a particular line or course of action translates into money at the end of the day. The money that comes in, the money that goes out and the money that’s left after we’ve covered all our costs associated with that. Good finance teams understand that and can help the business in evaluating decisions by pointing them to the residual cash that’s available because at the end of the day, the manifestation of every business is cash.
What advice do you have for businesses at this time?
Rodney: Be very aware of your financial position as close to the completion of your financial periods as possible.
A lot of the companies that I deal with that faced scrutiny, whether it’s from potential new customers, potential new suppliers or their financial institutions, or the financial backers of that organization, the number one concern that anyone who was a stakeholder or a supporter of that business had at the Covid time is, are you going to be around? And so, in order to give them that comfort, the closer you were to your numbers and the more you had a framework that allowed for reporting, but not just reporting, but reporting and the ability to respond to the questions that arise out of that reporting, the more likely it is you gave confidence to the people who had to make decisions about whether or not they were going to support you.
Most of the new business that we picked up during COVID, was people who were saying, “I wasn’t close enough to my numbers. I didn’t realize how much of a deficit I had in terms of the immediate awareness of what my underlying financial condition was or my underlying financial performance was.”
Rodney: Having money in the bank, without having an understanding of how that money turns into more money or how fast that money has the potential to disappear, you’re just as vulnerable as someone who has no money but knowing how to make more money and knowing how to retain money after you finished delivering your services is probably the most ideal scenario for a business.
About Employee Compensation
Rodney Davis provides his expert insights to help business leaders. In this conversation, he talks about how finance can help assess employee compensation as well as measuring staff performance and bonuses.
In an interview series, Rodney Davis helps to provide organizations with a blueprint for success, addressing common business problems with a strategic approach that always begins with his signature CONVERSATION.
Q: How do you determine if an employee is worth what you’re paying them?
Rodney Davis: That can be a subjective conversation point, but it doesn’t have to be. The job of a good finance person is to isolate the cost components and understand how they affect the bottom line. Only after that can you layer on the more human, subjective side.
That can be a subjective conversation point, but it doesn’t have to be. The job of a good finance person is to isolate the cost components and understand how they affect the bottom line. Only after that can you layer on the more human, subjective side.
Q: How can you compare employees with the same job description? How do you financially measure performance?
If I’m making jam, there’s a role for the oil, there’s a role for the fruit, there’s a role for the sugar. It’s the same principle. If I’m dealing with people, there’s a role for the salesperson, there’s a role for the marketing person and there’s a role for the finance person. The measurements for each of those people are associated with the inputs and outputs that we derive from each of those people. So in the case of a salesperson.
You assess the controllable and the uncontrollable outputs that come out of them doing their job and then form a set of metrics. Sales is a good one because you can measure how many leads they get, how many people they convert, how long it takes them to convert, what’s their average sale value, and so on. In the case of marketing, how much money did you give them to spend? How did that translate into dollars earned? In the case of manufacturing, how many units came down the line and how many of those units came out defective? So, you have different measurements for different job functions, and the job of finance in that conversation is to identify the inputs and outputs and the controllable vs uncontrollable and assess that individual against it.
Q: How can the finance guy help the senior management team have a conversation about staffing?
Rodney Davis:The baseline of every good budget has two components that are typically broken out from the rest. One is revenue and cost of goods sold associated with that revenue, and the other is staffing. In any good budget, staffing is a completely separate component, broken down to the individual number of positions in each of the different functions and all of the associated costs with each of those positions. So, when finance is having that conversation at the senior management level, they typically speak in terms of the staffing costs of the various functions and how those translate as a percentage of organization, in terms of cost or revenue. And of course they’ll provide metrics against those same functions in other organizations, so that you’re having a real conversation about the effectiveness of that team in carrying out their job. It’s often quite easy to get metrics that you can compare them to.
Q: What’s your point of view about sharing financial performance with employees of the company?
Rodney Davis:I believe that at a high level, sharing financial information with the organization can be a good thing, depending on your objective. Sharing it as a means of demonstrating to the team their effectiveness in achieving the company’s overall objectives, is usually not a bad thing. But I’m not sure it’s particularly useful to share it for sharing’s sake. If you don’t underpin it with KPIs, it’s not a useful conversation.. In all the reporting I do for companies, if you don’t bring ‘cause and effect’ to the conversation, your conversation ends up incomplete. So if you tell your employees how profitable the business is without telling them what drove that profitability and what could cause that profitability to disappear is not going to give them the right perspective.
Q: How much information about the financial health of the company should we be sharing with our employees?
Rodney Davis:I think it’s a situational call. There are varying degrees of information we should be sharing with varying levels of employees within the organization. I say that cautiously because if you’re unable to have a complete conversation and provide context, then sharing that information could be harmful. I have a rule in business that I followed for 25 years: Anybody in my organization that makes hiring decisions has a responsibility to see the results. Because if they’re making decisions that affect the results of the organization, they should see the results of the decisions that they make so that they can be held accountable. I’ve seen many organizations where the person making the decision isn’t even aware of the ultimate outcome of the decision they had made. That is a real error in an organization when dealing with senior managers. Senior managers must be accountable for the decisions that they make and the KPIs they choose to measure will enable them to see the associated costs or benefits of the decisions made.
Q: When an organization is doing well, how do you determine a bonus? What metrics should be put in place to help entrepreneurs determine bonuses?
Rodney Davis:I tell every one of my clients, if you can’t calculate the bonus or total compensation independent of your judgment, then there’s something wrong with your compensation plan. Interestingly enough, it’s fairly easy to ascertain what the right bonus levels are within your company or industry. They should be tied to the target compensation for that position.
Rodney Davis:Typically a company will say, “I want X percent of their compensation to be fixed and Y percent to be variable, and that variable compensation is achieved if they hit their target performance metrics.” For example, let’s say we’re talking about an executive. I think the target compensation and the competitive environment for an executive of that level is $100K and I want their compensation to be 80% fixed and 20% variable, because that’s consistent with the industry. I might say we’re going to give them a base salary of $80K, with a bonus objective of 25% as a target, and really drive home how important it is that they perform. We have an upside that’s tied to overperformance or we have a ratchet that’s tied to underperformance. Some companies will make that all-or-nothing, which I don’t think is the right move, because if you’re 80% into the year and you know you’re not going to get your bonus no matter what, you may take your foot off the gas. If you know that there’s something at stake, you’ll keep driving all the way to the finish line. So target earnings is one way you do it. The other way is this: you might say that the company has a return requirement of X, so we want a return on equity or return on revenue of X. If management does their job and they make that return, then the pre-bonus is higher, because they’ve either done cost savings or they’ve blown through on the revenue numbers. Then they might say, “We’re going to give management a share of everything above that target return on revenue.” In that case, you know that sky’s the limit. So, you might say, “If our return on revenue target is 13% and they’ve achieved 17% pre bonus, we might give them 50% of that, and 4% of that return,” which could in some cases be significant.
I’m very specific and very clear with senior management that there must be a predictability to compensation. And that has to be something that an executive can actually calculate. If your executives have that ability, invariably you’re going to find that they’re going to perform better, because they know the rules, they know where the goalposts are, and therefore they can shoot for the stars where they can determine how much effort they’re going to make to get there.
On Staying Ahead of The Competition
Rodney Davis advises companies on staying ahead of
the competition and understanding why pricing
strategies aren’t the only solution.
The CONVERSATION – On Staying Ahead of the Competition?
They’re definitely are ways that you can stay ahead of the competition, and again, data, data, data.
There are several ways we’ve approached this, and different scenarios require different approaches. The first entry point for that discussion is understanding what drives profitability for that organization, and in driving profitability for an organization, I always break them down into what drives revenue and what part of the cost structure is fixed versus variable when you get a dollar of revenue. And then understanding how much revenue do I have to drive to cover the fixed component. Understanding the variable component and so when I advise a company, that’s first and foremost is, do I understand their fixed versus variable? Do I understand how much revenue they need to drive to cover their fixed? Now we can have any conversation about cost, in the context of that paradigm and sometimes that labour component is variable, or a portion of that labour component is variable, and sometimes that labour component is entirely fixed, in which case there are other components that drive the variable nature of how their business costs move as a function of how their revenues go up and down.
Why You Shouldn’t Default Prices
A lot of times, operators get lucky. There’s just so very margin rich business, and so they start to convince themselves that they actually are great at pricing and great at margins, and they can just give up margin and get the sale, and the problem is, is depending on the barriers to entry in that marketplace, as competition comes in, first thing that they’re all going to do is chip away at that margin. So, if you don’t have a better strategy other than price, you better hope it’s a high barrier to entry, enter industry because eventually people will go where the easy money is, and price can’t be your only barometer as a system in a sustainable model. It’s just too difficult.
How Do You Keep Salaries Competitive?
The short answer to that is, and it’s one of the most interesting things I tell a lot of organizations, as it relates to their sales teams or other staff components is, there is a responsibility at a particular level or different levels in an organization for understanding the labour as a cost component of how your business makes money, and to me, that is at the manager level and above. So, what do I mean by that? I mean, you know, I have one client who, their business is sales, so they sell services and they have a sales team that operates out of a central sales room and those salespeople have to sell and so, the salespeople want to earn a particular salary, and we’ve been having this discussion for the better part of a year and a half, I think we’ve got it figured out now, but, in their case, it’s management’s job to bring the leads or to bring the opportunities for those salespeople.
The labour component of that, is not the person who’s doing the jobs, responsibility necessarily to make sure that they’re covering their salary. Depending on the level of that person, it’s the persons who are making that labour decision’s job to make sure that they’re paying the right amount to get the right resource into that role.
My experience has been when those superstars are there, who are worth more in the marketplace, sometimes you’re better off to pay them, to keep them because losing them can have a pretty significant knock on effect throughout your organization, but sometimes you’re better off to let them go, if you can’t figure out how to turn that into revenue and your profit for your organization, but you have to put that onus on the people who make the decision.
Why Price Isn’t Everything
One of the most interesting I can remember, was one of my clients was in the retail gas business in a highly competitive marketplace.
I remember going into that industry with a client where the entire marketplace was making decisions and just constantly undercutting each other on price, because they just assume that price was the differentiator.
And we went into that situation with a client who felt that price was the only barometer and we built what we eventually coined as a pricing database, whereby every week there were surveys done, independent surveys done, and we organize this program, implement this program, created this database, where every week there were surveys done of all of the major competitive gas stations representative sample of the market, and interestingly enough, in that case, what we learned fairly quickly was that there were four different pricing quadrants in that market, and what we meant by that was that each of those quadrants had a higher or lower elasticity, in terms of customer sensitivity to price. We also, then went and identified within those quadrants how you best price against the competition, and by putting the customer into that mindset, what we actually ended up with achieving over a two year period was an annual increase in their bottom line of $2 million by changing the pricing conversation from purely price, to understanding which markets had greater elasticity, and therefore you had an ability to price in one particular way and which markets had a greater customer service driver, which had not contemplated previously in that particular marketplace. Customer service did drive some of the customer decision making and it completely changed the way that they looked at their market competition and completely changed the way that they price their business, and then on the other side of that, helped with the cost implications.
On Finance And Company Culture
Rodney Davis shares his perspective on how companies and organizations can make key financial decisions without compromising company culture and how non-financial leaders can work with finance.
In the first of our interview series, Rodney discusses the struggle between financial leaders and company departments like sales and marketing. He addresses how companies and organizations can make key financial decisions without compromising company culture; how non-financial leaders can work with finance; and when CFOs should stay out of company discussions.
Q: Financially-based planning and decision making often seem at odds with the purpose and culture of many organizations. How do you ensure the two are aligned?
Rodney Davis: This concern may come from a technical lead, marketing lead, sales lead, or even operations. We often hear: “We know what’s necessary to achieve the goals of the organization. The finance person just doesn’t understand what we do.” It’s an interesting dilemma I’ve seen play out many times. Good finance people understand what drives the organization. Rather than having to prove yourself, let the data speak for itself. The conversation should only happen once you’ve distilled the key performance indicators (KPIs), or in layman’s terms, the cause and effect. When you take a particular action, you should always look at the outcome of that action.
Q: How do you set out goals that non-finance leaders can get behind?
The most important thing that a senior financial leader can do for his organization is to truly understand the cause and effect of the various areas of your business: technical, marketing, sales, and even finance. Find the metrics for success that each department uses and amalgamate them with your financial data, and then have a conversation. For example, the sales team may look at how many leads were generated. And of those leads generated, how many confirmed bookings? Of those bookings, how many converted into sales, and what’s our average sales size? Five or six simple metrics that salespeople can get behind, that are not subject to emotional interpretations or manipulation or changes. They are verifiable and they’re objective.
On the technical side, it might be how many hours of labour go into producing something. What are the costs of the raw materials based on the amount billed by suppliers, and what is the allocation of overhead? Again, they’re objectively determined. You marry the metrics they already use with the financial results, and you’re able to have conversations with these different leaders, speaking objectively about the financial implication of their actions. You then take away any doubt, like “those aren’t my figures” or “I’m not sure those figures are correct.” There’s always going to be some sort of tension with sales, marketing, technical or creative departments because the finance person says they can’t do it or they have to do it differently, which they think compromises their integrity. But it doesn’t have to, if you speak in these terms.
Q: Are there times when the finance guy should just butt out?
Rodney Davis: I used to be in the telco sector and my VP marketing, my chief marketing officer would send me their ads for approval. I’d say, “I don’t have useful input on colours, font size, or picture selections. Let’s talk about how many impressions it’s going to take to generate a dollar of sales or how long it’s going to be before the marketing dollars translate into revenue.” I would try and make sure that I wasn’t weighing in on items that were outside of my expertise. It’s a mistake that I think a lot of finance executives make, where you have a discussion about technical integrity of something, or get into creative conversations. You have to resist that temptation because it dilutes the effectiveness or the importance of your actual financial message. Which is what a CFO brings to the conversation.
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