4 MULTILEVEL APPROACH INITIATING THE FINANCE STRATEGY Where to Look First The health and well-being of the organization is the number-one priority of the small and emerging business owner. Leadership must focus on both the operational and the nonoperational (back-office) aspects of the business to keep the organiza- tion healthy. One of the greatest challenges for any business leader is balancing time and resources between front-line and back-office issues. Typically, the small and emerging business owner is, because of the life cycle of the enterprise, more oriented toward operations. Identifying and dealing with nonoperational issues, KEY TAKEAWAYS ■ Understanding the need to rely on more than instincts to make decisions. ■ Understanding the evolving nature of finance strategies. ■ Realizing that most issues affecting finance are not mutually exclusive. ■ Knowing where to begin the strategizing effort. ■ Understanding the need to gather all finance needs and identify all issues be- fore strategizing. ■ Understanding the need to prioritize all needs and issues before strategizing. ■ Understanding the multilevel model for strategizing. ■ Understanding the need to analyze the business life cycle. ■ Understanding the need to evaluate financial data customers. ■ Understanding the need to analyze the finance organization, information sys- tems, and finance/business processes. ■ Appreciating the role of data flow processes. ■ Distinguishing between upper-tier considerations and lower-tier considera- tions of the multilevel model. ■ Recognizing the need to manage cash flow. ■ Knowing the importance of setting balance sheet policies. ■ Knowing the importance of setting profit and loss (P&L) policies. specifically the finance function, can be a particular problem in this phase of busi- ness development. Many small and emerging business owners feel that it takes a certain level of experience to address the finance function properly. These owners can be proac- tive in maintaining a healthy finance area without having to be finance/accounting experts. The best place to start is with a positive attitude and two key realizations. First and foremost, they must appreciate the finance function—knowing what it is and how it will help the business. Second, they must recognize that they exist within a continuum of finance knowledge. No business owner knows everything there is to know about finance. The same goes for the other extreme—no business owner is totally devoid of knowledge. The fact that a viable business has been started in the first place implies that there is fiscal value in the enterprise (i.e., the enterprise yields benefits that exceed the amount of resources used). The business owner has already made decisions with a fiscal grounding—usually attributed to instinct. The danger is, however, taking comfort in the belief that the small amount of knowledge accumulated in the finance area is sufficient to run the business in- definitely. Business owners can never have enough knowledge to deal with every challenge the enterprise will face. They must recognize this fact as they mature and delegate duties and responsibilities. The need to strategize becomes logical as business owners become aware of this continuum of knowledge. Recognizing and recording business needs and ac- knowledging the organization’s capacity to meet those needs will help business owners approach the finance area, either for the first time or to improve it. There is no one way to develop a finance strategy. Fraught with subjectivity, this task has numerous dependencies and variables—elements that change and evolve as the business grows. A further complication lies in the different strategies needed for small and emerging, midsize, and large businesses. The differences lie in the demographics of management and the life cycle (level of maturity) of the business: ■ Small and emerging businesses. In such organizations, business owners typ- ically wear many hats—operations, finance, human resources, and so on. Staff is typically small, and business owners must rely on their own instincts to make operational and nonoperational decisions. The lack of finance ex- pertise may put the organization at risk, as sound decision making requires multidimensional thinking. When the business is in its infant stage, it often lacks overall infrastructure, particularly in the finance area (concrete com- ponents). The need for soft components of the finance function is less a pri- ority as the urgency to grow and yield cash is great. ■ Midsize businesses. More stable than their smaller or younger brethren, these businesses typically have dedicated finance staff focusing exclusively on finance issues. The finance area usually is good at accumulating histori- 68 MULTILEVEL APPROACH cal data but not as adroit at being forward looking. Infrastructure exists, though it may or may not be adequate. The business itself is typically stable enough to begin looking ahead at opportunities to grow or threats it wants to avoid. Addressing hard components of the finance function may take the form of continuous improvement as infrastructure may already have been conceptualized and implemented. Soft components of the finance function begin to be more of a priority as the business has the luxury of setting its own course. ■ Large businesses. These organizations have ample resources to dedicate to the finance area. Headed by seasoned, sophisticated executives, these or- ganizations have the manpower and experience to handle major business is- sues. Improvements in infrastructure are addressed on an ongoing basis and set the stage for future business initiatives. The focus in these businesses is on the soft components of the finance function. A premium is placed on the finance function’s ability to set policy and initiate strategies that will lead the organization in a prosperous direction, resulting in increased value for stakeholders. Developing a finance strategy can be intimidating for the small and emerging business owner. When beginning the process of strategy development, these ques- tions must be asked: ■ How long will it take? If the enterprise is examining the finance function for the first time, it may take weeks or months to construct a sound finance strat- egy on which everyone agrees. Once a consensus is reached, it may take an- other period of months to put the strategy in motion. ■ Will it endure? Once the finance strategy is codified and put in place, it will take on a life of its own. If done properly, this process becomes part of the corporate culture. Particular strategies will come and go as the business evolves; however, the process by which strategies are developed and main- tained must be embraced by business owners/executives. ■ Once complete, is it immutable? Nothing in the business world is certain. The finance strategy must become a living organism within the organization that changes and evolves with the business. The only thing more damaging than not having a finance strategy is clinging to one that is no longer relevant. ■ How hard is it to maintain? Maintenance of the finance strategy is a func- tion of the myriad of issues that affect the business. The finance function must be the basis of all aspects of operations. Maintaining the finance strat- egy depends on the changing needs of the organization, which depend on the business environment and overall strategy. If the industry in which the or- ganization operates changes frequently, maintenance may be an ongoing process, while maintenance in a stable industry may not be. INITIATING THE FINANCE STRATEGY 69 ■ How will the strategy be formed? Like any other challenge in the business, careful research and determination will be two key aspects of strategy devel- opment and implementation. Uncovering all current and prospective finance issues is the logical starting point. Subinitiatives then can be developed that put the overall strategy in motion. The key will be identifying and arranging all issues in a way that well-informed, practical decisions can be made. Evolution The finance function must evolve and change with the organization. Because most businesses are in a constant state of flux, the finance function must be flexible enough to evolve in both growth (organic and acquisitive) and contraction cycles. The finance function must be nimble enough to deal with environmental factors quickly and decisively in both cases. Faced with a cycle of growth, scalability will be necessary. Being nimble refers to the ability to refocus the finance function quickly if a new direction is taken by the business, while scalability refers to the ability to incorporate the impact of an additional initiative or business objective of the company. A strong finance function will exert control over a changing environ- ment and temper the chaos associated with change in both instances. This controlled evolution will serve the small and emerging business well as it faces the challenges of the high-velocity business world. The only way to control this evolution is to con- tinually update, review, and evaluate the strategy that governs the finance function. ASSESSING NEEDS Getting Started Where to start may be the most difficult question to answer. The inclination is to investigate the finance areas that are most familiar. Doing this may or may not be effective, as the finance knowledge relied on may be inadequate or exist in odd combinations. The ideal starting point lies within the business—in particular, ana- lyzing inherent resources and assessing needs. Every business is different, how- ever, with needs and resources that vary from situation to situation. It is worthwhile to begin this exercise by examining the case of Palmer Products Inc.: Palmer Products Inc. is a purveyor of collegiate candles. Started by two brothers, Mark and Andrew Palmer, the company owns the right to create candles in the form of over 50 college mascots. They also own the right to the respective fight songs, which play as the candles are lit. The two entre- preneurs have established a relationship with a manufacturer in Asia that can produce the candles and ship them to the United States at a very low cost. Having attended a university in which the culture of sports is very prominent, the brothers saw a market for these candles in university alumni, students, 70 MULTILEVEL APPROACH and others. The demand for their product is rooted in the intrinsic allegiance to the universities themselves and not so much the success of the sports pro- grams, though success helps. The collegiate product market is challenging in that colleges and univer- sities are extremely protective of their likenesses and demand annual renewals of the licenses based on fiscal success and the quality of the management team (measured by a required quarterly financial report). Mark and Andrew recog- nized that they cannot patent their product, so quick market penetration would be key to their success as they developed brand recognition before other larger companies got the same idea. The two relied on money from relatives to get the company started; these funds financed the first round of shipments from the Asian manufacturer. The manufacturer required large minimum orders to make it worth his while. Unfortunately, the brothers could not find a domestic manufacturer to produce the quality of candle they need at the price they can afford. Their relatives did not interfere with the business at this stage; however, they did insist on periodic updates to ensure the two stay on track. The brothers have not thought much into the future; however, they share dreams of becoming successful, high-level executives some day. They want to expand the business into a public company and eventually scale back their in- volvement, sitting on the nest egg they have built up in company value. They are realistic, however, and know that anything can happen between now and then. Parcel post is the chief mode of distribution as they get responses to their magazine ads. Their principal mode of advertisement is through campus magazines and bookstores. They also sell a significant number of candles outside of stadiums and arenas at football and basketball games, where they employ students to man small kiosks. They have incorporated for liability purposes, on advice of an attorney friend of theirs. The liability inherent in the product and the legal require- ments of the colleges and universities to create the candles require very ex- pensive insurance coverage. The brothers sold $50,000 worth of candles in their first year, and they plan on doubling that in each of the next 10 years. Eventually they want to consider taking the company public. Palmer Products Inc. is typical of most small and emerging businesses in that its leadership consists of innovative individuals with a keen insight for an unex- ploited market. This demographic usually lacks practical experience in the busi- ness world and is ignorant of the administrative area, particularly finance. Mark and Andrew seem to have made the right decisions for Palmer Products so far; however, issues they will be forced to address soon include: ■ Expansion/financing. Survival of the company may be based on the ability to acquire adequate financing to fund organic growth and/or strategic ac- quisitions. ASSESSING NEEDS 71 ■ Data customers. The management team (consisting of Mark and Andrew for now) must make decisions every day. They will need quick, reliable finance information to keep them in the know at all times. Indirectly, the universi- ties and colleges are consumers of sales and royalty data while the IRS will be the recipient of the financial results on the company’s first tax return. ■ Process limits. No business processes address the finance function at this stage of the company. Mark and Andrew prepare the quarterly reports for the universities by hand and remit the royalty payments based on these reports. They are seeking help from a tax professional to help them prepare Palmer Products’ first tax return. They are aware that they may have sales tax issues in multiple states but have no idea where or how to gather data to address this issue. ■ Systems/technology. The only technology the two brothers possess are two personal computers from their college years. They use basic spreadsheet and word processing software to handle all the tasks demanded of them to date. They want to expand their distribution capability to the World Wide Web but have not gotten around to completing a website, though they have been working on one for several months. ■ Environmental factors. Mark and Andrew recognize that they can be put out of business by any large company with expansive distribution capabilities. Their manufacturer seems accommodating, but they realize that he will pro- duce for any organization that orders in large quantities—something a large retailer could do. The brothers have been advised that an exclusive distribu- tion agreement would be difficult if not impossible to enforce in an interna- tional setting. Another consideration is that the universities and colleges have no obligation to renew the licensing agreements from year to year, a fact that impels the brothers to focus only on the short term. ■ Accounting/reporting requirements. Palmer Products has two reporting ob- ligations right now—a quarterly report of sales and royalties to be prepared for the colleges and universities and the federal tax return. They gather in- voices and rely on memory when it comes to filling out the quarterly remit- tance reports. They are in the midst of having the company’s first federal tax return prepared. They provided a shoebox full of receipts and invoices to the accountant and have been responding from memory when answering his questions. They are aware that they may owe sales tax in the state they are incorporated (Florida) and possibly in other states in which they have sold candles via mail order and their 800 number. They provide informal reports to their financiers (family) but nothing concrete or comprehensive. (They know this will have to change if they are to expand quickly.) They do not generate any sort of financial data to help them run the company, relying in- stead on their gut instincts. 72 MULTILEVEL APPROACH Need for the Multilevel Model All of the relevant issues are not exclusive of one another, although Mark and An- drew would like to evaluate them individually. The ability to acquire financing for expansion will depend on the nature of prospective data customers, which could be bankers, venture capital companies, or a consortium of friends, family, and ac- quaintances. The sophistication of the financial data demanded by customers will drive the quality of reporting processes as Mark and Andrew seek to generate ac- curate data in a timely manner. Meanwhile the limitations of their reporting processes will be dictated in part by the sophistication of systems and technology, which may be hampered by their ability to get financing. These interdependencies must be dealt with in a logical manner when conceptualizing, formalizing, and ex- ecuting a finance strategy. Rather than isolating each of the issues and attempting to prioritize them, arranging the issues and letting them build on each other will al- low the brothers to conceptualize a more stable strategic plan. Small and emerging business owners need to take this approach in developing a finance strategy. Ad- dressing the overall objectives of the business and building upward toward the more accounting/finance issues works best. This approach can be easily under- stood in a pyramidlike diagram (Exhibit 4.1) with fundamental (concrete compo- nents) issues relating to infrastructure and the business plan appearing at the base and the more malleable (soft components) initiatives appearing at the top. The essence of this schematic is the alignment of vital business and nonbusi- ness issues that have financial implications. The base of the pyramid represents the fundamentals of the business. The issues become more specific to the finance and accounting area as the base rises to the apex. The premise of this model is that cer- tain topics have more of an overall impact on the organization than others—and that no one issue stands alone or is mutually exclusive of another. For example, an- ticipated watershed events in the business life cycle (e.g., seeking a bank loan or taking on new partners in an expansion) will dictate the type and timing of the fi- nancial data customers encountered, which in turn will dictate the sophistication of the finance infrastructure, which drives the ability to optimize the P&L and bal- ance sheet presentation. Generally, concrete components of the finance function are more apt to be addressed in issues nearer the base of the pyramid while soft components are dealt with at the top of the pyramid. The challenge is to position the finance organization not only to address environmental and internal changes effectively but to bolster decision making as well. The multilevel model serves two purposes: as a working blueprint for the fi- nance function and as a reference to develop and maintain overall business strate- gies. Small and emerging business owners typically are more focused on the former, as the finance function is usually underdeveloped or nonexistent. The mul- tilevel model will allow management to isolate and assess the needs of the busi- ness and determine how the finance function will address them as the company ASSESSING NEEDS 73 74 MULTILEVEL APPROACH Exhibit 4.1 Multilevel Approach in Pyramid Form Life Cycle Tier 2 considerations Tier 3 considerations Tier 4 considerations Tier 5 considerations Tier 1 considerations Balance Sheet Optimize P&L - Optimize Infrastructure Data Customers matures. Thus, the multilevel model is one that evolves and changes with the busi- ness. In both cases, though, the layering of issues is key, determining how partic- ular needs will be addressed and assessing the trade-offs and costs involved in doing so. The goal is to address a need without degrading other areas of the finance function. An adjustment at the top or mid-level of the model can be evaluated for impact or relevance before the proposed initiative is put in motion. The small and emerging business should be focused on establishing a relevant fi- nance function. The objective is to properly arrange the company’s current profile and identify areas of improvement or development. The levels of this model must be de- fined to gain an understanding of how it lends itself to finance function development. TIER 1 CONSIDERATIONS: LIFE CYCLE What Is the Life Cycle? The life cycle of a business represents all events from inception forward. Small and emerging business owners may find visualizing the end of their business absurd given their current focus on building it. Amore practical way of thinking about company life cycle is to conceive the exit strategy (no matter how far into the future this may be) and all events leading up to it. If a business plan was prepared for the enterprise, chances are an exit strategy was considered or at least mentioned in some form. In the context of the business plan, an exit strategy defines the point in time and/or circumstances in which the business owner will leave the business or sig- nificantly reduce his or her role. Exit strategies outline such events as taking on venture equity, selling the company to a third party (or partners), and final liqui- dation. It is important to understand that an exit strategy not only defines the end point but outlines the events leading up to it. Events or milestones contributing to an exit may include due diligence related to financing arrangements such as ven- ture equity/debt, a private offering, or bank debt. It also may involve the plan for marketing the business to potential buyers. The exit strategy is the culmination of the business life cycle. The establish- ment of milestones in a logical sequence will bridge the gap between present-day operations and future exit strategies. While initially conceptualizing the busi- ness, an exit strategy may have already been defined via business plan. Many business owners and executives, however, may not have considered an exit strat- egy, or if they have, the nature of the business may have changed to a point where the original exit strategy and milestones have become obsolete. Small and emerging business owners must examine the life cycle for the first time (if they haven’t already done so) and revisit it periodically. Thinking Long Term Long-term planning may not be a priority now, but it is worthwhile for small and emerging business owners to at least conceptualize major milestones and the prospective steps to achieve them, regardless of the time horizons. Major events such as going public, selling the company, or transferring the company to children are a few examples of major life-cycle milestones. Prioritizing these events and es- tablishing how these milestones will bridge to the exit strategy will take some thought. These questions will help in documenting the milestones the small and emerging business owner will want to achieve: ■ At what age will the owner or significant executive retire? ■ Is there a succession plan in place? ■ Is an expansion planned? ■ Do the expansion plans involve growing from within (organic growth) or ac- quiring other companies? ■ How much financing is needed to fit expansion plans? ■ What kind of financing would be preferred? ■ What burdens will taking on debt create? ■ Will it be necessary to refocus the business on other markets and/or other products? ■ Is taking on other equity partners beneficial to the business owners? ■ Is the small and emerging business owner prepared for the scrutiny involved in taking the company public? TIER 1 CONSIDERATIONS: LIFE CYCLE 75 ■ What would it cost to participate in the equity markets? ■ How is the business positioned from a cash perspective to achieve any of the above? This list of questions is not exhaustive. Because some entrepreneurs are so close to day-to-day operations, taking a step back and looking at the big picture is imperative. When this self-examination is complete, the small and emerging busi- ness owner should have an understanding of: ■ Firm company succession over the next year, laid out in a step format. ■ Rough company succession over the next five years (10 years if possible), laid out in a step format. (Succession plans should include market and/or product development goals as well as revenue or asset thresholds.) ■ A schematic of the need for financing including the details addressing how much, why, and when it is needed. ■ The level of involvement by the business owner. ■ Whether the owner wants to continue with a significant role or whether he or she will accept a lesser role. The ultimate goal of this exercise is to create a rough time line of significant events. The basic premise is that major events do not unfold randomly but rather in a well-thought-out, controlled way. The early years of a business may seem like a struggle for the small and emerging business owner, but the leadership is best served to position the company for the next significant event as opposed to sur- viving day to day. Approaching the business in this manner will create a strategic culture that will carry it through the short, medium, and long term. Each milestone event should build on the preceding one, creating a succession that leads to each exit event, whether they occur in one or 20 years. Getting Personal The line between personal life goals and those of the business may be blurred for the small and emerging business owner. This lack of clarity becomes more com- plicated when the personal goals of other partners/owners are considered. A cur- sory understanding of personal goals and the trade-offs owners are willing to endure in order to grow the business will help the strategic vision of the company and prevent conflict between owners as the business matures and the challenges become more complicated. This reasoning suggests that Mark and Andrew Palmer should understand each other’s level of commitment to the growth of the company and the sacrifices needed to achieve it. 76 MULTILEVEL APPROACH [...]... addressed at Tier 3 of the multilevel model include: finance organization, Information Systems, data flow processes, and a policies and procedures manual Finance Organization The finance organization refers to employees and the tools (technology) they need to do their jobs This aspect of the finance structure will grow with the company, like it or not It is the challenge of the small and emerging business... that in Exhibit 4. 4, the small and emerging business owner will be able to gauge both the short- and long-term growth needs of the finance organization Getting the right tools in the hands of the right people will maximize output Knowing personnel needs well in advance will be advantageous to ordering and maintaining the right technological tools Other considerations in strategizing the finance organization... users and a frustrated expert The small and emerging business owner may want to consider a full-time IS person or outsource the function if necessary MANAGING THE MIX OF STAFF AND TECHNOLOGY Carefully thinking through personnel needs and equipping staff members with the right tools to do their jobs will pay dividends for the small and emerging business as it matures Pegging the sophistication level of finance. .. education and experience in their respective tracks Juggling this mix may suit different stages of the organization the accounting person early on when the organization is applying GAAP for the first time, and the finance person when the organization is looking for an operational strategist Talented professionals Does the small and emerging business have ready access to qualified finance people (access to the. .. Managers of small organizations usually are focused on customer needs and the important metrics that drive the business What about the needs of other potential data customers? Will the finance function be positioned to serve these needs? Who are those customers and what do they want? Is there anything that can be done now to lay the groundwork for meeting their needs? It may help to ask these questions:... Mark and Andrew Palmer to conceptualize the needs of the finance organization—keeping up with the company’s milestones while controlling the amount of capital dedicated to this function in the spawning years of the business Key issues in coordinating the finance organization will center on people, technology, and the proper mix of the two PEOPLE Assessing finance personnel needs and translating them... hand Exhibit 4. 4 provides a menu of needs for Mark and Andrew Palmer at Palmer Products, illustrating the particulars of what, who, and when This guide will be particularly helpful when it is time to hire high-ticket finance people Getting a handle on the size of the finance staff six months, two years, even five years down the road will give the small and emerging business owner an understanding of how... best to have the consultants teach the organization to fish as opposed to having them provide the fish Imminent and future needs The small and emerging business owner will face the inevitable circumstances of change due to growth Finance personnel capabilities will have to change as the company grows and faces new challenges The need for accounting people, for example, will be important in the early years... is not considered part of infrastructure in a traditional sense Finance policies and procedures are less fundamental to the business than understanding the exit strategy and developing processes and information systems, yet they underscore the management of the P&L and balance sheet (the premier responsibilities of finance) The small and emerging business owner may have resorted to implied policies or... makes the company unique? What aspects of the business can no one else replicate? How will the two preserve this? Can Mark and Andrew value these unique components? If they plan to sell the company, these unique aspects of the business will be considered goodwill and play a major factor in the price they would receive for their life’s work What is the succession plan? What happens if Mark or Andrew . Exhibit 4. 4, the small and emerging business owner will be able to gauge both the short- and long-term growth needs of the finance organization. Getting the right tools in the hands of the right. address the finance function at this stage of the company. Mark and Andrew prepare the quarterly reports for the universities by hand and remit the royalty payments based on these reports. They. ongoing basis and set the stage for future business initiatives. The focus in these businesses is on the soft components of the finance function. A premium is placed on the finance function s ability