by Ellen Gerl
A client of the Friendship EDZ Business Development Center in New York assured business counselors from the rural incubator without walls that he had everything under control. But staff suspected otherwise. During a follow-up visit, staff learned the firm still hadn't paid its sales tax and quarterlies were due, recalls Russell Combs, the former Friendship Center manager who is now director of technology ventures at the Appalachian Center for Economic Networks in Athens, Ohio.
It was time for incubator staff to step in. First, the counselors looked closely at the firm's inventory and accounts receivable to create a realistic analysis of cash flow. "We discovered their accounts receivable were totally out of control. The owner didn't feel comfortable calling people and saying, 'You've owed us for six months and we need the cash,'" Combs says. In the short term, incubator staff helped the client make the phone calls and bring in cash to pay the bills. The long-term solution was to "help him regroup and reflect on his management," Combs says.
Savvy incubator managers spot the warning signals of a client company in distress before it's too late. Whether it's a no-brainer like a missed rent payment or something not so obvious like rumors of infighting among investors, take it seriously. As Terry Collison, principal of the investment firm Blue Rock Capital, warns: "Even the subtle threat can be fatal." (See “Subtle distress signs.”) Incubator managers and other industry pros shared with NBIA Review these SOS signals to look for and action steps to put an ailing firm back on track.
The company owner ducks you in the hallway. She doesn't respond to phone messages. Or the client who never misses a CEO roundtable becomes a no-show.
Enter the incubator manager turned psychologist. "You have to read body language," says Edward Sybert, director of the Technology Advancement Program (TAP) at the University of Maryland in College Park. He's found that changes in normal behavior are danger signs you will notice through day-to-day contact.
"Daily communication traffic keeps a pulse on clients," he says, while acknowledging that TAP's size – 13 clients in a 32,500-square-foot facility – makes this possible. His solution for the client who's reticent to communicate? For one, persistence in meeting with the client. Next, he'll ask the blunt question: "Have you run into snags or roadblocks?" The No. 1 problem he hears relates to obtaining funding, so Sybert always is prepared to review various options.
At one San Francisco incubator, dropping out of sight isn't an option. Renaissance Entrepreneurship Center mandates that its microenterprise clients attend monthly meetings where "everyone goes to the podium for two to three minutes for an update on their successes and challenges," explains center business consultant Paul Terry. In addition, there are required monthly meetings with incubator staff and quarterly ones with Terry. From these meetings, staff glean that clients may be facing sales or other problems. And if a client misses a meeting, staff take special note. "Usually [clients] first need to be motivated that they need to stay connected to the incubator," Terry says.
Julie Holland, director of the NASA Commercialization Center in Pomona, Calif., also looks for changes in normal client behavior, especially when it comes to rent. "For instance, if they are late on a rent payment, but that's never happened before, it would be a big warning sign."
In the case of late payments, Sybert says he might negotiate a different payment plan with a client or even ask the client to leave. "If their argument is compelling we might wait with them – for a while," he adds. Since payroll is typically the biggest expense of the research and development firms in TAP, he might suggest that the owners ask employees to work without pay for a while.
A client's defaulting on rent can significantly hurt an incubator's bottom line. For instance, the Technology Innovation Center in Wauwatosa, Wis., faced a $7,000 blow when its third largest client – which occupied about 10 percent of the facility's space – left the incubator program without paying its last month's rent, according to director Guy Mascari. In this case, staff had recognized other warning signals more than eight months earlier. However, the principals were "unwilling to face up to problems and accept help," Mascari says. "We went to them with ideas for resources and stop-gap financing and they got kind of irritated. At this point they still were paying rent and they said, 'What's the problem? I'm paying my rent. I personally guaranteed my rent.'" Later overtures met with a similar rebuff.
Had the principals been more forthcoming, Mascari could have helped them sublease some of their space and lower their liabilities. But now, the incubator is taking legal action to recoup the loss to "the full extent of the rights of the lease," he says.
Bob Grether, owner of Productive Data Corp., a client at the Technology Innovation Center, sums up the problem: "Some of us entrepreneurs aren't as interested in some aspects of the business – such as paying the bills. When you go into a business you're going in for some passion for a product you think the market might want. The rude awakening: all the overhead that goes with running a business."
Center manager Mascari noticed some warning signs that Grether's company could use some help – Grether's making sales but not billing for three months or simply forgetting about rent – and recommended to the CEO a prospective employee who had financial expertise. Grether took advantage of the referral, hiring Dan Dollison earlier this year. Productive Data, which Grether says makes technical reference information "more consumable and digestible," continues to grow.
Collison argues that CEOs should understand that "cash is king." "You need a CEO who knows the cash balance of his or her firm on a daily basis, understands the flow of accounts payable and receivable and the age of receivables." For those who don't, education is in order.
"If the firm hasn't done weekly cash flow projections to see how much time they have, that's a warning sign," says Joe Kessinger, president of the Enterprise Center of Johnson County, in Lenexa, Kan. When his review of a client company's finances indicated that the firm had less than six months of cash, Kessinger began to meet weekly with the company owner. "We make sure they increase that six-month time and help them find financing to get them through the period," he says. "We also make sure they are concentrating on what's important – though the reality that they only have six months usually gets them focused."
Robert Meeder, president of Pittsburgh Gateways Corp., says educating CEOs that managing cash flow should be their prime concern is a tough sell. "Owners almost have to learn it with scar tissue," he says. He sees a common pattern among new business owners: "They max credit cards and don't pay withholding taxes on time. These are … hammers that come back to [strike] them," as the impact of missing these payments often takes a while to surface. He adds that it sometimes requires two or three crises before the business owners get it. (See “When all else fails – or helping to cut the losses.”)
However, in some cases, that may be too late. Meeder suggests incubator managers proactively counsel CEOs on cash flow management and realistic budgeting. "Typically, they budget vertically. That is, if they sell something in July, they think the money will be there. But sales out the door doesn't equal cash in the door," he stresses.
As an action step, Meeder says he compares a client's business to typical firms in the industry, using references such as Robert Morris standards. He points out to clients what is the typical time to receive cash, the typical percentage of bad debt and the time it takes to get a sale.
Incubator managers also can hook up clients with experts and mentors and create environments in which top executives feel comfortable admitting they need help.
For instance, a quarterly CEO meeting at the NASA Commercialization Center focused on learning to read indicators in financial statements to assess the health of a company. CEOs were encouraged to bring their financial statements and follow the presenter point by point. In the session, one CEO divulged that his company seemed to be in trouble. "That let us put him in touch with professional advisors who got him back on track," Holland says.
It might be a company car or some smaller luxury perk, but be wary of a company principal making a number of large "convenience item" purchases following some measure of early success, according to Meeder. Similarly, another hint of trouble might be the company suddenly initiating new business services or products or expanding staff after it receives the good news of a large contract.
"When there is a surplus income for a short period of time," he says, "the company manager thinks that it is going to be the norm. He thinks that anything he puts in the market will be accepted or he puts in an expenditure that raises overhead – something that requires continuing payments." Unfortunately, the early success doesn't support the longer-term costs of these expenditures.
Kessinger says the overly optimistic client sends up a red flag. "They'll say, 'We'll be fine because we know that sale's coming in next week,'" he says. "Part of our job is offsetting that optimism with skepticism and helping them plan for the worst."
Helping the founder learn to manage success could include counseling on capital budgeting and long-range planning. In addition, it may mean resolving human resources problems that can arise when the going's good. "Staff who get along during tough times may find themselves disagreeing on how surplus funds should be spent," Meeder says. However, catching snippets of staff grumbling may be your only warning sign here.
A company that lays off staff or cuts hours tips off Terry and the Renaissance Center staff that something's amiss. "We might discover that they're experiencing a loss of contracts due to their clients' downsizing or that sales by referral and word of mouth have run the course," he says. Action steps could vary from directing clients to a specific business consultant to helping them find government contracts or new, vibrant industries where they can redirect their efforts.
CEOs may be reluctant – for a number of reasons from pride to naiveté – to admit that layoffs equal problems. Understanding trends in the client's industry can help you recognize the reorganizing firm from the failing one. For instance, Mascari felt a client was not being forthright when he described his laying off 30 percent of the firm's employees as "just reorganization." This particular client was building Web sites for dot-com companies when the e-commerce industry began to fall apart, Mascari explains.
Some companies may ask employees to work reduced hours or forgo salaries until their cash problems improve. Or they'll pay employees with equity instead of salaries, an avenue that Meeder cautions against. "If a company spends its equity to cover operational expenses for the month or quarter, that's a signal of financial distress," he says. "Typically the owner regrets doing that later on. When you do succeed, you find that it is so much more expensive to buy it back."
Companies grow, roles change – and this is especially true for a CEO. One problem is when a founder of a venture firm – which Collison describes as a business poised for high growth and national investment – is unprepared for changes associated with true company growth. Collison says the signs likely will be subtle: For instance, you might notice that the CEO doesn't understand that new employees coming in may have narrower job descriptions than existed before, when the CEO and two others did everything.
Or you might get feedback from people in the community you put the client in touch with. For example, investors confided to Mascari that a company founder – a technical person whose Internet applications product they considered top-notch – didn't have the ability to communicate effectively. Mascari didn't shy from telling the founder he was turning off investors and needed to find an outside manager able to attract money. Since he'd become a good friend of this client, it wasn't hard to be frank.
"One of the most exciting things is to have a founder with product insight who grows with the company. Equally neat is when the founder evolves and takes a new role, and then someone else replaces the founder," Collison adds.
As a CEO becomes increasingly taxed with business and administrative roles, Collison says you must ask: "Do they have the aptness, fit and passion for this role?"
Sometimes the answer is no. Holland says she's found that for many scientists, being the chief technology officer better fits their comfort level with business. "I worked with a particularly gifted scientist for more than a year to develop a business plan to begin commercializing his technology," she explains. "One day he told me, 'I don't want to do this. I just want a license.'
"And that's OK. He'd done the soul searching necessary to recognize that being a business person wasn't right for him," Holland says.
An incubator manager can, and should, prod CEOs to introspection. Collison suggests you ask the founder, "Would you hire yourself for this role?" Help them to visualize some other role where they could offer maximum value for their company. "Unfortunately, this problem goes unexamined until precipitated by a crisis," Collison says. "Have this discussion early, rather than later."
From lagging product development to unhappy sales staff, the symptoms of distress in the area of sales take several forms.
Kessinger sees danger signs flashing when a company continually defers product release until it adds "just one more feature." He says software firms whose engineer-founders are perfectionists are the biggest culprits. "You can't make money if you don't release it," he reminds them, and he encourages them to introduce changes on future upgrades instead.
On the flip side, he's worked with firms so enamored with their product they assume a build-it-and-they-will-come attitude. "They don't realize how long it takes to get product recognition in the marketplace and how long the sales cycle is," Kessinger says. The first step he'd take is to find them a mentor who's been there, someone who'll say, "I thought mine would sell overnight, too, but the harsh realities are … ."
Collison also points out a subtle trouble indicator: the young company that establishes a channel partner relationship and believes this can serve in place of its own sales management function. "Typically, the younger company assumes its problems are over. The third party that's better established in the industry has products and know-how, plus it promises love and devotion forever," Collison explains. But, the channel partner's sales staff has no incentive to sell products of this fledgling company any differently than other products they sell. The best advice for the young company, he says, is "go directly to the marketplace and close the sale yourself."
Meeder says the incubator manager also should pay attention to the sudden resignation of a key employee with sales responsibilities in a client firm. "Those people in sales see the handwriting on the wall." What would he do? Talk to the owner to see if there's a plan to replace the sales person and probe whether the resignation is a symptom of "something more troubling."
Some incubators require quarterly financial statements from their clients, while others review them semi-annually, annually or not at all. But those that do review them believe they're just one more investigative tool for discovering that a company is struggling.
Collison says clues of possible financial troubles include inaccurate financial statements or accurate ones that are sloppy, untimely or incomplete. Reviewing numbers may help you pick up on a business model that's out of sync.
From analyzing the financials of a service-oriented company in the Friendship incubator program, Combs and his staff noticed that the client's "cost of goods seemed outrageous." Combs knows that working with a young company often requires more than hooking them up with a local accountant; sometimes it takes "a lot of homework."
This was one of those times. He and his staff researched some of the client's competitors outside the client's region – in neighboring areas of Pennsylvania, Michigan and Ohio – and asked those companies to share the names of their vendors. "Next we asked those vendors to give us quotes on some specific materials and we compared these quotes with our company's cost of materials. We found that the prices they were paying for initial goods were some 30 to 35 percent higher than what similar businesses were paying elsewhere. Basically vendors were taking our client for a ride."
Their next action step was to tag along with the client at a meeting with vendors where Combs took notes on the deals the vendors proposed. "We tried not to take a heavy-handed approach – not to jump ahead of the business," he says. But when the firm's owner asked for help on how to negotiate a better deal from the vendors, Combs' research offered some specific questions the client could ask and prices to shoot for.
Several managers noted that listening and watching helps you pick up on infighting among investors, company founders or board members. Such squabbling can indicate company ill health, but may be difficult to pin down.
Collison says that recognizing investor problems is like "looking for black holes" unless the investors are on the board of directors and you can observe the fighting "up close and personal." When there are several rounds of angel investors with different stakes in the business, it's even harder to catch, he says. The intelligence gathering may simply consist of asking questions and checking out reasons for grumbling. Steps taken before investments come in could help here, according to Collison. "If the investor documents are drawn up by a law firm used to deal structuring, they can proactively make governing structures that clearly define everyone's roles or parts. An incubator manager should have the opportunity to read and understand these as part of due diligence."
Meeder remembers a company founder who attracted to his team an engineer and a marketing specialist. Then, the founder's wife joined the team to provide administrative support. "[The founder] started listening more to his wife than the other principals, and pretty soon had cut out the other two from being involved," he says. The two unhappy employees asked incubator staff to intervene. It was a difficult situation, Meeder says, admitting that he and his staff were reluctant to be in the position of a "policeman arriving in a domestic dispute." Instead, they chose to coach the two disgruntled employees on how to communicate with the company founder.
Kessinger says you'll pick up on board problems by attending board meetings. And Sybert adds that if you have a good working relationship with your clients, they'll confide about board members causing concern.
"Your job is to understand the dissension and help clients create guidelines that offer board members a clear understanding of what their roles are," Kessinger says.
If you've missed all the early warning signals of a firm's distress, Kessinger says this final one is very clear: "When your entrepreneur starts putting together his or her resume." Avoid surprises, managers say, by listening, watching and making personal communication a top priority.
Not every incubator business is destined for success. There, we've said it. But incubator managers can soften a firm's fall from promising star to on-the-skids status. In fact, no managers that NBIA Review interviewed had counseled clients to declare bankruptcy. Here are a few options they helped clients explore instead:
Problems that can threaten a company's survival often are not obvious. Terry Collison, principal of investment firm Blue Rock Capital, offers the following distress signals that, although as significant as more evident problems, are not easy to spot.
Keywords: accounting/financial management -- client, benchmarking clients, company failure and dissolution, company turnaround
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