You’re in year 4 of a board of directors seat, and have the two below businesses in your portfolio. As a business leader or board-level owner/advisor which would you rather have over the next 4 years? We went through this experience with two clients over a 4 year horizon, and analyze the results for you in this post. But before we go any further, choose your leader/management team -- Case A or Case B.
Case A
A hard-charging Chief Executive with a reputation for getting complicated things done quickly
40% EBITDA over past 3 years, 20% top-line revenue growth
5 year track record of 10+ successful acquisitions coming into the business
Weak C-level leadership suite with marginal respect from staff, many seem “in over their skis”
Culture built around “get stuff done” mantra, and “sales first, questions later, build it later” principle
Copious news headlines and accolades in local press
Reasonably efficient enterprise systems. Nothing great, nothing too bad, most the tools needed to support sales, marketing, product, engineering are in place
Management structure and system modeled around “Theory X - Command and Control”
Case B
Corporate culture that promotes debate and making the best decision, even if it takes more time
Rampant systems inefficiency - anyone, for the most part can select the tools they want to use to get the job done
Reputation for slow and frustrating decision-making
Sales focused on one “flagship” cash cow product, significant trouble with going to market with new complex product lines
Employees are critical of senior executive leadership in the open - can openly question decisions
12-25% sales growth continuous over 5 consecutive years
Margin of 18%, has fluctuated between 15-19.5%, never higher
Brand name and employment brand name unparalleled in market, significant asset in personnel acquisition
Company culture modeled around “Theory Y - trust and transparency”, management system immature and incomplete
The Data
Let’s look at past 4 years trailing performance for each company on five metrics:
Revenue growth
EBITDA growth
Personnel turnover rate
Relative valuation
Valuation growth rate
Case A versus B, (trailing 48 month performance)
Trailing 4 months analysis
Case A exhibits a steady, exceptional EBITDA performance hovering at 40% for 48 months. Case B’s EBITDA is substantially lower, given the same industry, and hasn’t broached 20%. While Case A’s revenue growth has been exceptional as well, north of 20% YoY, it did see that growth decline from 28% to 20% in year 4. Case B has demonstrated a growing top-line, to 26% in its most recent year.
Case B’s EBITDA also increased slightly, demonstrating cost management during a 20%+ growth year. Both firms saw increases in their turnover. Case A’s turnover eclipsed 25% in year 4, whereas Case B saw turnover expand slightly to 12% from 8% the year prior. The structurally low turnover rate of Case B versus A is worth noting.
Lastly, EBITDA growth declined in Case A’s 4th year, to a negative, albeit from 41% to 39.7%. EBITDA growth in Case B’s 4th year increased from a negative the prior year.
Trailing 4 month valuation analysis
On a trailing 4 year basis, Case A is more highly valued than Case B, using an average of 9 valuation methods. Case A has an enterprise value of $2.4 billion, versus the $1.8 billion value of Case B.
On a trailing 4 year basis, Case A is the more valuable company, using ostensible industry-accepted metrics.
Now, let’s expand this analysis to what actually happened over the next 4 year horizon. Who did you choose to lead your firm, Case A and its strong leader and weakly perceived leadership team, or Case B and its comparably worse business performance?
Forward 48 month Performance
Case A versus B, (forward 48 month performance)
Case A saw a substantial increase in turnover to 35% in year 1. This was the continuation of a 3 year pattern in the prior 4 years, in which the already comparatively high turnover of Case A to Case B accelerated to 25% in year 4, and then peaked at 34% in year 6. Like Case A, Case B saw a slight increase in turnover from 8.7% to 14% in year 3 to 4. It also saw turnover peak in year 6, at 14.1%, but then decrease to 10% in year 8.
Case A’s Top line growth eroded to near zero in years 6-8, while EBITDA also declined over the timeframe, remaining negative all four years. Case B saw EBITDA growth into year 6, and then a resurgence to EBITDA growth in years 7-8. Revenue at Case B remained in the high teens over years 5-6, and then increased to north of 20% over years 7-8.
Forward 48 month valuation analysis
As a result of business performance, Case A saw a stagnant valuation over the next 4 years, hover around $3 billion, losing value over years 7 and 8. Case B saw a steady increase in valuation, and by year 7, had become more valuable than Case A, growing its valuation north of 15% in every year over the 4 year cycle. Case A ended with a valuation of $2.91 billion, whereas Case B ended with a valuation of $3.345 billion over the cycle.
The Lesson:
Depends on your outlook and objectives. Here’s how each case played out over an 8 year horizon. Case A’s strong executive leader, human resources, compensation and retention strategy, employment branding, M&A corp dev/integrations process, product strategy and sales culture led to true unicorn performance over a 4 year period. This proved to be unsustainable, but there were many warning signs in years 3-4. The increase in turnover from 17% in year 3 to 25% in year 4 was the direct result of corporate restructuring and layoffs aimed at preserving an artificially high EBITDA margin in year 4. The wake of these decisions led to two consecutive years in which turnover eclipsed 33% (years 5-6). This was largely A player and senior leadership resignation, followed by the predictable effects of individual contributors leading shortly thereafter in an echo effect. The negativity in the organization was reflected in the market by its poor employment brand, which hurt engineering talent acquisition.
Case B saw rapid growth, and was able to maintain strong personnel retention through the forward 4 year period. The synergistic effects of strong culture, employment brand, and retention, coupled with smart M&A, led to a boost in top line, as well as the ability to implement non-threatening cost controls that helped the business scale. We were able to maintain the balance between change towards more cost control and management effectiveness and personnel satisfaction, without having to turn towards the crude methods of mass layoffs and restructuring. As a result, Case B did not see the costs of turnover and brain drain impact their business, and were able to accelerate a growth stance and posture that made a relatively undisciplined organization with less command and control management capabilities outperform an ostensibly more valuable organization (Case A). Its investors also reaped the benefits of an enhanced valuation and stronger YoY capital returns.
Conclusion
While it is often attractive to hitch corporate fortunes to a “get it done” management team, or CEO, the impacts of that strategy can play out very negatively in the long term. Navigating change with the right corporate personnel, M&A, culture, and product and technology approaches ensures that organizations can prevent the cost of turnover, re-education, and personnel recruitment. Bottom line in these two cases, the difference was personnel retention. Case A created a climate that ultimately drove away A players, despite its better management metric performance in the trailing 48 month period. It was simply too good to be true. Case B harnessed the power of collective vision and commitment, and saw its results eclipse Case A within 6 years, despite several outward disadvantages. We see this play out all the time, and the lesson learned here is particularly important as businesses see generational turnover and shifts in personnel composition. The route to success in this climate is much more like Case B. Case A is in for another 4 years of costly rebuild, rebrand, and retooling, whereas Case B is likely to achieve organic growth for the next 4 years to come.
The selection of the right executive stance, however, is dependent on the objectives of the owners of the business. If the owners are looking to exit, or enhance valuation to begin a strategic process over a short duration, a true Theory X leader may be appropriate to achieve these goals in the desired timeframe. In fact, it may be the only option. Strategic clarity, from ownership down to the line level employee is vital to achieve management objectives in the right time frame. And the right strategy, depends on asking the right questions, and walking backwards from the owners’ desired business outcome.
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