Businesses constantly struggle with capacity issues. Manufacturers seek access to the ideal manufacturing capacity, and service providers look to employ the optimum number of employees.  Both understand their labor spend is a key component of a company’s profit formula. So how is the entrepreneur to scale in an uncertain economy?

Those who had not experienced rapid market erosion previous to the liquidity crisis learned an important lesson; high fixed costs can be truly catastrophic when demand contracts quickly. Employers must marry labor costs with demand. There are several steps one can take to mitigate labor capacity risk:

Optimize Labor Efficiently- Most entrepreneurs intuitively understand that they should push low value activities down through (or out) of the organization.  Senior managers should aim for “zero administration”, where virtually all of their time is spent improving service or profitability, and not loading paper in the copier.  A good administrative assistant is worth their weight in gold. Similar thinking should apply to all; all work should be allocated to the appropriate staff based on their skill level, experience and cost.

Outsource Low Value Activities Based on Demand- The zeal for outsourcing is far from over. Organizations are not only seeking lower costs, they are looking to move resources outside their organization so that they can scale  their bandwidth quickly. Look for outsourcing partners who have infrastructure that can move, (in real time) with your business. Such organizations typically have an existing core competency in the services provided, including technology and human capital geared towards executing such work.

Increase Weighting of Incentives to Total Cash Compensation-Those who only provide subjective bonuses are actually doing themselves a disservice. Practically the entire Fortune 500 have moved to some type of performance based pay. Part of the rationale is to only pay out incentives when an organization reaches certain performance thresholds.  Failure to have a significant portion of cash compensation in incentives (20% or more) creates fixed costs and puts stress on a business and on employees. Fluctuations in demand require drastic action such as lay offs or furloughs.

Measure Labor Meticulously- Labor KPI’s are amongst the easiest predictive indicators to measure, and directly affect the bottom line. Examples include overtime, labor dollars per unit, direct labor, indirect labor and labor as a percentage of revenue.

Beware of External Demand Indicators- Within virtually every business segment there are external measures that provide context on future demand.  Add external indicators to your scorecard/dashboarding system so that you can stay in tune to the market place. Government websites, trade associations, and private research organizations offer a litany of statistics.  Plot such data  against company revenue to find which numbers correlate with business growth.

I recently had a conversation with a CEO who was lamenting about the disparity between public company valuations and those of privately held concerns. As of July 2011, the S&P is trading at a multiple of 14, while private company multiples remain in the 5-6 range. Investors value public company access to capital, and scalability into large consumer markets.  Of the Top 10 U.S. companies by size, none are pure play B2B companies.

Small companies come in all forms; some compete with larger branded companies, and some market directly to them.  In the age of confluence, some do both. How can small companies survive in a land of giants?

The primary difference between Fortune 1000 companies and smaller ones is more fundamental than which markets they serve. Intel founder Geoffrey Moore makes a distinction about business architecture – the difference between “complex systems” and “volume operations”[i].

Many smaller B2B companies are built to support specialized and custom solutions, while most Fortune 500 companies are built from the ground up to serve the masses. While customization may command higher prices (per transaction) than generalization, high volume companies cross a threshold where their infrastructure promotes a lower cost per unit and the experience curve takes full affect. Thus, B2B companies face an inherent profitability disadvantage.

Where Microsoft offers its highly useful suite of Office products at around $400 per license, Apple’s B2C model (which is often utilized by small businesses and micro-businesses such as designers and the like) offers Pages and Numbers at $9.99 each. One offer is based on high intellectual capital value and the other on mass appeal and ease of use.

For smaller B2B companies to reach new levels of profitability, requires they find a path to scalability. Of course not every business wants to be big. Some entrepreneurs prefer a “family culture” and more tempered growth (with less risk).

One way to effect profitable volume is to find a balance, where products and services are “mass customized”. Mass customization is all the rage in consumer products where individuals can even build their own handbags and Nike basketball shoes to their specifications.

Smaller companies (B2B and B2C alike) should seek out solutions that allow for better utilization of existing solutions across more customers. In other words, the provider should not need to reinvent the wheel with each project. Often, optimizing margin requires leverage of a base product or service that can be replicated, at times with features configured to the customer’s individual needs. To configure from a menu of choices is considerably different than satisfying each specific whim, which may offer greater intimacy with the customer, but may also require the business to sacrifice profit. For every feature created for an individual customer, there is a resulting opportunity cost (time, money and energy that could be invested elsewhere).

The other requirement for getting big is a shift towards systems thinking, where management teams make decisions within the framework of their company’s capabilities. For a new initiative to succeed requires careful analysis of the resources required to implement it. The key for smaller companies who aspire to do business with larger ones it to utilize systems and processes consistent with the expectations of the customers they serve.

Competing against larger companies requires a unique mindset. Often small businesses use concepts like judo (where the larger opponents energy is often used against him) to beat the larger foe at the point of attack. Consider the depth and width of the market you want to serve, and scale your resources accordingly.

Being Opportunistic in a Volatile World

Last week my post drew considerable attention, perhaps because of its shock value at a time when the news was truly shocking. While the tsunami was a natural disaster, the response on the part of the Tokyo Electric Company was a human calamity. Lack of preparation will invariably lead to unintended consequences, if you are managing a nuclear power plant or any other business.

The reverse is also true. The entrepreneur capable of understanding seemingly unrelated external forces, and weaving them into a thoughtful strategy, will clearly realize strategic advantage. How might the strategist consider social, technological, economic, ecological and political factors to gain insight on how to take advantage of ever changing market conditions?

Scenario planning is a methodology whereby the entrepreneur considers converging factors that (in combination) creates a tipping point. Consider some of the following predictions, based on facts already in evidence today.

In the next decade, we are likely to see:

Predicative Modeling-Cloud computing enables the migration and cross-referencing of large institutional databases.  For example, actuaries, using sophisticated algorithms are able to model ailments based on lifestyle choices monitored in real time. They are able to calculate your risk of a heart attack based on which smoothie you tend to order at Jamba Juice, your frequency of exercise, prescriptions you use, etc. Offered as a benefit of a health care plan, the member is offered incentives to opt-in and receive preferential rates. Such tools slow down rampant health care inflation.

A Cashless Society-The majority of transactions amongst big banks are managed by exchanges where no money actually changes hands. Coins of small denomination are nearing extinction. Today, you can download an iPhone app that serves as a debit card, and can be swiped within Starbucks locations.  For most transactions, cash is already irrelevant.

Smart Infrastructure- Automobiles come preinstalled with all of the features of an iPad (the 2011 Hyundai Equus will come with one) and all the benefits of the internet. Smart grids control the flow of traffic, directing drivers to particular lanes at a given speed to optimize drive time and reduce accidents. Traffic signals are regulated based on traffic volume. Sensors predict bridge and rail failures.

Of course, rapid change will occur in every industry, and the strategist must weigh various opportunities based on an organization’s ability to take advantage of them. As a general rule, organizations should seek to achieve scale and reach within its core (at least 30% market share) before expanding into new endeavors. As Jim Collins points out in his sequel to Good to Great (How the Mighty Fall), many companies fail because of an “Undisciplined Pursuit of More”.  In their zeal for diversification they often leap too far from their core competency.

Each opportunity must be assessed within the context of the organization’s resources, bandwidth, and human capital.  For every opportunity there is a cost, and an opportunity cost. To pursue any new opportunity an organization must leverage resources which dilutes focus on the core business.  Choose your opportunities carefully.

Many business owners are asking, just what should I expect in 2011 and beyond in terms of growth and demand?  Recent 2011 forecasts from Kiplinger’s include:

*        GDP Growth 2.8%
*        Unemployment Ending 2010 at 9.5% and slightly lower in 2011
*        Prime Rate 3.25%
*        10 Year T-notes 3% by late 2011
*        Inflation of 1.5%
*        Crude Oil $75-%80 barrel in early 2011

Demand and pricing is scattered.  The deflation debate seems to have softened as prices are stable and flat (projected to rise 1-2% next year). Upward pressure on raw materials and commodities such as cotton and copper are higher.  Providers of some consumables such as gasoline, coffee and cereals are raising prices, while prices for electronics, computers and automobiles are eroding. [i] A battle could be brewing over “rare earth” elements 95% of which are controlled by China. Materials such as Lithium, used in micro-electronics and products such as iPhone batteries could skyrocket.

The jobless recovery continues.  While the addition of 151,000 jobs in October was encouraging, it would take 20 years of growth at that rate to return back to the level of employment before the recession. Over 2% of Americans have been out of work for a year or more, and with the eventual waning of unemployment benefits, the future is bleak for the unskilled.  As a whole, soft employment and tepid housing prices will offer little in the way of a significant recovery; and the economy will be split between growing and sluggish industries.

The most creative and opportunistic will flourish.  Forms of social media and online marketing are practically free, providing impetus for those with a great idea to get the message out quickly and cheaply. Those with cash will buy up competitors and commercial real estate.

Venture Capital investment has exploded from the depths of a cataclysmic drop to less than $4 Billion in Q1 of 2009 to a projected $11 Billion by Q4, 2011.[ii] With multiples exceeding 6x, this is still a great time to sell a business.

The Federal government is about to enter a phase of complete stagnation. Splintered ideology will not provoke much in the way of bipartisanism and compromise.  Consider health care. A complete repeal of the health care is unlikely, and Republicans will push for less costly reforms. But Parma, and the medical community are gearing up for the addition of  nearly 30% of Americans who are uninsured and offer the industry new volume. In the absence of legislative movement, the administration will be forced to rely on regulatory actions led by political appointees and their cronies.  Early signs are that the Fed’s attempt at “quantitative easing” is not moving the needle very much on lending.

Emerging markets continue explosive growth in Singapore, China, India and Brazil (representing 75% of global GNP growth in 2011).[iii] Infrastructure stocks continue to boom. Cloud computing enables continued strength in the technology sector.

There is momentum behind the return of low level call center jobs to the U.S. as “rural outsourcing” is hot in information technology and other sectors. Small town America offer substitutes for outsourcing,  including Indian Tribes offering U.S. based alternatives, at only 10-20% premium from their Asian counterparts[iv] .

There is plenty of room for optimism. Competitors are weakened, and companies with strong balance sheets and cash flow should prosper.  Well run companies will invest based on relatively stable macro-economic assumptions. The strong will get stronger. Focus on being one of them.

[i] The Kiplinger Letter November 19th 2010

[ii] Money Tree Reports

[iii] The Kiplinger Letter November 19th, 2010

[iv] Rural Outsourcers” Vs. Bangalore

Most of our clients aspire to a similar end game; some type of liquidity event (sale). Often, such transactions lead to extraordinary material wealth, and provide a payoff for the entrepreneur’s years of sweat equity.

A recent study validates content previously published in this space. The value of businesses is not proportionate based on size. A $50 Million revenue business could be worth significantly more than 10 times that of a $5 Million business.  Within the current M&A environment, the “size premium” is magnified further by a dearth of “deal quality”.

In 2009, companies with less than $5 Million in EBITDA (earnings before interest, taxes, depreciation and amortization), yielded an average 5.1x multiple, compared to those with more than $5 Million who commanded a multiple of 5.9x.   The premium paid (16%) for profitable larger companies last year was five times the premium paid in 2006 (3%). A study conducted by GF Data Resources concluded that “average performers” (companies with less than a 10% EBITDA) earned a 4.3x multiple compared with 5.7x for above average performers. That is, a company that earns a $5 Million profit before taxes is a far more attractive asset than one with less revenue or lower margins.

As an organization moves through its lifecycle, there is a disproportionate multiplier effect to its value by virtue of which buyers are in play. Private Equity investors and lenders view the $5Million EBITDA business as better prepared to weather economic fluctuations.  We have heard the cries of smaller, poor performing businesses that have very little access to capital. Conversely, the flight to safety has created remarkable competition for businesses of the desired scale ($5 Million+) .

Thus, the entrepreneur needs to be patient and focus on the infrastructure required to support growth.  Taking the time to grow a business delivers an incredible incremental return. Assume a $40 Million business earned an 8% EBITDA ($3.2 Million) and was valued at five times ($16 Million). If the business were to leverage its infrastructure and grow to $50 Million at 10%, it would realize a $5.0 Million EBITDA. If the higher margins and scale were to produce a half turn (multiple) increase, the enterprise value would be: ($5M x5.5=$27.5M) Thus, the 25% increase in sales and 25% increase in profitability yields a whopping 72% increase in enterprise value.

The size premium should give us pause. It provides the entrepreneur with motivation, and the knowledge that his years of work and grit can provide a significant pay off.

There is a joke making its way around on the internet: If Nancy Pelosi and President Obama were on a boat in the middle of the ocean and it started to sink, who would be saved…the U.S. economy.

This week the President announced new tax initiatives aimed at U.S. job creation. While details are sketchy, the focus appears to be on new infrastructure and tax breaks on new plants and equipment in 2011. The President did not spell out how the administration would pay for the new proposals.  Rep. Dave Camp of Michigan was quoted as saying Obama’s business tax measures serious proposals worthy of consideration. But he said that “raising taxes to cut taxes is at best a zero sum game.[ii]” It is hard to imagine the offer to provide incentives for new factories will impact droves of small businesses.

Regardless of your political affiliation one must accept that the U.S. is headed for a train wreck; the confluence of a sluggish economy and expiration of tax breaks on December 31^st. If Congress does not act, those making $250K or more will feel the shock of drastically higher marginal tax rates.  Many small business owners fit the bill, so not only will higher tax rates affect the affluent, but front line workers as well.

As pointed out in Businessweek recently, the “Bush Tax Cuts” as they are sometimes referred to were offered at a time of a balanced budget (following a temporary surge in tax revenue during the dot.com era). Now that the Federal government is perpetuating escalating deficits, tax relief may be difficult to swallow.

But one could ask, is the issue really the tax rate, or the spending rate?  It is fairly well understood that lower marginal rates encourage investment and at times have proven to increase tax revenue.  So are higher taxes the answer? If the government were run like a business, it is pretty clear the struggling business owner would just cut his overhead, but that does not seem to compute in Washington.

So here is the real kicker. Long term deficits will undoubtedly translate into inflation, which is the last thing our economy needs.  The only logical conclusion is that any extension in tax cuts that will deflate revenue must be married to a proportionate reduction in spending. You simply can’t do one without the other. Amongst other problems, a massive national debt and devaluation of the U.S. currency will mitigate the Fed’s ability to manipulate interest rates and inflation.

So in our zeal to affect policy as business people, we cannot just focus on the regulations that affect us directly, but also the bigger picture of the nascent economic turmoil that will plague us if governments don’t reverse course soon.  Today’s deficits are tomorrow’s taxes.

If you are a gambler, one would have to bet that U.S. inflation (the worst tax of all) will return with some fervor. It is really not a matter of if, as much as a matter of when.

[ii] Suddenly, a raft of tax-break proposals from Obama