Honey, I Shrunk the Company
When overexpansion strains your finances and control systems, it's time to get back to the basics
There's a thin line between fast, profitable growth and overexpansion. Cross that line -- something that's all too easy to do in a volatile, entrepreneurial venture -- and you risk losing track of financial controls, long-term strategic goals, sales, and profit margins. A sure path to disaster, unless someone recognizes the problem and reorients the company with a comprehensive and disciplined financial makeover.
Fortunately for Incomnet Inc., a technology company in Westlake Village, Calif., private investor Sam D. Schwartz did just that. And the method he used to do it -- meticulously analyzing and repairing every troublesome aspect of the company's internal financial affairs -- could serve as a blueprint for any chief executive eager to backtrack from overexpansion or, better still, avoid the problem entirely.
In 1987, Incomnet had annual sales of about $1.2 million and great future prospects for its computer network, which tracked used car parts for auto repair shops. But the company's present was mired in bad debts, budget overloads, and a series of business-threatening lawsuits -- all the result of an uncontrolled, hyperaccelerated growth strategy. Just five years old, the company had already eaten up $13 million raised from private and public stock offerings, much of it with Schwartz's help, without ever turning out anything remotely resembling a profit (the net loss the previous year was an astonishing $4 million).
"I decided I had to step in or watch the company go down the tubes," recalls Schwartz of the day in January 1988 when he went to Incomnet's corporate headquarters to request the resignation of the company's CEO and founder. While Incomnet's salvation came from the outside, most CEOs are more than capable of applying Schwartz's medicine to their own businesses, so long as their financial-reporting systems can provide accurate results.
Schwartz started quite simply at first with a pile of notebooks, one for nearly every aspect of the company's business operations: finance, corporate overhead, marketing, customer relations, legal and accounting activities, and much more. After interviews with employees and customers, company tours, and an exhaustive survey of Incomnet's financial records, Schwartz listed all that was wrong or right in each area. And he got specific -- down to examining every line item on Incomnet's woeful financial statements.
For Incomnet, as is true in most cases of overexpansion, two problem areas loomed largest: corporate overhead and finance. So Schwartz decided it was time to perform some triage. "Corporate overhead was $900,000 at a time when our working capital outlay was negative $1.6 million, all on sales of just $1.2 million," he recalls. "It was clear that I had to question the value of every single overhead expenditure, no matter how entrenched or how petty it seemed."
Schwartz ultimately shrank corporate overhead to a mere $400,000 a year. Office leasing costs were a big part of the problem since the company, with just 30 employees at its largest, was spread out over four sites across southern California.
"There was no rhyme or reason to the location spread -- accounting personnel were working in offices with the engineers, while customer service was someplace entirely different," says Schwartz. Within a month he combined all corporate operations under one roof. Meanwhile, he instituted salary and hiring freezes and pulled the plug on costly executive perks that included health-club fees and luxury cars.
Most of the employees decided to stay with the company, despite the austerity plan. Schwartz himself took only $1 in salary for his first six months as CEO.
Attacking the rest of the company's financials proved tougher, if only because the problems were so widespread. For Incomnet, these were the biggest problem areas:
* Current assets. "A CEO has to know that this number is real when he looks at his balance sheet, because it's his source of liquidity -- the money he can use to pay bills if he needs it," emphasizes Schwartz. (Current assets become especially significant for companies in capital-intensive stages of development, such as building up inventory or diversifying product lines.) Unfortunately, close examination proved that Incomnet's 1987 current-asset figure of $1.3 million was bloated at best, thanks to the inclusion of obsolete and unsellable inventory and accounts receivable that were so old they stood little chance of being collected. After Schwartz wrote off these and other items, Incomnet's current assets dropped to about $180,000 for the end of fiscal 1987. "True, it's smaller," he says with a smile, "but it's a number that I know I can trust."
* Working capital. Although fast-growing companies occasionally push this number into the red, it's a good rule of thumb, says Schwartz, for it to be consistently positive, indicating that the company knows how to operate within its means. But the last time Incomnet's working-capital figure had looked good was 1984, after its public offerings. Rather than doing another major fund-raising, as the company's former CEO had wanted, Schwartz instead concentrated on bringing it into the black by cutting overhead and other expenses such as research and development (which he cut from $1.2 million to $200,000 within two years). Penny-pinching worked: by 1989 working capital had risen to $500,000, from 1987's level of negative $1.6 million.
* Accounts receivable. When Schwartz arrived back in 1988, Incomnet's collections system was in disarray, with payments averaging 110 days and some as many as 150 days overdue. "Yet most of our customers were telling us that they couldn't manage without our computerized network," he says. So he took them at their word and decided to revamp the entire accounts-receivable system, requiring customers to pay for services monthly, in advance, the way utilities and cable-TV services do. One result: cash flow has gone from negative $60,000 monthly to positive $50,000.
Schwartz's measures began to have a cumulative effect. In 1988, with sales downsized to $1.6 million, Incomnet nearly broke even, losing only $41,000. Then last year came its first-ever profit: about $250,000 on sales of $2.7 million.
With Incomnet pared down to profitability, Schwartz was able to settle the company's 33 outstanding lawsuits (which mainly came from the company's inability to pay its bills) and, best of all, he can now concentrate on what he loves best: future, controlled growth.
Basic steps for avoiding overexpansion
It's a lot easier to control your company's growth from the beginning than to downsize it back to profitability, the way Sam D. Schwartz had to at Incomnet Inc. Here are some simple ways to do it:
* Design an internal financial-reporting system that gives you the numbers you need to run the business. At Incomnet, Schwartz receives weekly reports on cash, sales, inventory on hand, installations scheduled, recent installations, overhead expenses, and other details that he considers vital to his decision making.
* Stay current. These numbers should be updated at least on a monthly basis -- and more frequently if sales volume, expenditures, or other conditions warrant it. Schwartz receives an updated set of financial statements every Monday morning by 9:00 a.m.
* Look for unexpected or worrisome trends. A month or two of negative cash flow is nothing to be concerned about, if you know why it's happening and when you expect it to turn positive. But if it's unexpected, it may indicate that there are glitches in your accounts-receivable or expense controls -- and that may mean it's time for remedial action.
* Be your own objective auditor. Make an annual ritual of sitting down and evaluating your own financial statements. This is the time to determine whether your key numbers, such as current assets, are reliable; whether the company is operating within its means; and most of all, whether recent growth and expenditures have been justified by their contribution to your bottom line.