I can pinpoint the moment last June when I had the uneasy feeling that I had just gotten a glimpse of the future of business, and it wasn't what I'd expected. The occasion was a meeting in Monte Carlo with one of the company founders competing to be named World Entrepreneur of the Year. I was there as the American judge on the panel brought together by the program's sponsor, Ernst & Young. The winner would be announced at an awards ceremony attended by hundreds of entrepreneurs from around the world. Although I've been helping to select the U.S. Entrepreneur of the Year for more than a decade, I had never been involved in the international judging, and I'd spent a fair amount of time trying to get prepared. But nothing could have prepared me for Vikas Goel.
Goel is the 36-year-old CEO of a Singapore-based company called eSys Technologies, which he founded in 2000. Born in India, he had arrived in Singapore in 1996 with no capital and no contacts. Four years later, he launched eSys with one employee and a part-time staff member working in a one-room office. On the surface, his timing could hardly have been worse, since right about then the bottom dropped out of his chosen line of business, the distribution of computer components.
But where others saw potential disaster, Goel saw opportunity. And by 2005, the company had sales approaching $2 billion, 112 offices in 33 countries, and four manufacturing plants where its employees assembled the products it had begun to sell under its own brand name, including a PC that went for about $250 at retail. Goel had accomplished this, moreover, without taking on any long-term debt or bringing in any outside investors--and while operating with a gross margin of as little as 3 percent. Yes, 3 percent. With his cost of goods sold running at 97 percent of sales, he had to cover all his expenses--sales and marketing, engineering, G&A, the works--out of the meager 3 percent left over. Yet, even so, the company had been profitable every year. Its net pretax margin was less than 1 percent, but the fact that eSys had net profit at all was incredible. In all my years in business, I'd never seen such a feat. That record had earned Goel his designation as Singapore's Entrepreneur of the Year in 2005 and made him a leading candidate for World Entrepreneur of the Year in 2006.
Even more amazing than what Goel had done was how he'd done it, coming up with a slew of innovative techniques that had allowed him to slash not only his cost of goods sold but also virtually every other expense. One such technique was something he called Total Business Outsourcing, which involved centralizing business functions at a single facility in a low-cost, high-skilled country. Thus, for example, a visitor arriving at the eSys office in, say, Chino, California, would be greeted by a receptionist in India who appeared on a plasma screen and communicated with the guest via VoIP.
Goel had been equally creative in developing a low-cost, centralized Enterprise Resource Planning system that connected and monitored all of eSys's facilities through the Internet, thus allowing the entire company to operate in real time and online. He had harnessed other technology to automate computer manufacturing plants in Dubai, New Delhi, Singapore, and Los Angeles and to build a revolutionary distribution system--integrating manufacturing facilities with regional supply chain hubs--that, according to the company, gave it the lowest inventory holding costs in its industry and got its products to market faster than any of its competitors. Indeed, Goel claimed that eSys was 500 percent more efficient operationally than the rest of the industry, with the thinnest gross margins and the lowest expense-to-sales ratio. I didn't doubt it.
What really bowled me over, though, was the way Goel had financed the business. He began with the observation that vendor credit is the cheapest financing money can buy: It costs nothing. In contrast, bank credit comes with an annual interest expense of about 6 percent and long-term credit costs about 8 percent. Equity is the most expensive capital, since investors usually expect compounded annual returns of 20 percent or more. Clearly vendor credit is the way to go, provided you can get it. One way is to demonstrate through your performance that you have the potential to become a very large and reliable customer. Goel did that and then went a crucial step further. He realized he could make vendors and lenders even more comfortable about extending credit by buying insurance on whatever the company owed them and making them the beneficiaries. This gave eSys access to additional capital at a fraction of the usual cost--the equivalent of about 2 percent annual interest.
It was this innovative low-cost or no-cost positive cash flow model, as Goel called it, that allowed eSys to grow as fast as it did and get established in so many countries in such a short span of time. After five years of breakneck expansion, the company had $350 million in vendor credit and $150 million in bank lines, and not even a penny of long-term debt or outside equity. With this relatively cheap capital, eSys had acquired 12 money-losing businesses in markets around the world, turned them around by applying its innovative cost-cutting methods, and become a global business virtually overnight.
It was, in fact, the first truly global start-up I'd ever seen. By that I mean it was the first company I knew of to operate worldwide almost from day one, taking advantage of the cost savings available in different countries. Goel and his people went about their cost-cutting methodically. They would break down every aspect of the business into a set of processes, figure out how to make the processes as efficient as possible, and then use the latest Internet-based technology to set up the operation wherever the company could achieve the greatest savings. Accordingly, eSys located its distribution hubs in Dubai, New Delhi, Los Angeles, Singapore, and Amsterdam in order to reduce inventory holding costs. For credit insurance, it went to Switzerland and Germany, where it could get the best rates. It set up IT services and back-office operations in India. It handled finances out of Singapore, which has the lowest effective tax rate in the world--below even that of Hong Kong and Ireland. And if Singapore ever raises its taxes, eSys can move the corporate offices to any country that offers a better deal.
Although almost all the information I had about the company came from Goel himself, I knew his story had passed muster with the Singapore Entrepreneur of the Year judges, which gave me confidence in its accuracy. But I had mixed emotions about its implications. On the one hand, I couldn't help admiring the genius of the man who had created such a business model and who argued, with apparent justification, that it could be applied to almost any business involving the physical movement of goods. Equally admirable was his mission--to bridge the digital divide by putting affordable computers in the hands of people who would not otherwise be able to own them. From what I'd read, moreover, it appeared that he had developed a vibrant, entrepreneurial culture inside eSys and that he treated his people well, giving them responsibility, encouraging them to be creative in finding more efficient ways to operate, sharing the savings they achieved, managing by trust rather than fear, and spreading equity throughout the organization.
But Goel's model also made me uncomfortable. What if this really was the future? What if every company were able to set up operations globally so as to minimize expenses, including taxes? Where would governments get the money for essential functions? What would happen to standards of living around the world? The eSys model was clearly great for eSys, but what if everybody adopted it? Was this really something we wanted to encourage?
And I had more personal concerns in my capacity as CEO of Missouri-based SRC Holdings with responsibilities to my shareholders, who in our case also happen to be our employees. We've been in business for 24 years, growing from a single, money-losing remanufacturing plant into a profitable mini-conglomerate with holdings in businesses doing a combined $400 million in annual revenue. We've been able to accomplish this by developing the habit of looking ahead and asking the what-ifs. When I looked ahead from the perspective of Monte Carlo, I had to consider the possibility that we were going to see a lot more companies following Goel's path, and some of them might be our competitors. That was a future my company wasn't prepared for. I realized that my colleagues and I might have to consider making fundamental changes in our business after I returned.
To be sure, this wasn't the first time that developments in other countries had forced us to change the way we do business. In the 1970s and 1980s, the challenge had come from Japan. Back then, the media had labeled our part of the world the Rust Belt and suggested that our children's generation might be the first in American history to have a lower standard of living than their parents' generation. So we'd adopted Japanese techniques--just-in-time, quality circles, and so on--in an effort to become more competitive.
Then it was NAFTA and the challenge of competing with Mexico, where the fully loaded labor rate was $2 per hour. That was scary. To avoid being caught in a crunch, we tried to reduce our average labor cost by having some work done in Mexico. The quality was poor, however, and our people didn't like it. They viewed any manufacturing we did there as a threat to their jobs. So we stopped. But we learned that you can't wall yourself off from other countries. The world would close in on you when you weren't looking.
That lesson came home to me again two years ago as we were preparing for one of our board meetings. Out of curiosity, I had asked our purchasing people to tell me the number of countries we were buying parts from. The total turned out to be 56. I was stunned. I had no idea that we were depending on so many suppliers outside the United States. I had someone create a map showing where all of them were located. It blew people's minds. Here we were, minding our business in Springfield, Missouri, and suddenly we discover we've gone global. That's how it happens. You just wake up one day and realize the world has become your marketplace--not in some abstract way but directly, personally. In the end, you don't have much to say in the matter. The only question is: How are you going to deal with it?
Now my company is figuring out how to deal with a type of global competition that has received little attention in the United States. Entrepreneurs in Asia, Eastern Europe, and Latin America are vigorously supported by their governments, hailed by their media, and embraced by their cultures. Their companies are a source of national pride--and for good reason. They've provided jobs, created wealth, and helped lift entire economies. In many cases, they have contributed money, people, and time to addressing urgent social needs.
In Monte Carlo, I could see evidence of that pride wherever I looked. What left the greatest impression on me--aside from Vikas Goel--was the respect with which the foreign media treated the various Entrepreneurs of the Year gathered there. The contrast to the U.S. media's attitude was striking. While newspapers, magazines, and television stations from other countries provided extensive coverage of the conference and the judging, I didn't see a single representative from an American media outlet. For that matter, the U.S. Entrepreneur of the Year, one of the Home Depot (NYSE:HD) founders, didn't show up either, sending an assistant in his place--much to the displeasure of one judge, who grilled her mercilessly about her boss's absence. I don't know whether American lack of interest in other countries' entrepreneurs reflects arrogance, ignorance, or complacency, but I'm concerned that we will pay for it when we meet the Vikas Goels of the world in the marketplace. Of course, some U.S.-based companies--Dell (NASDAQ:DELL), Ingram Micro (NYSE:IM), and Tech Data (NASDAQ:TECD), to name three--have already met Vikas Goel in the marketplace and have had to deal with the consequences.
In the end, our panel did not choose Goel as the 2006 World Entrepreneur of the Year. That honor went to Bill Lynch of South Africa, who had turned a money-losing car dealership into a $6 billion transport and mobility empire after arriving from Ireland in 1971 with a village school education, few prospects, and 2,000 British pounds. Lynch's business has now been around for more than 30 years. Whether Goel's can last that long remains to be seen. You have to question the staying power of any company operating with a pretax margin of less than 1 percent. But sustainability aside, Goel has already demonstrated that it is possible to improve efficiency and cut costs in just about every area of a business by taking advantage of the technological tools of the new world economy and operating on a truly global scale. I suspect other companies will pick up on the techniques eSys has pioneered, and some will no doubt introduce innovations of their own. The effect will be to put increasing pressure on the margins of companies like mine. Based on what I learned in Monte Carlo, I decided that if SRC Holdings was going to remain competitive, we'd have to improve our efficiencies and cut our costs, and we couldn't limit ourselves to the lines of the income statement covering direct labor, materials, and overhead. We also had to look at the expense lines--including the one for taxes.
There was one possibility that I could see right away, but it involved changing the ownership structure of our company, and especially the role of our Employee Stock Ownership Plan, or ESOP. Under a law passed by Congress in 1997, an ESOP in an S corporation is exempt from federal taxes on the portion of the company's profits attributable to its ownership stake. An S corporation doesn't pay any taxes itself because all of its profits pass through to the owners. If the owners are individuals, they pay income tax on the money they receive. But if 100 percent of the S corporation's stock is owned by an ESOP, no federal taxes are due annually. Instead, members of the ESOP pay federal taxes on the money they receive when they cash out. (The ESOP may still have to pay some state taxes; the laws vary.) So the federal government does get its share in the end, while the company gains a significant competitive advantage. It can use the extra cash from the deferred taxes to price more competitively, to make acquisitions, to start new businesses, to do everything businesses do to create jobs and build wealth. What's more, the wealth winds up in the hands of employees, thereby helping to reduce the gap between haves and have-nots.
Aside from being a great deal for employee-owned companies, the law on ESOPs in S corporations is a means for addressing the danger I saw in Goel's business model. If companies can shop the world to find the lowest taxes, competitive pressure may force a lot of them to do it. That could pose huge problems for countries with higher tax rates, unless they create a mechanism that allows businesses to remain competitive. The ESOP law is such a mechanism.
Then again, there are challenges to running a company owned by an ESOP, not the least of which has to do with creating an ownership culture wherein employees not only have stock but also think and act like owners. Fortunately, SRC Holdings has a strong ownership culture. Our ESOP already owns about a third of the company's stock, with the rest in the hands of individual employee-shareholders. While we are presently organized as a C corporation, we could go subchapter S. The ESOP could then borrow enough money (about $50 million) to buy out the other shareholders and use the tax savings (3 percent of sales, or about $6 million a year) to help pay off the debt. It might take five or six years to complete the transfer, but thereafter we would have that extra $6 million in cash flow to reinvest in the business. That would put us in a very solid position.
But there's always a risk in borrowing a lot of money, and it would be a risk our employees would be taking. They would be the ones who'd be doing the work required to pay off the debt. They would also be the ones who stood to gain the most if they succeeded in paying it off--or lose the most if we got in trouble. We would be doing it mainly to make our culture sustainable and to give the next generation a shot at having the kind of run my generation has had. On the other hand, members of the next generation might do better by taking another route--going public, say, or bringing in private equity. The decision about what to do, I felt, had to be theirs.
So I formed a committee of employees who'd received the Top Gun awards we give each year to people singled out for special recognition by the company's managers. The rule is that the managers have to select employees who've made significant contributions beyond their departments, doing things that have had an impact on the company as a whole. I chose seven Top Guns and asked them to return with a recommendation on how we should handle buying out the stock held by employees, as we would eventually have to do in any case. I made it clear that having the ESOP buy the stock was just one option. Another was to continue doing what we've done in the past--borrowing the money to purchase the stock of employees as they leave. Or we could go public, or do a private equity deal, or sell the business, or liquidate other assets we own. The committee members thought it over and recommended that we become an S corporation and have the ESOP acquire everyone else's stock. When I asked them why, they said that they wanted to keep our culture of ownership, and taking the ESOP route seemed like the best way to do it--maybe even the only way to do it over the long term.
For now, at least, that's the path we're taking. In choosing it, there were obviously considerations other than the prospect of having to compete with the likes of Vikas Goel, but I do have to give him some credit for waking me up. It's a brave new world of business that we're heading into. Thanks to Goel and the other entrepreneurs I met in Monte Carlo, my company will be better prepared to meet the challenges that lie ahead.
Jack Stack, contributing editor and CEO of SRC Holdings, and Bo Burlingham, editor-at-large, are co-authors of A Stake in the Outcome.