Given the current economic picture with bank failures and bailouts, debt ceilings, inflation concerns and interest rate issues–small and medium sized business owners and their advisors need to think carefully about how they communicate with lenders. Storm clouds are building, so this is a time for umbrellas. Consistent financial performance and a strong growth story used to be enough—not anymore.
Banks are becoming more risk averse and are keen to see their customers do the same. A more comprehensive and detailed review is now commonplace and this will now include non-financial metrics and ESG measures to ensure the business is well placed to navigate choppy waters.
While many types of analysis include financial performance including historical financial statements, benchmarking, cash flow projections, budget forecasts, and a financial valuation, it’s no longer adequate. I’ve worked in the succession and exit planning space for over 20 years, and can tell you first hand that a company’s non-financial metrics are just as important as the financial metrics. We look at more than 150 non-financial metrics across corporate governance, occupational health and safety, IT and cyber security, environmental and sustainability measures, remuneration models, and management structures.
Non-financial metrics boil down to the key metrics business owners can focus on to reduce risk and therefore increase value and the likelihood of being able to borrow successfully. They can also impact the multiple a business can achieve on sale and will be greatly considered by any lender. In our experience, these are also the areas that are largely in a business owner’s control, and some can be improved relatively easily.
The Five Key Areas of Non-Financials
- Risk analysis across the 6 key areas: people (management, remuneration and incentives), IT & cyber, corporate governance (management and controls, advisory board and reporting processes), health and safety, compliance and regulation (lodgements of taxation and financial obligations, legal and licensing), and financial management (reporting, controls, cash flow management and budgeting, and forecasting). For example, it’s typical in small to medium businesses to be very dependent on founders and key people. This leaves the business open to risk as the business could not operate if the founder or one of the key people left. A clear remuneration strategy or an employee share plan, mitigates against risk of staff turnover despite some good HR practices.
- Environmental, social, and governance (ESG): ESG factors can be material to a company’s financial performance. A 2020 study by Harvard Business School found that companies with strong ESG performance were more likely to have a lower cost of capital and higher valuation multiples. ESG factors can impact financial performance through a variety of channels, including reputation risk, operational efficiency, and innovation. For example, companies with strong ESG performance may be better positioned to attract and retain customers, employees, and investors.
- Succession: Having a clear understanding of management succession, identifying who will run the business when the owner leaves (or retires or dies) and ownership succession, the longer-term exit or succession plan. For example, putting a board structure in place to mitigate against governance risk as well as buy/sell agreement, which could cause quite significant issues if one partner leaves the business, gets sick, or is hit by the proverbial bus.
- Benchmarking and profit gap: Benchmarking against industry peers enables businesses to identify areas for improvement and focus on growth opportunities, looking to peers in foundational areas like business model, financial management, people, compliance, and management team
- Value acceleration: Illustrating the risks in any business will help prioritize action and help to have a strong growth plan for the equity value of the business.
A prospective lender will see the non-financial measures of a business as a reflection of how the business is managed. They will of course look at financial performance but focusing on operations of the business and determining where there is risk–and where action is being taken to mitigate against it–is integral to business’ success as well.
The big issue is that by nature entrepreneurs are natural risk takers. They are growth focused. Working on some of these risk areas may not be exciting, but these areas will assuage bankers’ fears around the health of a business. In fact, in addition to strong financials and unit economics, which prove the business model is robust and sustainable, proactively presenting a detailed risk analysis and a mitigation plan will hold any business owner in good stead when looking at sale, investment, or funding.
Dr. Craig West is Founder and Chairman of Capitaliz, a leading digital platform for exit planners and advisors to deliver scalable business valuation, succession, and exit planning outcomes. @CraigWestCPA
Image by eko pramono from Pixabay
