Money for Nothing and Checks for Free
How do companies create value? A simple question with many complex answers. A simple view is that companies tht deploy capital and net returns above the cost of that capital represent value created. Economic profit or Economic Value Added in the vernacular of Stern Stewart.
Capital is sourced in many ways. Banks, venture capitalists and investors take the view that any placement of capital in a company should yield adequate returns that not only exceed their own cost of capital, but are also likely to deliver a significant premium. Trade flows are another significant source of capital. Billions of dollars flow daily between companies where the only sought return is the delivery of goods. But are there opportunities left on the table?
I was recently in Xiang Yang fabric market in Shanghai. A fascinating medium in which to watch the financial equivalent of speed dating. Foreign businesspeople and tourists flock to the market in search of a bargain. On this particular sultry day, an American businessman was set to do battle against a shrewd middle aged Chinese shopkeeper, a veteran negotiator to be sure. He was negotiating price, she was negotiating value. After five exhausting rounds, the deal was closed. He walked away satisfied with his price, a 40 per cent discount. Our veteran negotiator happily pocketed 300 per cent above her best price. Both were winners in the value game, or were they?
Like so many procurement negotiations, a focus on price ignores much of the value creation. Over the past 20 years, many companies who made their reputations and fortunes from supplying leading brand names now compete fiercely in the same market space. ‘Biting the hand that fed them’, so to speak. Think Microsoft and IBM.
Like IBM, a well known US listed company faces the same competitive threats. So the challenge was how to turn an ominpresent threat into an opportunity. We conducted a limited trial to change the procurement paradigm. We focused on two key questions
We chose a small small supplier with great market potential. The forecast spend for the year was $500,000. Not a large amount to be sure, but adequate for our purposes. We assessed the supplier would benefit greatly from a contract with our client through brand association, scale and market penetration. Clearly there was a value upside for the supplier other than just the negotiated price. Equally, a lower price would potentially drive the supplier out of business. How many of your suppliers fit the profile?
The challenge was to deploy mechanisms to access the upside without overly burdening either company, particularly in the post Sarbanes Oxley environment. There were a number of options available to access value creation; direct discount, revenue share, equity, warrants and other performance based measures such as rebates. Based on our knowledge of the market and product, we chose a mix of revenue share, direct equity and warrants. These and other mechanisms protected our client’s interests in a number of ways:
The next challenge was the acceleration of cash flow. Fortunately, corporate banking and trade structures have evolved over the past few years giving rise to a number of options in accelerating cash flow. And yes, if you go with a bank there are always options to negotiate additional discounts on other products and services. Checks for free of course! However in our client’s case, yielding adequate returns from excess cash was already a challenge. In their case, deployment of their own funds offered a safe return above any existing cash or bond rate. Why AAA rated companies have billions sitting in short term markets earning single digit returns while their cash strapped suppliers are funding their receivables at prime ++, I will never understand. But that’s another topic!
Armed with cash, appropriate protection mechanisms and good due diligence, we negotiated a contract that framed the intent of both companies to work together to create value in the market. A contract consistent with the intent of any strategic supply relationship. The acceleration of cash was managed in tranches tied to milestones. This structure provided the supplier with highly valued working capital while minimizing risk to the buyer. An equivalent if you like to COD (cash on delivery). The rest, as they say, is history.
One year later the results are in. The companies both benefited in the supply relationship, working closely on enhancing the product and driving out to the market together. Operationally, a great synergy and good supply relationship in its own right. A major competitor, one of the world’s leading corporations, took note of the supplier and acquired it. In the process our customer’s interest was protected and they realized a handsome cash return of $3.4m for money they would have simply been exhausted on cost of goods. ‘Money for nothing’ as they say. In reality, it is more a great return for minimal incremental investment.
While not every supplier relationship should be structured this way, there is no question your business with suppliers creates value beyond what your pay. It is a common misconception that payables are considered ‘free’ cash flow. Pushing payables has been the mantra of the consultants. Easy short term cash, sure. But no free lunch. That cash comes at a real cost and that cost is often much higher than you think.
Too often we hear from leading corporations that competitors access the value they create in their supply relationships. Innovations, operational improvements and better pricing leak outside those relationships all too easily. An acknowledged challenge shared by most large organizations. However in every problem lies an opportunity. There are many structural mechanisms to access and protect value creation. And many ways to create sustainable value for you and your suppliers. Even with the biggest suppliers, it is never a question of ‘if’, just a question of ‘how?’
Cash flow is an asset capable of investment returns and should be treated as such. If working capital was the catch cry of the 90’s, collaborative capital is definitely the agenda for the new millennium. If it’s not on your to do list, think again.