UK: UPS AND DOWNS OF THE PEOPLE BUSINESS. - Is there always a threat that the value will walk out of the door with key employees or can a people business be worth more than the sum of its parts?

by Martin Vander Weyer.
Last Updated: 31 Aug 2010

Is there always a threat that the value will walk out of the door with key employees or can a people business be worth more than the sum of its parts?

Martin Beck, chairman of the quoted design group Fitch, would like to achieve 'a new model company'. He is creating a model to meet a particular challenge: that of a people business which happens to rely on other people's money. Fitch's ownership structure seeks, he says, 'to align the interests of shareholders and employees in the growing value of the business', combining the incentives of partnership with the disciplines and capital accessibility of a public company.

Fitch is a classic 'people' business. But what is a 'people' business? All businesses are at the mercy of the people who run them. But that is not the essential point: some companies consist of nothing but people, a formula which carries distinctive opportunities and special problems, particularly in terms of identifying value in the business. To the outside investor, the fundamental question is: are people businesses ever worth buying, or should they just be left to own themselves?

In the simplest terms, 'people business' is a label which applies usefully only to those enterprises based exclusively on knowledge and cerebral talent, rather than on physical or financial assets and products - businesses in which, using the cliche usually attributed to advertising guru (and latterly WPP chairman) David Ogilvy, 'the assets go down in the elevator at night'. It applies, to a greater or lesser degree, to firms operating within strictly defined professions (the law, accountancy, architecture) or those which are advisory (management consultancy, PR) or intermediary (headhunters, estate agents, or mergers and acquisitions boutiques).

In each case, the job can in theory be done by people equipped with nothing much more than rented desks, telephones, and the requisite training or talent. The products are intangible: concepts, designs, introductions, forms of words, arrangements between third parties. As businesses, they have two other things in common: in economic terms, they tend to be secondary and dependent upon front-line levels of activity in manufacturing, retail spending, house-buying, and so on. And they have a very high degree of job mobility: practitioners of these arts can hop from one firm to another, or operate solo.

Businesses which fit this definition typically start life as a partnership, the simplest and most horizontal of all corporate structures. Like-minded professionals pool overheads and risk for convenience, but retain control of their own individual portfolio of clients or activities. The dilemma faced by 'people businesses' as they grow up is summarised by Charles Mead, a human resources specialist who has worked in management consultancy, advertising and a City solicitors' firm: 'Partnership is good as an ownership model, but can be very ineffectual in terms of governance. The challenge is how to ensure that the whole is greater than the sum of the parts'.

This challenge has to be addressed in the development of any successful partnership or employee-owned business. Sheer size, and external competition, may dictate the adoption of techniques borrowed from shareholder-owned, vertically-managed businesses: this encourages, for example, inter-departmental co-operation and cross-selling. Opportunities for expansion may create capital requirements far beyond the personal resources of the partnership. Indeed, the more that capital is deployed, the less any business can be managed as a pure people business - and, as the recent crisis of the Saatchis demonstrates, the greater the tension which can develop between shareholders and key employees.

Other factors enter this complex equation. Job mobility within the sector or profession (or the retirement of founding partners) may create a need for greater liquidity of ownership, and for greater transparency of value in the business. As the business matures and expands, the business value may increasingly attach itself to the collective brand name of the firm, rather than to the individual star performers within it who become less essential or more easily replaceable than they may imagine themselves to be. And, on a technical level, the scale of clients' affairs may expose partners to professional liability risks too large to be contemplated on an unlimited basis.

Liability provokes the examination of new ownership structures for these professions, as with big corporate law practices. But the point is not lost on any of the partners that a limited company structure means a sale of all or part of their stake in the business is possible: this applies not just to the relatively meagre terms which apply to a withdrawal of partnership equity, but eventually on the much more exciting basis of a price/earnings multiple. Partners in traditional professions do not expect to get rich quick, although wealth may discreetly accrue to them over the course of a long career. Owner-managers, on the other hand, may build their entire business strategy around an intention to sell, and extract maximum value for themselves, within a fairly limited time span.

Are people businesses inherently unsuitable for non-employee ownership, even if shareholding is in practice likely to be limited to sophisticated investment institutions rather than small private investors? Can the injection of outside capital help to generate value in a people business which, as it were, exceeds the sum of the people? Are investors right to be so wary of such propositions? Extreme caution would certainly be the recommendation of those institutions that bought estate agencies on generous multiples at the height of the late-1980s property boom, only to see earnings evaporate and bright young salesmen slip away to set up their own low-overhead agencies in direct competition.

Complex questions arise when a people business stakes its fate on the whims of the stockmarket, and when - as happened in many cases during the recession - the underlying business begins to go wrong. Some high-profile case studies throw this into focus.

Fitch, which specialises in design work for retailers, traces its history to 1962 when founder Rodney Fitch joined the Conran Design group. A decade later Fitch, by then managing director, bought the firm with three fellow directors from its then owners, Burtons, and re-named it. In 1984 it became the first design group to be quoted on the second tier of the Stock Exchange, the Unlisted Securities Market, swiftly advancing to a full listing. Seeking to underpin its value to investors with physical assets, it bought lease properties in Soho and a glamorous headquarters building near King's Cross - a converted bottling plant described by one employee as 'very '80s'.

Meanwhile, other businesses were acquired in France and the United States. When the retail sector dived in the recession, Fitch - which was in effect a geared play on the retail boom - was in deep trouble, with its property assets adding a burden of debt and unlet floor space. In 1993, a rescue was effected by a cash injection from Sir Terence Conran and a French investor, Brand Trust. Last year, Rodney Fitch left, the King's Cross building was sold, and the business broke even again. To incentivise staff in the next phase of Fitch's recovery, an unusual option deal has been struck. The chairman Martin Beck (an American who came in with the 1988 acquisition of Richardson Smith in Boston and Columbus, Ohio) believes that the deal aligns the interests of all parties in the continuing success of the firm. His kind of business, he acknowledges 'is traditionally a terrible model for a public company'. Shareholders, naturally wanting to see costs down and returns up, are unlikely to be interested in the ambience and the quality of work which are so important to designers. Staff, on the other hand, are liable to lose sight of the 'self-regulatory function' of a small employee-owned firm: to feel that 'this place belongs to somebody else, and I can't see them. And it can't live without me anyway.' In a business in which the flow of operating income is inherently unstable, public ownership and the information disclosure that goes with it tend to create a spiralling effect: bad news is rapidly exaggerated by the market, and market capitalisation (which, by definition in this kind of business, reflects a very large element of goodwill) dwindles very rapidly with immediate knock-on effects for internal morale. However, according to Beck, public ownership prevents managers from sweeping bad news under the carpet: 'The business is constantly held up to a mirror, which is good'. An ideal structure, he says, might be based upon a 51/49 split between employees and outside shareholders - preferably led by sympathetic specialist investors, of which Sir Terence Conran is a shining example.

At the time of the 1993 rescue, Fitch's management team owned less than 5% of the company's shares. In the new option deal, Conran and Brand Trust (who bought in at 11 pence, the shares having previously been suspended at 42 pence) are making available options over almost half of their 60% stake in the company, at only one pence per share. In effect therefore, the two major shareholders are offering to give their shares to staff, subject to the achievement of performance targets. In simple terms, Conran and Brand break even on the deal when the share price passes 22 pence: they are betting that the business value will be rebuilt quicker if the key designers (65 out of a total staff of 300) are incentivised by an option scheme so generous that it effectively makes them co-owners.

One lesson of the Fitch story is that the value of a people business is underpinned most effectively by securing the key people in place, rather than by buying the place in which they happen to work. Volatile businesses which are 'geared plays' on the swings of the physical economy need to be exceptionally light on their feet to be able to survive famine as well as feast.

A second conclusion - illustrated by the torments of WPP - is that people businesses may be overstretched, financially and managerially, by acquisitions. WPP chief executive Martin Sorrell, who began his meteoric rise as Saatchi's finance director, was always a deals man rather than an advertising professional. WPP was originally (as Wire & Plastic Products Ltd) a quoted manufacturer of, among other things, supermarket trolleys. Sorrell turned it into the financial equivalent of such a vehicle, stacking it with bold acquisitions which, at the final check-out, could only be paid for by a crippling accumulation of debt.

In 1986, Sorrell reversed the fledgling WPP into one of the world's best-known advertising agencies, J Walter Thompson, with a $350 million bid. Two years later he made a $400 million bid for Ogilvy & Mather. 'People said we paid too much for Ogilvy,' Sorrell once remarked, 'but although we bought it at the top of the cycle, acquisitions are about relative pricing. Our share price was high too.' But not for long. One disgruntled shareholder was later to accuse Sorrell of having gone for 'volume and vanity rather than profit and sanity'. By late 1990, the company had $1.4 billion of debt, and advertising billings had suddenly slumped. The share price collapsed from over £5 (having peaked in 1987 at £9.25) down to 35 pence. With such a burden of debt, other types of company would look to dispose of assets: for a people business like WPP, the process of sale was likely to damage any value in those assets. Receivership was staved off by a debt-for-equity swap with the company's banks in 1992 and another equity issue in 1993, all of which meant heavy dilution for existing shareholders - who were obliged to go without a dividend for several years.

As the company returned to a respectable but unspectacular level of profit for 1994, shareholders were asked to approve a lavish salary, bonus and options package for Sorrell - which The Times described as 'a game of double, but no quits'.

Shareholders had a very rough ride, all the way through, and Sorrell survived only by fiendishly clever negotiation with his bankers and stock-market advisers. Many observers would draw the conclusion that an acquisition spree on the WPP scale, whether financed by debt or through the stock market, was inappropriate to the nature of the advertising business. When people businesses aspire towards global market coverage they may be better advised to proceed by confederation or alliance, forms of linkage much closer in spirit to the partnership principle.

But even with the benefits of hindsight, not everyone would agree. Shandwick (with a market capitalisation of £47 million) is the only quoted international PR company: it is ranked second in its industry worldwide. UK managing director Colin Trusler is 'quite convinced that the effects of going public are positive. It provided us with acquisition currency, and we bought 40-odd companies between 1986 and 1990. We needed to own those businesses in order to guarantee delivery to our clients, to create a common culture and an international brand.' Whether the shareholders are convinced that it has all been a positive experience is a different question. Having roared up to 182 pence before the 1987 stock-market crash, Shandwick's shares hit a low of 3 pence in September 1992 when the ravages of the recession became evident. They have since recovered modestly, and now hover around 35 pence. But a £19 million rights issue was completed last year, and Trusler says that institutional shareholders never sought to force the company into decisions it would not have taken anyway. Shandwick has come up with a different recipe for building and managing people businesses within an umbrella public company structure: only a tiny number of senior managers are involved in shareholder relations, while the bulk of the group's business is conducted through small subsidiary companies of 30 to 40 people, each with an average of £2-3 million of operating income.

Recognising the individualistic nature of talented PR people, each of these business units operates as a shallow pyramid, allowing freedom of action. But the group has matured beyond the concept of big-name individuals on whom the success and value of the company as a whole depends. 'Small businesses have stars who can hold them to ransom and unbalance the quality of earnings. We like high performers, but we also like to keep them as part of a team,' Trusler says. There are performance-related pay schemes in the group, but a relatively small number of Shandwick employees are shareholders, and virtually all of its subsidiary businesses are wholly owned.

Shandwick believes it has made the transition from a small people-business to a large one, in which - so long as the balance sheet is not overstretched - the volatile elements of the business are less significant by virtue of size and spread. The importance of size is also a factor frequently mentioned by investment professionals when asked why markets are suspicious of people businesses.

The small-to-medium sized design or PR company looking for new expansion (or seeking cash to perpetuate the business when the founding partner retires) is most likely to approach a development capital firm - but unlikely to get a helpful response. British development capitalists prefer to put their money in straightforward businesses with asset backing and readily valued products.

According to a director of one of the City's leading development capital houses: 'These people business propositions come to us all the time. We always look to see whether the key people are effectively tied in, or whether the business has consolidated to a point at which its name is good enough to survive the departure of some of the senior people. Those would be the most vital considerations, but the short answer in practice is that we virtually never invest in them.' At the next level of corporate maturity, when stockmarket flotation becomes an option, reactions may be a little more positive - but still not very encouraging. Stewart Millman, a director of NatWest Markets, is a veteran of the new issues market: he says that the 'people' element of the business is not an overwhelming factor in deciding whether a company is suitable for flotation.The problem is that people businesses, however big they may be in their field, are invariably small in stock-market terms. Companies with less than £200 million market capitalisation make up less than 5% of the total London market capitalisation, and the larger issues tend to mop up most of the investor demand even when the market is running strongly. So there just is not much appetite for smaller companies, whether they are people business or not.

Those advertising agencies which become listed companies tend - like WPP and Shandwick - to show very volatile share price performance, indicating the nervousness of investors. One sector analyst argues that the 'assets going down in the elevator' argument really is a tired old cliche, and that 'there is no more speculative risk in agency businesses than in many other business sectors, where managers can just as easily make strategic mistakes'. The substance of really large agencies is not so much their star players as the spread of their client lists, and for many multinational advertisers the choice of agency has as much to do with the ability to provide coverage around the world as with securing the services of one brilliant creative director.

Thus, when a people business becomes larger and more mature, the outside world judges its value by its total portfolio of resources and achievements rather than its individual performers. This is effectively the top of a ladder in a complex board-game of snakes and ladders. At the first stage of the game, the value of the future output of one talented brain, working alone, is almost impossible to measure. At the next level, a partnership of talent has a value, albeit an uncertain one: when it has a track record, a brand-name of its own, a spread of clients and a long-term linkage with its key personnel - that value can be turned into cash.

There are also many waiting snakes: burdens of debt or unsympathetic outside capital; unwise and unmanageable acquisitions; the wrong kind of assets; negligence suits; or the loss of the sense of ownership and commitment which created the business in the first place.

Smart people-businesses will stay light on their feet; pursue quality rather than market share; form pragmatic alliances with like-minded people; stick to their known field with the resources they know they can muster; they incentivise their key staff and keep a balance between individual brilliance and corporate teamwork.

With all of this, the value will look after itself, and it will surely be greater than the sum of the parts.

Martin Vander Weyer is an associate editor of the Spectator.

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