There is no better time to prepare for an economic downturn than when times are good. With the memory of the severity of the 2007–2008 financial crisis still fresh in the minds of many directors and executives, how should companies prepare for a downturn in the cool of the day, rather than reacting in crisis mode?
Most business plans do not currently anticipate economic downturns; however, a contingency plan makes good business sense because it positions companies to act decisively when recessionary storm clouds loom on the horizon.
Organizations develop contingency plans to address market opportunities should they arise and document specific action steps that are triggered if certain events occur. Such events might include natural disasters, cybersecurity breaches, terrorist attacks, fire, fraud, theft, or embezzlement. These perils may never occur, but the plan nonetheless stands ready with a response team organized to implement it.
The focus of this discussion is how to prepare for an economic recession that causes revenues to decline below a predefined threshold. It is virtually irrefutable that a recession will occur, which is why it’s wise to create a contingency plan to (a) mitigate the financial impact of a severe economic downturn on earnings and share price and (b) position the company to gain market share during the recovery.
In preparing a contingency plan to accomplish these two objectives, action steps are sequenced, prioritized, and grouped by corporate function and operating unit so that ownership of each step is clear. Targeted cost savings in the current and subsequent projection years should also accompany each action step. Key plan elements for most companies include.
Headcount and hiring changes. Distressed operating environments present a time for shepherding the talent most critical to retain. Focused retention, objectively determined workforce reductions, and changing hiring practices are often important components of a contingency plan.
Compensation, benefit, and incentive plan adjustments. Temporary revisions to compensation, benefit, and incentive plans may be necessary to stabilize the firm’s financial condition. Vetting the economic realities of a declining top line and the need for adjustments to the reward system with key personnel before a downturn creates a broader support base for the plan when it is implemented.
Asset divestitures. Management should categorize the company’s assets—underperforming versus high-performing, strategic versus nonstrategic—so that a plan can be developed for each asset category. The plan should consider the timing and the immediate and long-term financial impact of asset sales, and the need for such sales as signs of extreme economic scenarios appear. Timing can be a critical factor due to the difficulty of selling assets in a depressed market. Sale-leaseback transactions for certain facilities are also an option for raising capital.
Selling, general and administrative (SG&A) expense cutbacks. SG&A offers many cost reduction opportunities. In the context of a contingency plan, the objective is to adjust the cost structure to support stabilization and preservation of the enterprise.
Consider other options. Other steps a company can take include:
Hedge raw material costs and lock in sales prices, thereby stabilizing margins — at least for a time;
Consider outsourcing non-core activities that are not strategic to the business, if it will reduce costs such as certain human resources support, accounting, manufacturing and transportation activities;
Focus marketing on sustaining brand awareness during a recession;
Discontinue underperforming operations; and
Address the impact of upstream and downstream interconnectivity within the value chain, e.g., what steps would the company take if a major supplier were to go under due to the downturn?
Hierarchy for cost-savings initiatives. Management should outline a comprehensive menu of prioritized cost-savings initiatives that could be implemented either in part or in its entirety, depending on the severity of the downturn.
Communications plan. In times of economic uncertainty, timely and open communications are vital to preserving morale so that employees know where they stand, and how they and the organization can get through the crisis. Straight talk and transparency are important because, from an employee perspective, no news does not necessarily mean good news.
An effective plan should determine the metrics to be managed against the enterprise’s specified targets such as net operating income percentage, gross margin percentage, acceptable variance from budget, earnings per share, minimum cash reserves, and maximum debt levels. With targets identified, a financial forecast over an appropriate period should be prepared to establish a baseline. Considering different scenarios—revenue declines of, say, 10 and 20 percent— the costs and expected benefits from the various elements mentioned above should be considered to ascertain specific actions management should take under the circumstances.
Once completed, the plan should be reviewed with and approved by the board. The company then resumes its growth strategy with full knowledge that the contingency plan is ready when the time comes—and, unfortunately, it will come. A vetted, actionable contingency plan saves precious time during a crisis because there is a broader base of support for its execution. Preparedness leads to decisiveness under fire.
Management should review the plan on a regular basis to ensure it remains current and apprise the board of any significant changes made to the plan. Going forward, management should monitor the external and internal economic indicators appropriate to the company, and periodically review the analysis with the board. Once the plan is initiated, a project management office should be designated to drive its implementation. The project management office monitors the achievement of the assigned initiatives and provides status reports to senior executives and the board.
Developing a response plan under sunny skies rather than when the recessionary storm breaks would demonstrate a board’s due care and sound business judgment in discharging its oversight responsibilities to address a credible threat. Further, entering a distressed operating environment without a thoughtful, comprehensive plan can lead to hasty decisions, inefficiencies and costly delays. An organization’s stakeholders deserve better.
The majority of companies in the United States are small cap, defined as companies below $500 million in market capitalization. While they are rich in ingenuity, small-cap companies have unique challenges that can be daunting for any board to manage. With smaller staffs and fewer resources than their large-cap counterparts, the time and talents of company executives are spread thin in the face of pressure for fast growth in an uncertain economic environment. This July, NACD, in partnership with Epsen Fuller Group, Fenwick & West, and Latham & Watkins held its second Small-Cap Forum. Over the course of a day, a collective of experts helmed six sessions at San Francisco’s Four Seasons Hotel to dissect the directors’ role in helping to build their companies. The following are three themes that emerged from the presentations:
Plan ahead. Many small-cap companies make the mistake of placing too much emphasis on budgeting. Innovation rarely, if ever, emerges from evaluating figures. Shift gears to take a close, hard look at your company and think about creating a strategic plan. A plan should ideally map out the next five years of the company—no fewer than three—and determine what resources are needed to meet those goals. Allot plenty of time outside of regular meetings to discuss various game plans, setting milestones to review the strategy.
Work with the founder. When assessing and building out the company’s long-term goals, the board also needs to pay attention to management. Small-cap companies often have a culture centered on the founder/CEO, and while that person’s innovative and entrepreneurial drive may have been enough to give legs to a nascent business, those skills may not be aligned with the firm’s needs and goals in subsequent stages of growth. That said, the board shouldn’t write off the leadership already in place. Building support around the C-suite can help enable the CEO to succeed in an increasingly expanding role, or to step down with dignity if required. By extension, start looking within the company for talent that can take the reins in the next three to five years. Broaching this topic can be highly sensitive; however, the longer a leadership gap exists at the CEO level in a small-cap environment, the greater the risk of a succession crisis.
Mind the gaps. The purpose of board-level committees is to share the workload so that board members can effectively “divide and conquer”; however, small-cap boards are traditionally half the size of a large-cap company—so small that the same directors frequently serve on multiple committees. Stretching resources this thin means that there is zero room for non-contributing directors, or else the board runs the risk of being unable to carry out its responsibilities effectively. Small-cap boards should create a skills matrix that charts each director’s areas of expertise—and reveals where the board’s collective knowledge base may be lacking.
A small-cap board should also put forth the effort to bridge the gap between the company and its shareholders. Any opportunity to engage with and better understand your shareholder base is a good idea, and is a particular imperative in the small-company environment where ownership may be more concentrated. Also realize that many small-cap boards become targets of activist investors. Prepare for those interactions not only by doing due diligence on activists’ investment styles and track records, but also by being willing to listen to the activists’ points of view.
Look for a full recap of the Small-Cap Forum in the September/October 2014 issue of NACD Directorship magazine.
The 2013-2014 NACD Public Company Governance Survey found that strategic planning and oversight ranked as the number one issue for directors. While risk oversight came in at number 3, Paula Cholmondeley—who serves on the boards of Terex and Dentsply International Inc.—finds it curious that risk doesn’t follow strategy as the number 2 priority because these issues are part and parcel of each other.
During a May 6 panel discussion at the C-Suite to Board Seat program at the Four Seasons Hotel in Washington, D.C., Cholmondeley and fellow panelist Greg Pratt offered their perspectives on the board’s role in overseeing strategy and risk. Cholmondeley emphasized that strategic thinking is where directors add the most value to a company. Furthermore, boardroom discussions surrounding strategy should be viewed on an ongoing basis—not as a single event. Chairman of Carpenter Technology Group and director of Tredegar Corp., Pratt went on to compare strategy to a GPS system: A tool that tells you where you are, where you want to go, and the possible ways to reach that destination. According to Pratt, directors have a responsibility to use strategic discussions and planning to decide which route is best for the business.
THREE KEY TAKEAWAYS FOR OVERSEEING STRATEGY
1. Educate yourself—and others. This is especially important for directors serving on boards in industries in which they do not have prior experience. Reading industry publications, attending relevant conferences, and getting exposure to as many sources of industry information possible can help directors enrich board discussions. Similarly, directors should ensure that the strategic goals are well-known throughout the company. This could include requesting that the CEO meet with staff so that goals are communicated to the lower levels of the company.
2. Set reasonable benchmarks. Directors should consider the critical assumptions underpinning the strategic plan. For example, how much progress is the company expected to make in the course of a month? Evaluate whether those benchmarks are reasonable for your company by consulting regional or national industry sources as well as third-party sources.
3. Monitor the course and evolve the strategy. The board should consistently review corporate performance with respect to the strategy, and alter course when necessary. Boardroom culture should support open discussions with the c-suite—and management should feel free to report to the board areas where the strategy may or may not be working. As a company reacts to different economic environments, the board needs to be able to evaluate which initiatives worked, which initiative work over a period of time because they are key to your business.
1. Get the committees involved. While ultimate responsibility for governing risk lies at the board level, the board can look to committees for support. In publically-traded companies, the audit committee has traditionally assumed the responsibility of risk oversight. A growing trend, however, is to delegate specific risks to various standing committees. The board can also create new committees that manage the emerging facets of risk, such as keeping the board abreast of new sources of competition.
2. Work with management to assess risk. Open communication between management and the board is critical, especially because the C-suite is likely to be the first to see that a strategy is not working. Directors should learn how risk discussions take place within the various departments and business lines, and establish multiple avenues through which directors can work with management.
3. Be aware of the risks around the corner. The board should constantly review potential non-traditional sources of competition, for example, Amazon’s move to enter the dental distribution market. Likewise, a company should work to make itself obsolete—best itself at its own game before the competition—and then create a strategy that will again put the company on the cutting edge of its industry.
NACD will continue to discuss these issues throughout 2014. Our Directorship 2020 events explore the disruptive forces that create new challenges in the boardroom and our forthcoming 2014 Blue Ribbon Commission Report will address the board’s role in recalibrating strategy. The topic will also be discussed at the next C-Suite to Board Seat in Beverly Hills, CA.