01/10/2001
'People businesses' promise investors healthy margins and handsome profits, but there are many risks attached
Managers often complain, or boast, that their 'biggest assets could walk out of the door at any moment'. Chairmen and chief executives traditionally close their annual statements with a heartfelt thank-you to their staff, 'without whom nothing would have been achieved'.
People are undeniably important to every business. But what happens when the people are a company's only asset? Or has every business now become 'a people business', given the demise of traditional manufacturing companies? How do you value a company which is based largely on the ability of its staff to pull in revenue?
This is not a new problem, as Alan Matthews at Beeson Gregory points out. 'People have been talking about this for as long as service companies have been around', he said. 'There are fairly standard measures which we use to decide how much a company is worth. These are mainly based on multiples, be it multiples of revenue, earnings, margins, or revenue per employee. There are all sorts of fancy methodologies you can use, but most of them boil down to the ability of the business to generate cash'.
Cash generation
The bottom line in calculations such as these is that cash generation is absolutely essential. 'If you can't get cash out of your people, then they have no value. And on top of this, the ability to generate cash has to be sustainable', said another service companies analyst.
'Cash is the foundation of any business', he continued. 'After that, the challenge is to build a brand up, so that if people do decide to walk out of the door, the company still has a chance of hanging on to the business'. This is a key area of concern ? the enterprise has to remunerate its top staff well enough to keep them happy and hang on to them.
From an investment perspective, it is important to keep an eye on management changes at the top of a people business. This is especially true in, for example, a small consultancy business where there are relatively few 'rainmakers', that is, the people who actually bring in the business in the first place. If a director leaves ? an event which will have to be notified to the Stock Exchange ? there is a chance that he or she will take people with them.
However, it can be virtually impossible to tell from the outside whether a firm's top staff are happy or on the brink of mutiny. If these 'rainmakers' actually left the business, the effects would be much more keenly felt at a small business than at a multinational with thousands of fee earners.
One way to make people less likely to leave the business is to introduce equity participation. This means that the success of an employee is directly linked to the success of the organisation as a whole. At the simplest level, it suggests that employees are more likely to put in extra effort for the good of the company if they hold shares in the company. As Alan Matthews says, 'When looking at service-and people-based companies, we would want to see incentive schemes in place. This also applies to acquisitions, where we would expect to see things such as deferred pay-outs'.
One factor to pay attention to in assessing a people business is the size of the barriers to entering the market. These can vary greatly, as Matthews points out. 'If you work for a High Street estate agency, it is not really that difficult to strike out on your own and set up a rival agency next door. But take SHL, the psychometric testing business. An ex-employee could hardly go and replicate that business, because of the amount of intellectual property in SHL. Similarly with Watermans, the engineering consultancy. I can't imagine an ex-employee suggesting that he carry out an entire project management scheme on his own just because he used to do the same thing at Watermans. There is a knowledge base in the infrastructure of the established firms which can't easily be reproduced'.
Assets and attributes
It is important to be aware that 'people businesses' do not have assets in the traditional sense. Revenue is generated by the people they employ, and, as one analyst pointed out, 'All an employer can do is milk them [but] they have to be kept happy'. When you invest in a people business, you are not buying a share of assets; you are buying access to a cash flow which should be sustainable. This of course makes it riskier than investing in traditional asset-backed businesses, but these risks are usually well-known and should be factored into price.
People businesses have the potential to be more volatile than companies in other sectors. However, they do have the ability to cut their costs fairly drastically in lean times by simply cutting their single biggest cost ? their workforce. This is especially true if the business conforms to the '80:20 rule' ? meaning that 80 per cent of the revenue is generated by 20 per cent of the workforce. In these instances, it should be possible for a business to cut its costs right back, without sacrificing too much of its future profitability if conditions improve.
The secrets of success
Ian Buckley is chief executive of Tenon, the ambitious Aim-listed company which is building up a group of accountancy practices. He echoes the previous sentiments by saying that when Tenon buys an accountancy practice, it is 'essentially buying a maintainable profit stream'. He contests that there is more to a business such as an accountancy practice than just the staff it employs. 'It is not necessarily true that the revenue would walk out of the door if key members of staff left. The secret is to make sure that the clients become attached to the business as a whole rather than to one person in particular'.
It is also important to look out for signs that the ability to earn revenue does not rest solely with one person, thus increasing the risk of that revenue 'walking out of the door' with a departing employee. 'In a professional services business', says Buckley, 'you should try to make sure that the different services are offered by different people. In practical terms, you would want taxation services offered by one person, the legal side by another, administration services by another, and so on'.
Specialist financial adviser Kingsbridge is a good example of a people business. It is based on the ability of its senior staff and directors to attract and keep its high-profile client list, which is dominated by high-earning young men from the world of football. It was set up by David McKee and Kevin McMenamin, now joint managing directors. Both McKee and McMenamin, along with fellow director John Murray, are very well-known figures within the football community. But at 51.5p, its shares are trading on a very ambitious forward p/e of around 50 times 2001 earnings.
Kingsbridge is one of a clutch of football-related businesses to have floated on Aim in the last year, including Sport Entertainment and Media, Premier Management, CSS Stellar and Proactive Sports. These businesses are largely premised on the ability of their senior directors, all well-known in the worlds of sports and entertainment, to attract and retain big clients with their considerable fortunes to manage. As Ben Archer at Teather & Greenwood says, the success of the business is often based on trust. 'In the case of Proactive Sports', he says, 'there is a bond between the player and the agent. It has only lost two or three clients in its history, partly because it has several ex-players on its board who know what the clients need'.
In terms of the protection offered by businesses such as these in an economic downturn, Archer adopts a positive stance. 'They offer more defensive qualities than most of the other businesses in the media agency world, as footballers' wages keep on going up, and football's popularity shows no sign of waning. There is the international element too ? clubs like Manchester United have a massive overseas following, so it has exposure to that as well'.
