There has been a lot of discussion since the onset of the COVID-19 crisis on the need for small-medium size businesses (SMBs) to re-open and re-start. However, there are some very difficult and complex issues to understand in this directive; it is not simply a matter of an SMB opening its doors again.
Current situation for SMBs as they come out of COVID-19
1) No or limited business for last 2-4 months:
As the crisis gradually and incrementally unwinds, SMBs will have had almost no business, or very limited business, for at least 2-4 months, and possibly much longer. Many SMBs have been essentially shut down, including retail stores, restaurants, and hotels. Many others have seen a very substantial drop in business; for example, auto dealerships have experienced sales reduction by as much as 50%. Small manufacturing firms that sell to the Tier 1 and Tier 2 suppliers to the OEMs have seen most of their business evaporate. This has a number of implications: loss of revenues and negative NOIs, loss of market and clientele, reduced valuations, loss of trained/skilled workers, and falling far behind in accounts/payable, loan payments, and lease or mortgage payments.
2) No cash:
Most SMBs are privately held, and often family-held. They operate quarter to quarter, and have virtually no cash reserves. Retained earnings at the end of the year are either paid out to the owners as dividends or are used to fund the next years’ capital budget and growth plans. Therefore, these SMBs lack the working capital needed to reopen.
3) Limited access to capital:
SMBs do not have the same access to the capital markets as larger publicly held companies. Institutional equity and debt investors are not usually interested in the smaller capital requirements of SMBs, forcing SMBs to rely on bank loans, angel investors, and owner’s equity and promissory notes.
How can SMBs come out of the COVID crisis successfully
1) Find new working capital:
These SMBs will need additional cash to meet their working capital needs, including: re-stocking raw materials and inventory (especially of perishable materials, such as food); rehiring and retraining staff; getting at least partly caught up on A/P (in order to place new orders for inventory with vendors); and paying down at least some of their outstanding loans and lease or mortgage payments.
2) Staffing needs:
The SMBs will need to rehire and then retrain staff, either former employees (most of whom were laid off or furloughed) or new ones. This will have to occur before new revenues will be generated.
3) Re-establishing their marketing efforts and sales channels:
The SMBs have not been able to sell to their clients, and have therefore lost many of those client relationships and market position. They need to recreate their market position and sales distribution channels, while reconnecting with previous customers.
4) In summary:
All of these challenges require meeting the first need: getting new working capital. These SMBs have been losing money for the last several months, and they will need a significant infusion of new working capital to re-emerge. How they will get this capital is a difficult question. The banks are also hard hit by this crisis, since they have been experiencing a significant increase in non-performing commercial loans and mortgage loans. Institutional debt and equity investments are not generally available to SMBs. The SMB owners have seen their personal wealth substantially eroded because of their company’s losses (and the major drop in the general equity markets in which these owners are invested), which is also true of many angel investors. And the availability of grants and loans from the federal and state governments is still uncertain at this point, and most likely limited.
We are likely going to see the continuation and acceleration of the previous trend towards industry consolidation and market domination by a small number of large players. The larger firms, especially those that are publicly held, have greater cash reserves, have greater access to institutional equity and debt investors, and are more likely to survive the downturn and re-emerge with the ability to acquire other smaller firms in their industry. For them, this could be a very good opportunity to strengthen their position, at the expense of industry diversification.
2) Substantial increase in M&A activity:
Many of the SMBs will not be able to come out of this COVID crisis, and will seek to sell their company or assets, at distressed levels, especially when the owner is older and had been considering an exit anyway. This will contribute to the trends toward industry consolidation; we may see the larger SMBs acquire the smaller ones, again at the expense of industry diversification.
3) Significant pressure on the bankruptcy infrastructure:
Some of these SMBs, especially if they can’t find a buyer for their assets, will seek to file under Chapter 11, leading to a major increase in bankruptcies, and putting additional burdens on the courts, receivers, auction houses, and attorneys, beyond their capacity.
4) Alternative funding sources:
While the traditional lenders who serve the SMB market, including commercial banks, asset-based lenders, and A/R factors, may be reluctant to set up new funding relationships, even with existing clients, an infrastructure of alternative funding sources exists. This includes Merchant Cash Advance companies, non-bank lenders, and other forms of “hard money” lenders. While these represent possible solutions to the working capital needs of SMBs, they carry substantial risk to these SMBs of very high interest rates, and onerous conditions. Sometimes, these cures are worse than the problems they are solving, and should be approached very cautiously.
Every crisis also brings along opportunities and options:
1) Acquisition of competitors:
For those firms, including SMBs, that still have some access to capital, this could be an excellent opportunity to acquire some of their competitors who are unable to re-emerge from the crisis.
2) Restructure business:
SMBs could use this enforced down-time as an opportunity to spend the time and energy needed to rethink their business, including: restructuring staffing and work flow; re-evaluate marketing strategy and sales distribution channels; and update their business plan and cashflow proforma (including exploring new business options).
3) Recapitalize the company:
SMBs could reach out to their existing shareholders, for a frank discussion of the revised business approach, and perhaps obtain additional capital from them for post-COVID growth. SMBs could talk with their current banker, especially if they have managed to stay current on their loans, about the possibility of a restructured loan package. Alternatively, they could explore new banking relationships.
SMBs could use this down-time to clean house: finally conclude financial reporting; clean out old inventory and raw materials; get caught up on maintenance; explore new ideas in R&D that they have not had the time do earlier; review the chart-of-accounts to see if it can be improved; implement an ERP system, which is difficult to schedule when they are busy; and encourage their remaining employees to spend this time getting on-line education in skills, including Certification programs.
Opportunities for Service Providers
1) Continue marketing, to build a pipeline and a future book of business, and to retain your visibility in the industry.
2) Work with SMBs that are still relatively solvent to explore options for acquiring competitors or vertically-integrated complementary companies; make use of this opportunity to find bargains.
3) Assist distressed sell-side clients in finding a buyer for their assets.
3) Use any forced down-time to work on your own professional development, including taking on-line courses, and work on certifications and licenses.
4) Re-examine your business plan, marketing strategies, and marketing materials, including updating collateral and your website.5) Work with your existing clients to prepare for the post-COVID time by developing marketing materials, data room, and CIM, ahead of the actual transactions.