123rf23820806 largeLike individuals, companies have accumulated knowledge that helps them function and thrive. This institutional knowledge can be in the form of an operations manual or be more abstract like a companywide approach to dealing with a challenging customer who likes to be addressed by his nickname or should only be contacted by email.

[quotesright]This accumulated knowledge is every bit as vital to a company’s success as its bestselling product. [quotesright] Unlike the bestselling product, a new owner cannot be sure knowledge will be there after the transaction, especially if key data is only in the head of the owner.

[quotes]Brain drain is the loss of institutional knowledge[/quotes] that occurs when the current owner and members of his team depart after the transaction. Diversifying the institutional knowledge among a wider group of employees and memorializing processes and procedures is important to prevent brain drain, both the perception and the reality.

Most businesses start out with a small group of employees or even a single owner. As the business grows, the owner and the key employees control certain customer relationships or processes by always handling certain tasks themselves. While the business may benefit from the consistency of these individuals in the short term, [quotes]long-term value can be reduced by concentrating too much knowledge with a few individuals. [/quotes]

[quotesright]In some cases, the business owner can be held “hostage” by a key employee who threatens to leave if not paid more. [/quotesright]

Consider the case of a service company that handled voiceovers for major corporate call centers. The owner had developed the company from a small operation to a company with national and international clients. He was involved in every new piece of business for the first 20 years of the company’s existence in some form or fashion.

Over time he developed a staff of employees capable of handling all the needs of even the most major clients. He was no longer the primary point of contact for any client, but still knew about each client relationship.

When it came time to sell the company, [quotesright]it was easy to explain to a buyer how the company would function without the owner, [/quotesright] despite his 25-plus years in the business. The development of a true team approach to servicing the client allowed for a smooth transition.

Second Tier Management

At inception, an owner puts together a team of people to help the business move forward. Hiring is based on the company’s needs but also on what the business can afford at the time.

Over the years, the business has success, growing from $1 million in revenue to $5 million and then to $10 million. The company has different needs and different resources. The owner’s original team may no longer be optimal. A larger and more complex enterprise needs a more effective management team. [quotesright]It is no longer acceptable for the owner to be involved in every decision and have managers execute on the owner’s wishes. [/quotesright]

We were asked to visit a business a few years ago that had a long successful history of manufacturing and delivering a custom-made consumer product. Ownership had made an apparently successful generational transfer several years before. The new owner was still relatively young but was interested in selling the company.

It became apparent after some discussion that he had inherited several key managers that were ineffective and unable to help the business evolve in the direction it needed to continue its success. He was uncomfortable firing anyone that had been with the business so long and was someone his father had hired. [quotes]The owner was between a rock and hard place.[/quotes]

As a company expands, it can outgrow its current management’s capabilities. In a worst-case scenario, [quotesright]management (or lack of management depth) becomes an impediment to continued growth and actually begins to cost the owner more in lost profits[/quotesright] than the increased cost of hiring more qualified talent.

Ownership should work with the company’s outside advisors or bring in an HR consultant to periodically review whether the current management structure is capable of reaching the company’s goals.

As owners contemplate a transition, they often assume the new owner will bring in new managers. They can convince themselves to do nothing rather than confront a management shortcoming. Buyers will often bring in new managers. They will just as often reduce the sales price based on the perception that current management is inadequate and there is a cost (and risk) to creating a new team.

[quotesright]Buyers will pay a premium for a solid management team that does not need wholesale changes. [/quotesright] A good management “engine” will enable the new owners to execute their plan for growth to increase their opportunity for a solid return on their investment.

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-         by Greg DeSimone - Beacon Equity Advisors, Inc.