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February 1, 2018
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April 26, 2018

The importance of sharing bad news proactively

Consider the following case study:

You are the CEO of a privately-held company. Over the past several months you have been in a series of discussions with an investment firm regarding a capital raise for the business. Based on the end-of-quarter MIS reports that are on your desk, it is evident that the business has significantly under performed as compared to the budget which has been shared with the prospective investors.

What do you do?

a. Investigate the reasons for the under performance – understand if it is a timing issue, forecasting error, change in external environment, or something more fundamental with the business operations. Proactively reach out to the investment firm and inform them about the miss in budget as well as your action steps to address it.
b. Pretend nothing has changed. After all, the investment firm hasn’t committed any capital yet.Disclosing this one-time miss may lead them to lower their valuation for the business or even walk away from the transaction. Address the issue internally and hope for a turn-around in the next cycle.

The above scenario isn’t unusual. Budgets can be missed for a wide variety of reasons –internal and external. However, while management may not have been able to control the miss in the numbers for the quarter, they can absolutely control the communication around it.

First of all, let’s debunk the ostrich philosophy. The discovery of the under performance may be delayed but it always happens. Always. For investors, if it appears that an issue was not communicated proactively by the management team but was only disclosed when essential as part of the diligence process, it creates huge and even insurmountable doubts about the quality and integrity of the management team.

As investors, the concern at that time is less about the miss and more around the cause of the delayed disclosure. Is it a question of competence on the part of management or intent? Neither alternative is flattering for the management. If we believe it is intent, there is concern about what else may be hidden. If it is competence, that raises serious red flags in terms of management’s control over the business.

Businesses will invariably have their ups and downs, and projections, by their very nature, are susceptible to unknowns. What we value is the capability of management teams to handle unforeseen circumstances with maturity. As investors, we back management teams, not their business plans. Management’s reaction to unexpected outcomes informs our assessment of their ability to handle future issues or uncertainties.

Management’s behavior is also indicative of their perception of the relationship with investors. Do they view investors as true partners or as outsiders with whom information is only to be shared with on a strict need-to-know basis? Proactive sharing of information (good or bad) by management gives us comfort that we will be viewed as co-pilots rather than passengers on the growth journey. Surprises, as highlighted in a previous SCP thought piece, which point to a lack of open communication are grounds for us to walk away from a prospective transaction.

We understand that it’s not a pleasant call to have to make to a prospective investor to tell them that the budget numbers, which may have served as an anchor for valuation, have been missed. There will be questions –several of them in fact – from the investment firm to understand the fundamental reason for the slippage. After all, it is the investor’s job as custodians of capital to understand if the under performance is reflective of a fundamental change in the potential of the business and to determine if that does change their views on entry and valuation.

The silver lining is that these situations also offer the management team an opportunity to assess the sort of partner that the investor will be. Partnerships work well when things are good, but face their true test when the going gets tough. Management teams can use such opportunities to understand whether an investor is simply going to ask questions to apportion blame or truly help the management team work through issues. In the past, we have worked with portfolio companies to better understand and address whether a budget miss was a result of inaccurate forecasting methodologies, a change in the way we did business, or a broader market phenomenon. Timely identification of the root cause and proactive addressal can go a long way in strengthening the business and the partnership.

It’s important to keep in mind that under communication on the part of the company’s management also impacts the investment team’s credibility. They are batting for an investment in the company and sharing their conviction about the long-term potential of the business with their own investment committee. Keeping them in the dark undermines their professional credibility. If it turns out that the deal team was unaware of the under performance, it pokes holes in their own conviction about the business and the relationship that they have established with the management team.

Not the best way to start off a long-term partnership.

Trust is the most fundamental element in any partnership. Once broken, it is extremely difficult to rebuild. Even if the transaction goes through, the partnership has started off on the wrong foot. Budget projections going forward will be viewed with a heavy dose of skepticism as will other discussions with the management team.

In our investing experience, we have seen companies react in both ways. We were in active discussions with a company when it became apparent that they had not been forthcoming about revenue slippages and only divulged it when there was no other option. The breach in trust that the lack of communication created was a higher barrier for us than the under performance, and it led us to disengage from the conversations. Conversely, in another scenario, an under performance was disclosed along with the reasons for it. The timely disclosure helped everyone move to a resolution and action plan that was agreeable to all sides.

The importance of open, transparent conversations cannot be overstated. Obviously, a miss in budget is disappointing, but if handled correctly, everyone can move past it in an amicable way and continue the conversations. Investors realize that a miss against budget can happen even after they have deployed their capital. Upfront communication from the management team on the reasons for the slippage along with their plans for addressing it, enhances the level of comfort and confidence in the investor’s mind because it provides evidence of how the leadership of the company will handle such situations should they arise in the future.