Recession-proofing important for SME owners

(April 2008) Economic optimism among Canada’s small business owners has led to a widespread lack of contingency planning, a new Harris/Decima report commissioned by BMO Bank of Montreal concludes.

The survey found more than three-quarters (77%) of 777 Canadian small business owners with $5 million in revenues or less describe the Canadian economy as good, while a further 9% describe it as excellent.

In addition, a staggering 92% believe they can withstand financial difficulties despite the fact two-thirds of them say they have no contingency plan in place in the event of an economic downturn.

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“While it’s encouraging to see such optimism among small business owners, a contingency plan should be of paramount importance, particularly in times of economic volatility,” says Gail Cocker, senior vice-president, commercial banking for BMO Bank of Montreal. “From our experience, the best time to develop and review contingency plans is during good times, rather than scrambling to adjust during a sudden downturn.”

The study found the retention of business savings is the most popular form of dealing with financial challenges. More than half of small business owners opt to use their savings for future protection, and over 40% say they are prepared to put their own personal savings to use in the event of a financial downturn.

Small business owners also indicated cost-cutting as a way to fight lean times. Streamlining processes was popular among respondents, with half opting to identify inefficiencies as their contingency plan.

“It is different from business to business. Generally, when there is anxiety about the future as far as the economy is concerned, business owners will restrict their spending. It makes sense for a large part. You also want to make sure they have enough emergency funds on hand in case the slowdown is much more protracted than you expected,” says CFP Tina Tehranchian.

According to Tehranchian, who is the branch manager for Assante Capital Management in Richmond Hill, Ontario, for relatively young businesses, slimming down and relying on cash-on-hand may not see them through tough times — even if it is a great business model.

She says one of the first things small business owners should do is ensure they have access to a line of credit from a good commercial banker. This will ensure the business can survive and develop if a recession coincides with its early critical years of development.

“During the first few years, a few bad months of poor income could kill a great business,” she says. “For a lot of micro-businesses, banks require personal guarantees on their loans. What it really comes down to is making sure they do have a line of credit — even if it’s on their home.”

Tehranchian only brings up the home-equity line of credit because it is the most common form of collateral clients have that ensures them a lower interest rate, which is crucial to have during lean times. She stresses a home-equity line of credit is not for all investors. She only suggests it to clients who are disciplined and are only going to use it as a way to safeguard their business. It’s not to pay off consumer expenses.

If the business owner is married, and the spouse has a strong income from another line of work, then an advisor can try to use that to get a preferential interest rate on an unsecured line of credit.

More mature or well-capitalized small businesses can probably ride out a short-term crimp on income, says Mark McNulty, an investment advisor with Raymond James McNulty Group.

Ninety-five per cent of McNulty’s clients are dentists and he says an economic decline does cut into their lucrative cosmetic dental business. Generally, they have enough personal net worth and run businesses that can generally sustain themselves during a decline in business, since much of their practice is derived from insurance.

McNulty says his job as an investment advisor is to make sure his client’s wealth is not too deeply impacted by the financial markets.

“When it comes to investment management, we use what we call a ‘don’t screw up investment management philosophy.’ Money from their business is going to be their main financial driver. It’s not going to be investment returns,” McNulty says. “We want to keep pace with inflation and make a 2% to 3% real return; we don’t want them to take any significant risks. They have an actual impact on their business as opposed to an uncontrollable investment management. If there is a stock market downturn, our clients aren’t going to have to worry about that; they can just focus on their business.”

One tricky planning issue for clients is the timing of selling their business. McNulty believes it has always paid to wait out economic downturn before selling the business — assuming the business owners can do so.

McNulty also says tighter credit conditions mean there will be fewer buyers for his clients’ businesses, where the projected investment returns from the cash flow can be quite substantial. The money a dentistry practice should earn over the next three to five years will generally outperform the proceeds from a diminished sale price on the business.

“When you are selling a business, take a dentistry practice as an example, you are selling a huge cash flow. What that means is the seller is giving up that free cash flow. Typically, you see investment return on the capital you have invested in business somewhere around 20%. Tell me where you are going to get investment returns where you get 20% on your investment and you have control on the outcome of the business.”

As far as personal investment savings go, if a client thinks there is a real chance the business might not survive, Tehranchian suggests the client consider moving his registered long-term assets to creditor-protected segregated funds.

“This strategy really works better the longer the assets have been the insurance company because the longer you’ve had the assets in the seg fund, the more success you’re likely to have in court retaining those assets,” she says.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com (04/17/08)