Diversification: A significant transition risk for MSMEs
By Distress Management, Financial planning, Risk Management, Transition

Many entrepreneurs opt for diversification to mitigate the risks from existing business. However, success depends upon how well it is handled from the beginning.

Recently I had interacted with an entrepreneur who is setting up a new business in an altogether new vertical. His existing business is doing very well. There is enough buoyancy in the order flow and he could almost overcome the challenge from COIVD 19 lockdown. However, having seen the volatility in the business he started exploring the ways and means to mitigate the risk to himself by diversifying into another area which is not sharing the same type and level of risks the present business is witnessing.

During the interaction, I could found his approach was very detrimental to his own interest and there are very chances of harming himself if he takes that route.  I would like to summarise in the following points:

  • He asked his senior executive to hire a person to prepare DPR (Detailed Project  Report). He, in turn, hired a consultant having long years of experience and got the DPR done.
  • The entrepreneur did not involve himself during the course of the preparation of the report  and the author was asked to submit the final report
  • The assumptions were outdated and not reflect the present situation in the industry.
  • Strangely the DPR is not exactly aligned to the objectives set by the promoters
  • DPR is prepared with an aim to secure the bank loan; not a document to help the entrepreneurs to understand the nuances of new business.
  • It does not explicitly say whether it is worth pursing;  how is the reward structure for investors.
  • No risk analysis from the perspective of the entrepreneur and mitigations they suppose to look at.  
  • Packed with download from search engines, the DPR does not discuss the technical feasibility to the point of relevance.

Transition Risk for MSMEs

The change is an integral part of the entrepreneur‘s journey. In the normal course within the existing business,  these changes are brought in the incremental way to align with new trends,  introducing new products as per the customer requirements or compliance the new regulations etc.. It rarely requires external help except for some highly specialised interventions. In any case, the context and expected outcome are well within the comprehension of the entrepreneur. Thus there is little chance of failure due to the changes going to be implemented.

However, it is not the case with entering into a new venture where we have no knowledge or have any expertise.  Transition risk is a significant risk for MSMEs. We have studied many MSMEs which have failed during their transitional phase of diversification. We observed the common traits as below:

Hands-on involvement, a hallmark of their success in the first venture is notably missing in the subsequent ventures. It is a fact that the visibility of the leader and the day-to-day involvement of the entrepreneur in the operations is a potential advantage in the implementation of a new venture. We did not see that level of involvement in the proposed ventures among them. It can be attributed to their unwillingness to come out of their comfort zone( of running core venture).

Not enough deliberations, just pursuing ideas; sometimes just fancy ideas- Many a time the strategy of diversification is driven by the irrational perception of the potential of the opportunity presented than validated by the facts and figures. No attempts were made to understand key success factors of the opportunity and how we are placed to capitalise that.  The depth of deliberations is very shallow. Low level of preparedness including identifying key risks is quite evident.

No proper financial planning. In some of the projects, surprisingly they have initiated the construction without financial closure leading to midway stoppage of the work. No milestone, or no visibility of date to launch the commercial operations. In almost all cases the financial distress in the new venture just seeped to exiting one resulting in the loss of momentum in the well-run company.

Lack of HR strategy: It is a fact that when a company sets on the ambition of high growth or diversification, what is important is clear and unambiguous HR strategy that creates a sense of assurance and promote willingness among the employees to work passionately for the betterment of the organisation.

Absence of Internal audit: Having vested the responsibilities in the hands of the professionals is not enough. In an employee-driven business environment, there is a need for rigid checks and balances to oversee the performance and mitigate the risks.

Diversification is needed…

Many sectors show some sort of cyclicality of varying degrees. Any business faces a higher risk of a downturn and diminishing revenues when it caters to one product or market.  During economic uncertainties, small and medium enterprises are more vulnerable than their larger counterparts to this risk.

Diversification is beneficial for an entrepreneur to secure long-term financial stability. It is prudent to diversify into different products, industries, and markets.  This not only helps one to boost revenue but minimize risks associated with business uncertainties.

However, what is important is the degree to which the promoter involves himself in shaping the new entity matter the most to see its success.

We believe that the following measures help to reap the benefit of diversification:

  1. 360 degrees view of our preparedness and meticulous analysis of the opportunity.
  2. Entrepreneurs need to study the business plan  thoroughly before consenting to it
  3. Seek independent advisors to help to shape the venture however make a background check to validate their credentials. Give attention to conflict of interest, if any.
  4. The attention span required will remain as much as in the startup stage of the first venture.
  5. People make difference: It doesn’t matter how great your products or services if you don’t have great people, and if they are not being led by great leaders then you’re not going to be realising your company or organisation’s full potential. It is possible to groom people for excellence provided if we have a clear HR strategy.
  6. If you choose to operate through management team it is also necessary to have independent audit (internal & management) of the business on an ongoing basis to get a third party view about the state of affairs in the new entity. The ongoing audit will bring the checks and balances that there will not be surprises and shocks.

Conclusion:

The diversification strategy is good to beat the downturn in the existing core business and secure financial stability. However, its success depends upon entrepreneurs approach and policies.