Diversification strategy for SMEs in India- Tread carefully
Many SMEs are looking for diversification strategy to overcome the challenges associated with existing businesses. One needs to tread carefully or it may end in disaster.
Recently I had an opportunity to interact with a successful real estate builder who has been successfully executing many projects in Tier II category of the market remain to focus on value for money transactions without brand identity.
In recent time he has been getting jittery about the long-term stability of his business and mainly compelled to feel so by demonetisation and introduction of RERA. While demonetisation had sucked into liquidity in the Tier II space in real estate industry, RERA has raised entry barrier and imposes a rigorous regulatory burden upon builders.
Against this backdrop, he started exploring diversification strategy to migrate to more long-term and stable revenue generating business. They scanned for opportunities and interacted with their friends & relative and narrow down to set up a luxury hotel in their city. The decision was not difficult as they were very familiar with the economic geography and they own a very good land parcel on an arterial road in the city which connects to all important destinations quickly.
They decided to enter into this business rather hastily. They sought the help of their own accountants prepare a business plan to secure bank funding.
They started working on the project and started construction work on the site with their own resources which anyway will be adjusted as their contribution by the bank while sanctioning the loan. However, to their dismay, the bank refused to consider the proposal as they found it is unviable.
The matter got complicated for them. They were helpless and desperate to tie up the funds to complete the project and are scurrying for funding.
The concerns around their strategy of diversification:
When I analysed their report I found that the project report submitted to the bank has too many deficiencies. The benchmarks taken to establish viability were too high and unrealistic. They have no knowledge of running the hotel business. The business environment is not conducive to support premium hotel which they are proposing. As they have no knowledge, there is no proper understanding of operational strategies post construction.
Why Firms Diversify?:
Every business, successful/unsuccessful, looks at diversification of revenue base as a strategy for many reasons. The reasons may be broadly classified as below:
– To grow the balance sheet
– To more fully utilize existing resources and capabilities.
– To escape from undesirable or unattractive industry environments.
– To make use of surplus cash flows.
The above are moved by economic interest. In India, we have another reason for diversification. Many of the businesses are considered less appealing in social terms. Hence those who attained success in such businesses tend to diversify into more glamorous one to attract social attention.
Diversification and SMEs:
SMEs fear that they may face possible extinction when falling behind the fierce competition in the marketplaces. Whenever there is new regulation governing the industry, undoubtedly, SMEs business viability will become a big question mark in that segment. Given the limited current capabilities, SMEs may face substantial hurdles to constantly expand the business scope. Diversifying business activities may well be the option that those SMEs attempt to pursue as a way of breaking-off the limitation wall.
Diversification into unrelated areas may be prompted by any of the following:
– after a core business has matured or started to decline.
– to reduce cyclical fluctuations in sales revenues and cash flows.
– to overcome the new entry barrier like new laws.
Evaluation of opportunities:
Diversification decisions involve two basic issues:
a) Is the industry to be entered more attractive than the firm’s existing business?
b) Can the firm establish a competitive advantage within the industry to be entered? (i.e. what synergies exist between the core business and the new business?)
Having decided to diversify, the businesses confront with choices to move on. However taking such decision is no mean task for SMEs as the intellectual capital to support such an initiative is quite low in-house. Secondly, many of them are not familiar with tools and processes for undertaking an analysis of alternatives to choose from. Porter’s three essential tests are one such approach to ease the process of selecting an alternative.
Porter’s three essential tests:
To ensure that companies are diversifying to create long-term value, Michael Porter has devised three tests, which need to be fully satisfied.
1 Attractiveness test
a) Aims to ensure that diversification is directed towards an attractive industry.
b) Assesses the factors in Porter’s five forces to determine if something is attractive since firms can sometimes pay too much to enter.
2. Cost of entry test
a) Ensures the cost of entry does not capitalise all future profits (i.e. only do it if it can be done cheaply).
b) This test tends to act as the main culling factor for diversification.
3. Better off test
a) The new business unit must gain a competitive advantage from its link with the existing business or vice versa.
b) If it does not fit into the firm’s present, then a firm should not proceed with diversification even if it is cheap. It also needs to have synergies to share resources and capabilities for the long run.
One can infer that diversification strategy if related to existing business it can be beneficial. In the instant case, the common denominator is their expertise in the construction business. Though an important contributor to the success of the project, its role is minuscule in the overall picture of elements that goes into hotel business to make it successful.
How to mitigate the risks from diversification:
We have been emphasising the need to have well prepared prudent financial plan to mitigate the risks. The prudent financial plan flows from well thought out business strategy.
Secondly, it is not necessary that one should not diversify into unrelated areas. One should try to get himself abreast with the nuances of the new venture or hire an industry veteran as partner or launch in a limited way to get the feel of the industry before making the full-scale investment.
An entrepreneur should plan well before embarking on investment.
The desire to escape stagnant or declining industries has been one of the most powerful motives for diversification. But, growth strategies tend to destroy the wealth and standing acquired if not handled properly. Diversification plans in SMEs face important limitations in resources and lack of functional skills. These are causes of failure of many well established SMEs.