[Top tips & case study] Understanding economics
In part three of a series of PM Forum articles on ‘the seven habits of a commercial adviser’, Ben Kent and Adrian Furner discuss how advisers need to demonstrate an understanding of economics. [Habit 3]
What does ‘economics’ mean to you? Traditionally it is a difficult term to grapple with. A formal definition would be ‘the study of the production and consumption of goods and the transfer of wealth to produce and obtain those goods’. For many, the definition of economics goes much wider than this which is why it can be hard for advisers to grasp what it really means to their clients.
Understanding financial documents such as the balance sheet and the profit and loss account is only part of it.
‘Understanding the economics’ means not only understanding how your client makes money, but how the advice that you are providing will impact on this.
Three main steps to economic understanding:
- Organisational economics – understanding how your client’s company is structured, how and when it reports its financials, the internal reward structure.
- Macro and market level economics – understanding how your client fits into the wider world/their market, now and in the future.
- Transaction economics – understanding the economic drivers and implications of the specific opportunity.
A commercial adviser not only has a good grasp of these areas, but is able to articulate them clearly to the client. They are able to identify and articulate the value that they have brought, as well as any potential risks to the client, in financial terms.
To achieve this, numeracy is a key competency. Numbers are the language of business, but many professionals are tongue tied. A lack of financial fluency can put professionals at a grave disadvantage. It excludes them from the serious c-suite conversations and makes it difficult to justify the value of their recommendations. “If you can’t quantify what impact this project will have, why should we pay you £100k?”
In my 25 years of doing this I have met two lawyers who can add up which means it’s difficult for them to be commercial. They delineate between that which is a commercial point and that which is a legal point and shouldn’t. I’m not paying £1000/hr to make all the difficult decisions, I’m paying for someone else to not just advise, but to make a decision. Dr. Robert Easton – Managing Director, Carlyle Europe
A useful way to understand this is by looking at a typical M&A transaction. Ben Kent shares his experience and tips.
I started out my career in the corporate department at a Magic Circle firm. I worked on a series of acquisitions, but my understanding of finance was limited. I now realise that a better understanding of M&A economics would have really helped
me deliver better quality, more focussed advice.
At its heart M&A economics is quite straightforward. Financiers generally value a business by analysing three factors:
- The value of its assets
- Its ability to generate future profits. Many will use a Discounted Cash Flow model (DCF) to do this
- The value of comparable companies.
This will give you a base price, ie. the price of the business if it was sold as a standalone business.
Financiers then look at potential synergies to calculate the benefits of two businesses merging (on the principle that one plus one should equal three). This will push the price up:
- Cost synergies include savings from sharing head office costs, rationalising property or shedding staff.
- Revenues synergies are the additional revenues you achieve by crossselling additional services to each firms’ customers.
It is critical that lawyers understand the valuation model and which synergies are driving the price. It enables the lawyer to
focus due diligence and negotiation of the sale and purchase agreement on the issues that really matter. For example, if
the deal is driven by revenue synergies it is critical to review contracts with customers and make sure that the sales teams are locked in. If the sales teams leave then the revenue synergies will be nearly impossible to deliver.
Unfortunately many lawyers are not given enough financial training to understand these points and as a result focus on points that are commercially irrelevant.
[This article originally appeared in professional marketing magazine. For further details go to www.pmforumglobal.com. In the next issue: Habit 4 – Understand the people]