Diversification is a complex business decision; a decision where one moves out of the comfort zone of the current business and expands into a new segment of an industry that the company is already in, or enters into a business outside its scope. And getting a fairly accurate risk-to-reward estimate makes this corporate strategy successful and helps sustain businesses in the current competitive environment. In this interview, Vinamra Shastri, partner and practice leader, business advisory services of accountancy and advisory firm, Grant Thornton India, shares some insights on diversification strategies for entrepreneurs.
What is your advice to entrepreneurs who want to diversify? Can you give us a list of things-to-do before a company decides to diversify?
Today’s market demands a clear corporate strategy, combined with a relentless focus from the management to implement that strategy. You need a clear understanding of your core capabilities, the strengths of the business and where your opportunities exist before putting together a diversification plan.
When do you think is the right time to diversify? How does a company decide this?
There is no right time to diversify; sometimes even the worst times could be used as opportune moments for introspection and new venture planning. However, there are some triggers that could define the diversification decision. One, if your business reaches a strategic inflection point, where sales and profitability plateau and you know that the business would slowly lose steam and eventually die out. Diversification into related businesses could lead the company out of the slump. Two, when expanding the value chain either up or down, making your business more lucrative; or offering you a competitive edge that you can leverage to garner greater market share. Three, diversification may also be a great decision if you know you have the distribution model in place which you can use to push other products or services. For example, if you already have a distribution network of 10,000 retail points selling your soap, it might make sense to diversify into shampoos and sell them through the same channels.
How do companies go about analysing the risk-reward equation?
The risk-reward equation can be analysed by evaluating two important numbers, the capital at risk (CAR); which would be the sum of initial capital expenditure and working capital margin required, as well as the funds to absorb operating losses forecast for the initial years. If the internal rate of return (IRR) is significantly greater than the returns that you can achieve from your existing business, only then should you even consider diversifying.
But knowing what to look at is the easy part. It is arriving at the current estimate of CAR and IRR for any new business planned that is tricky. The only advice I can offer is to be very thorough, pragmatic and conservative while arriving at these estimations.
How do companies ensure that they meet the challenges of their existing business and also make their diversification a success?
Most diversified companies use a portfolio-based approach to manage their portfolio of businesses. To succeed, essentially the CEO’s role has to change from being the business manager to a portfolio manager, who has to create value by ‘parenting’ businesses and considering synergies between them. This approach to corporate strategy is useful in deciding:
Which new business to enter?
What is your corporate business plan and does each of your businesses have a viable strategy that will generate sustainable profits?
Have you developed an appropriate business-fund allocation structure so you know what businesses you should invest in and how much you would invest?
Is there an opportunity to exit some businesses?
What should be the ideal people management policy in case of diversification? Is it good to request senior/proven executives to move to the new business or look at fresh hires?
For any business, people are often the only difference between success and failure. The success of any business depends on the allocation of appropriate management time as well as the right human resources. Having new people come in is a good idea, but you have to lend them corporate support by ensuring that the new management team also has old hands from the existing business, who you can trust and who can ensure that adequate resources are allocated to make the new business succeed.
Is it a good strategy to look for business synergies among various divisions within the company when they diversify?
Yes. It is always wonderful to have synergies, although one should be practical enough to not overstate the degree of synergies that exist.