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• Making a Business out of Knowhow -
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MANGING KNOWHOWBut the Cergus quartet found it hard to increase billings above £100,000 a head per year. The big money was being earned by the banks and the brokers who had the underwriting capacity. The reward for their 'risk' was a fee on each share sold to the public. Though Cergus would prepare the whole prospectus for a flotation they would receive only a small fraction of the fees earned by the underwriting banks.
The founders concluded that their original business idea of 'consulting' was not the most profitable long-term way to exploit their knowhow. They decided their skills would be much more profitably employed if they were selling broker- age and merchant banking services. For this they needed capital. Argus lacked the necessary resources to finance such a development and its leaders also felt that combining journalism with merchant banking posed ethical problems.
However, since the Cergus team were determined Argus gave them leave to seek backing from a wealthy third party who would take a majority stake in the company. Argus was to retain a symbolic minority holding.
Cergus soon found a new partner who was already active in the capital mar- kets but had no experience in the stock market. A new merchant bank was formed in the autumn of 1982. There were a number of start-up problems. Many new people had to be recruited and no-one in Cergus or the new parent had any experience in stockbroking or in how to manage the back-office of a merchant bank. In addition, the four founders themselves, though they relished the challenge of merchant banking, disliked the idea of being brokers.
The youngest disliked it so much he left and another soon followed. The two original entrepreneurs found themselves with a large number of newly recruited people, half analysts and brokers and half back-office staff.
The new parent appointed a representative to manage day-to-day operations but he knew nothing about the stock market. His lack of appropriate professional knowhow soon made his position impossible and he withdrew. The two founders were left to solve the managerial problems themselves.
The booming stock market buoyed up the brokerage operation but the profit in the first year was low. The parent company became concerned but had no idea how to handle the situation. It was, in any case, heavily pre-occupied with making other acquisitions and so had little spare management capacity.
The Cergus management team - by now increased to five - considered their strategy. They found pure broking as a long-term business idea uninteresting but thought their considerable skills in financial analysis could become the basis for a portfolio management and investment banking business. Without informing their parent they recruited more financial analysts.
In its second full year as a broking firm Cergus earned SKr50m (£5m), well in line with the market average. The profits came mostly from the brokerage business but portfolio management was showing good progress too. By now the company was employing 60 people, considerably more than its original parent Argus, and profit per employee had risen to the £90,000 a year level.
However, the managers of Cergus feared that this profit level would not be sustainable in the long-term since it was largely the result of booming market
MAKING A BUSINESS OUT OF KNOWHOW - THE BUSINESS IDEA
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conditions. New entrants into the stockbroking market, several of American and European origin, were putting pressure on margins. The managers felt Cergus needed a strong, international partner.
The parent company managers disagreed. They believed the future was bright in brokerage and were wary about bringing in another partner who would dilute their interest and might pull Cergus away from them. They were doing very nicely out of Cergus, Its rapid profits growth had increased their own profits by 50% in the previous year.
The disagreement festered and in the autumn of 1984 developed into open conflict. A large institution acquired 50% of the parent in an agreed takeover.
The Cergus management had been kept in the dark during the merger nego- tiations and when the staff and managers found out they objected strongly to the new arrangements. The 35 professionals were particularly angry and demo- ralised.
During a stormy week in the autumn of 1984 the two founder members were fired. They went straight to a competitor and during the following month another 25 professionals, some three-quarters of the revenue producing team, left. Most of them went to join the founders despite the generous golden handcuffs proffered by the new owner.
Cergus had previously estimated its market value at about £35m, equivalent to £600,000 per employee or £1m per professional. When the news broke the parent group's market value slumped by £10m in one day. That implied a value for Cergus of £15m. Its value had more than halved within a month.
• Lessons to be learned
The story of Cergus contains a number of clues about how to value knowhow companies, how to make money out of them and about how not to manage them.
1. THE START-UP PHASE The start-up of Cergus was typical for a knowhow company. Money was no problem because all the capital they needed was in the heads of the founders. The start-up phase was easy because the network and the clients were already there. This is a common feature of spin-outs; the entre- preneurs are invariably well established in their market before they go into busi- ness. These contacts put flesh on the bones of the business idea and make the project viable.
The original parent Argus made the first strategic move by letting the sub- sidiary leave the premises. After that the connection between the companies was merely the sum of the relationships between the people. The decision to let Cergus go was deliberate. There was a feeling that physical separation was necessary because of inherent conflicts of interest, but it meant that in flying the nest Cergus became isolated from the Argus culture. After that it was just a question of time before it began developing its own strategy. This led to the next phase - the change of business idea.
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MANGING KNOWHOW2. THE NEW BUSINESS IDEA Cergus was very successful fight from the start and was quite profitable when it changed its business idea.
Creative consultancy is demanding, high pressure work and is well paid but a single consultant can only create a limited amount of added value if clients are charged on an hourly basis. The market itself imposes limitations on the price per hour or the 'billing rate' as it is sometimes called. Clients will simply refuse to buy the service if they are charged £1,000 an hour, for instance, even if it could be shown that such fees were a fair reflection of the value actually added by the work. Cergus, in common with every other consultancy, was unable to charge the actual value of its services. By comparison, the fees charged by the banks and brokerage firms were enormous.
It was thus natural to look for a way of exploiting the knowhow other than through straightforward consultancy. The solution Cergus chose was to link its knowhow to financial capital, thereby giving it 'leverage'.
At this time the value of the company was roughly £100,000 per professional - about £400,000 in total if anyone had been foolish enough to acquire it. A small consultancy firm with little need for financial capital has no need of external owners who can only contribute money.
But with their knowhow tied to a good, capital-intensive business idea the Cergus consultants were worth a lot more and they knew it.
3. ARGUS' STRATEGIC DILEMMA The management team at Argus was faced with a strategic dilemma. Professional ethics and the lack of financial resources made it impossible for Argus to fund the start-up of a brokerage firm.
But there was no way back for the Cergus consultants. They were eager to exploit the potential they saw on the booming stock market and anyway the relationship with Argus had become attenuated after the years of isolation.
Argus therefore decided to allow their colleagues in Cergus to develop their own strategy. If they had not done so there would almost certainly have been a row. Instead the two companies could now maintain a professional relationship and act as each other's ambassadors in their respective markets.
Argus acted like a true professional organisation. It preferred to preserve the relationship in a 'federation' instead of trying to keep the subsidiary within the formal framework of a conventional group. A normal industrial company would regard the Argus decision as pure folly, especially in view of the very high profitability Cergus was to achieve with its new business idea.
4. THE NEW PARTNER The new majority owner of Cergus was invited in by the Cergus management. They had a high regard for the company despite its lack of experience of the stock market. It is important to note, however, that its only contribution was financial.
When the new parent's management representative failed to win the respect of the Cergus professionals and thus the power to manage effectively, the parent made a serious strategic error: it withdrew and thereafter hardly involved itself at all in the activities of its new subsidiary. By not assisting the