By Hari Middleton
This week we are focusing on the topic of handling finances for your business, so we thought it would prove helpful to provide two case studies on businesses that were forced to file for bankruptcy owing to financial failings. By discussing the cases of The Lehman Brothers and RadioShack, a few clear takeaways and essential lessons can be observed and implemented when managing your start-up’s finances.
The bankruptcy of the Lehman Brothers –
While I am sure that Ryan Gosling did a better job explaining this in the 2015 Oscar winner ‘The Big Short’, I will try my best to do it justice! The 2008 financial crisis was caused by a large chain of events. A housing bubble emerged throughout the US; a bubble is defined as an item that is priced above its actual worth. This ‘bubble’ was a result of three main factors:
1. Value of houses increased by over 130% throughout the US from the mid-90s to 2007.
2. Banks offered low-interest rates which encouraged more people to take out mortgages.
3. Decline in mortgage standards with banks lending to sub-prime borrowers (people with low creditworthiness)
Yet when demand for housing reduced the ‘bubble’ started to burst, resulting in many people defaulting on their mortgages. While banks then started selling the properties that had been used as collateral to reclaim much of its money, they soon realized that the property prices had dropped so much that they lost money. This led to what is now known as the ‘sub-prime mortgage crisis’.
The Lehman Brothers were particularly at risk from this crisis, having in the past been described as a ‘real estate hedge fund disguised as an investment bank. This was a very appropriate description given the amount of money they had borrowed to keep on investing, which meant that the Lehman Brothers gearing ratio was an astounding 44:1 in 2007. As a result, in 2008 the Lehman Brothers were left with no choice except to file for bankruptcy, which in turn became the largest in US history.
Lessons to learn from this case:
While of course, this case addresses an example that’s scale is significantly (ever-so-slightly) larger than that of the start-ups we are working on. Nevertheless, it provides some key universal lessons that can be applied to a start-up of any size.
Poor risk management — This came about through taking on extremely large amounts of loans to invest in mortgages. Furthermore, it is financial rule number 1 that you don’t invest borrowed money. This shows how important it is to keep the companies leverage at a sustainable amount.
Lack of adequate regulations — This allowed customers with poor credit scores to take out mortgages that realistically would never be repaid. Thus, showing just how essential it is to have clear rules and regulations regarding financials. Especially when offering customers credit or else ‘bad debts’ can arise.
Eggs in one basket — Given Lehman Brothers almost sole focus on housing, when the housing bubble burst, they were left in a position they could not leverage their way out of. Highlighting the importance of diversification throughout the business as a way to help reduce the risk.
RadioShack or ‘The Shack’ as they became known, was once the go-to location to pick up the latest technology and electronics having over 4000 stores across the United States. Nevertheless, through a broad variety of financial and strategic mishaps, in 2015 they were forced to file for bankruptcy.
Despite, Bob Dylan telling the world in 1964 that ‘The Times They Are a-Changin’, it appears that RadioShack didn’t get the message. By failing to correctly identify competition and emergent trends RadioShack was unable to adapt and evolve into an e-commerce retailer. Such a failure to move stores online left RadioShack stuck with brick-and-mortar stores and a host of other issues. Namely product cannibalisation occurred with many of its stores taking revenue from each other, as denoted by the outrageous fact that RadioShack once had 25 stores all within a 25-mile radius in Sacramento, California. This led to severe cash flow issues for RadioShack, a factor worsened by the expensive nature of storing inventory when not operating through a centralised hub.
Typically, when struggling with cash flow businesses will take out finances to ensure they don’t go solvent, and this is exactly what RadioShack did. However, when they received a loan from Salus Capital in 2013 the agreement clause stated that without prior consent they could not close more than 200 stores a year. Consequently, in 2014 RadioShack was forced to file for bankruptcy when they ran out of cash and were subsequently unable to close down stores.
Lessons to learn from this case:
Cash really is King — As the CEO of Volvo, Peter Gyllenhammer once said ‘Cash is King’, and this has proved the case again with RadioShack. Without such cash flow issues, RadioShack would not have needed to take out a loan with bad terms. Thus, we recommend that all small business owners keep and maintain a cash flow statement. You can find many tools online but one of our favourites is from the Association of Chartered Certified Accountants
Be careful about who you accept finance from — One of the main reasons behind RadioShack’s bankruptcy was the fact that as per the loan agreement with Salus Capital they were unable to close stores when they needed to. Therefore, whenever you are discussing receiving finance, always do lots of background research and make sure that you go over the contract with a lawyer.