Mid-Cap Business Strategies:

Mid-Cap Business Strategies: How Mid-Caps Think about Growth and Financing, How Motivated They Are for Growth, What Drives Their Ambition, What Are Their Major Concerns or Worries A COMPAS Report for Roynat/Financial Post COMPAS Inc. Public Opinion and Customer Research September 10, 2004

Contents 1.0. Introduction...3 2.0. Growth Strategies...4 2.1. Capture Market Share for Existing Product Above All Not M&A, Diversification, or Expansion Abroad...4 2.2. Three Types of Strategies Market-Based Strategies vs. Product-Based Strategies vs. M&A s...6 3.0. Financial Strategies...8 3.1. Traditional Sources over Modern Sources: Retained Earnings, Tier One Banks, and Personal Investment, Not Merchant Banks, Venture Capital, Government, IPO s, and Divestiture...8 3.2. Retained Earnings Offer Advantage of Low Cost but May Impede Cash Flow...10 3.3. Ambivalence about Tier One Bank Interest Rates...12 3.4. Merchant Banks are More Flexible but May Not Offer Best Interest Rate...13 3.5. Government Programs Offer Lower Interest Rates at Expense of Bureaucratic Burden...15 4.0. Growth in the Minds of Mid-Cap Executives...17 4.1. Ambition Half Committed to High Growth, Many to Moderate Growth, 14 to No Growth...17 4.2. Profitability the Biggest Motivator for Growth Psychological Motivators Far Behind...17 4.3. Growth Factors and Challenges to Consider The Goal of More Customers and the Concern about Finding Good Staff...19 2

1.0. Introduction Business strategy is the theme of this third in a series of quarterly surveys of midcap companies for the Financial Post under Roynat sponsorship. We look at growth strategies, growth motivators, financing strategies, and key worries. The key findings are as follows: Seeking to develop and build market share is by far the most important of nine possible strategic growth options, far ahead of M&A, going abroad, strategic collaboration, and other options; Retained earnings are the first source of capital used by Midcaps to finance growth, followed by personal investments retained earnings have potentially significant drawbacks, according to business leaders, including impeding cash flow thereby limiting growth and reducing profit to shareholders; The thirst for growth is driven above all by a desire for profit the goal of heightened morale is not a major motivator; Midcaps greatest concerns or worries relate to finding good staff and management and treating customers well finding capital and dealing with government are lesser concerns. A total of n=300 CEOs or equivalents of mid-cap firms (i.e. sales of $10- $100 million) were surveyed in August 2004 by professional interviewers using CATI 1 (telephone). Samples of this size are deemed accurate to within 5.7 percentage points 19 times out of 20. 1 Computer Assisted Telephone Interviewing 3

2.0. Growth Strategies 2.1. Capture Market Share for Existing Product Above All Not M&A, Diversification, or Expansion Abroad How Canadian midcaps go about achieving growth is one of the most intriguing issues for business school professors of strategy, business journalists, and entrepreneurs alike. For their part, the CEOs of midcaps need to consider both their own strategies for growth and those of their direct competitors. The most traditional strategy of seeking market share remains by far the dominant choice for business leaders according to the COMPAS/FP survey of the leaders of midcap firms conducted under the sponsorship of Roynat, as shown in table 2.1A. Increasing a firm s share of the existing market for existing products is the only one of nine different strategies that a majority of business leaders say they follow. Almost two-thirds (64) of respondents score this option above the midpoint of 4 on the 7 point scale. Building market share is not only the prevalent strategy among businesses as a whole, but it is especially so among the most growth minded companies. As mentioned, COMPAS asked business respondents to indicate to what extent they embraced each of 9 practices for expanding the firm s position. COMPAS also asked respondents to score on a 7 point scale the degree to which the firm was committed to growth. From statistical analysis, it emerges that the desire to expand rises with plans for growing market share more (r=.345) 2 than with any other type of expansionary strategy. Commitment to development market share is stronger among the most growth-minded companies (those scoring 6-7 in their commitment to growth) than among the others. The mean commitment to market share development is 5.3 in this group compared to 4.6 among those that are moderately growth-minded (scoring 4-5 on the growth scale) and 3.5 among those with the lowest growth mindedness (scoring less than 4 on the growth scale). 2 No other expansionary practice yields a correlation above.300 when measuring the relationship between desire to expand and the various expansionary practices. 4

Table 2.1A: And using a 7 point scale where 7 means a lot and 1, the opposite, to what extent is your company planning to pursue the following types of expansionary practices? [RANDOMIZE] Mean 7 6 5 4 3 2 1 DNK Market development, expanding the market or stimulating demand for 4.8 21 18 25 14 7 4 10 1 the product New product introduction 4.2 21 15 15 10 8 7 21 2 Geographical expansion, expanding within 3.6 18 7 14 9 9 8 33 1 Canada Strategic relationships, for example collaborating with non-competing 3.5 9 12 12 13 14 11 27 2 company to target the same potential clients Natural or organic expansion without much 3.1 9 6 11 14 12 11 35 4 organized planning Horizontal expansion, for example buying out a 2.8 9 4 12 10 9 8 46 2 competitor Foreign expansion, expanding to a foreign 2.4 9 7 5 5 5 5 62 3 market Vertical expansion, for example buying out a 2.1 2 3 8 5 10 11 59 2 supplier or customer Diversification, going into an unrelated business area 2.1 2 5 6 8 7 13 58 1 5

Far below market share development as a priority is new product launches in second place. The introduction of a new product earns a mean score of 4.2, barely above the midpoint on the scale. Only a minority of businesses embrace each of the remaining strategies for growth: expansion across Canada, strategic collaboration, organic expansion without planning, acquiring a competitor, going abroad, acquiring a supplier or customer, or diversification, in descending order of choice. 2.2. Three Types of Strategies Market-Based Strategies vs. Product-Based Strategies vs. M&A s Up to this point we have described the relative appeal of various expansion strategies. Here we examine the underlying structure with which mid-cap leaders perceive their growth strategy options. We derived business leaders mental maps of their strategic options by means of a multivariate statistical technique known as factor analysis. It emerges that mid-caps classify expansionary practices into the three categories of mergers and acquisitions, market-based, and product-based expansion, as shown in table 2.2A. The mergers and acquisitions factor, dimension, or way of thinking is comprised of horizontal expansion, vertical expansion, and strategic alliances. The market-related factor is comprised of natural or organic expansion, market development, geographic expansion within Canada, and foreign expansion. Product-based expansion includes new product introduction and diversification into unrelated business areas. Mid-caps are significantly more likely to plan for market-based expansion (factor mean 3.5) than product-based expansion (factor mean 3.2), or mergers and acquisitions (factor mean 2.8). Those mid-caps with the least commitment to growth (scoring less than 4 on the 7 point growth commitment scale) score lowest on each of these factors or ways of looking at strategic options. Respondents from the low growth companies assign significantly lower scores to each of the three categories of expansion than do those committed to moderate growth or high growth. 6

Table 2.2A: Three types of expansion: Mergers and Acquisitions, Market-Based and Product-Based as Identified through Factor Analysis Mergers and acquisitions.852 3 Marketbased expansion Productbased expansion Q2A - Horizontal expansion, for example buying out a competitor Q2B Vertical expansion, for example buying.730 out a supplier or customer Q2H - Strategic relationships, for example.509.424 collaborating with non-competing company to target the same potential clients Q2I - Natural or organic expansion without much.736 organized planning Q2G - Market development, expanding the.733 market or stimulating demand for the product Q2D - Geographical expansion, expanding.422.452 within Canada Q2C Foreign expansion, expanding to a.417 foreign market Q2F - New product introduction.807 Q2E - Diversification, going into an unrelated.663 business area Factor mean 2.8 3.5 3.2 3 The numbers in the cells of the factor structure are loadings or correlations between each variable (e.g. Q2a) and the mathematically derived factor. A loading of 0.852 signifies that there is a correlation of + 0.852 between Q2a and the first mathematically derived factor, which we have termed mergers and acquisitions. 7

3.0. Financial Strategies 3.1. Retained Earnings, Tier One Banks, and Personal Investment, Not Merchant Banks, Venture Capital, Government, IPO s, and Divestiture Most mid-caps use traditional sources of financing to fund their expansion. In practice, 73 of mid-caps surveyed use retained earnings, 4 60 obtained financing from the Big 4 banks, and 58 have used personal investments to fund expansion, as shown in table 3.1A. By comparison, few respondents have used venture capital (11) or divestiture of capital (10) or equity (12) to finance expansion. Over one-quarter (28) of mid-caps use merchant banks. Table 3.1A: With respect to accessing financing or capital to fund growth or expansion, which of the following has your company used? [ROTATE BUT ENSURE D ALWAYS FOLLWS C] Yes No DNK/REF Retained earnings 73 25 3 Financing from The Big 4 or Tier 1 banks 60 38 3 Personal investment 58 40 2 Financing from merchant and other smaller banks 28 70 2 Government programs, for example the 20 78 3 Business Development Corporation Divestiture of equity, for example an IPO 12 85 3 Venture capital 11 85 4 Divestiture of capital, for example selling equipment or technology 10 88 2 4 With respect to accessing financing or capital to fund growth or expansion, which of the following has your company used? 8

Venture capital and divestiture of equity appear to be especially useful to those considering horizontal or vertical expansion. For example, those who say they have used divestiture of equity are significantly more likely to plan for horizontal expansion than those who have not used divestiture (mean 3.9 vs. 2.7). A similar pattern occurs among those who have used venture capital. Those who have used venture capital are also especially apt to plan for geographic expansion (mean 4.5 vs. 3.4 among those who did not use venture capital). The traditional means of financing will continue to be at the top in the future and elicit heavy repeat usage. In practice, 77 of respondents say their company will consider using retained earnings in the future, as shown in table 3.1B. This group is comprised largely of repeat users. For example, 93 of those who used retained earnings to fund growth will consider using retained earnings again. Following an analogous pattern, 65 of respondents would use Tier One banks in the future, including the 86 of current Tier One bank users who would use this source again. Fifty percent of respondents would use personal investment in the future, down nominally from the current level of 58. The projected drop is likely due to the fact that only 72 of those who have used personal investment to fund expansion would do so again. Merchant banks are projected to play an increasing role in funding expansion. Thirty-nine percent of mid-caps say their company would consider using merchant banks in the future compared to a current level of usage of 28. Eighty-three percent of past users would use a merchant bank again in the future. Meanwhile, venture capital (19) and divestiture of either equity (17) or capital (16) will remain the least popular means of financing growth. Mid-caps are least apt to repeat usage of divestiture of capital (55), divestiture of equity (67), and venture capital (58). 9

Table 3.1B: And which, if any, would your company consider using in the future? [READ LIST IF NECESSARY AND ROTATE] Yes No DNK/REF Retained earnings 77 19 4 The Big 4 or Tier 1 banks 65 32 3 Personal investment 50 47 3 Merchant and other smaller banks 39 57 4 Government programs, for example the 37 60 3 Business Development Corporation Venture capital 19 77 4 Divestiture of equity, for example an IPO 17 80 4 Divestiture of capital, for example selling equipment or technology 16 81 3 3.2. Retained Earnings Offer Advantage of Low Cost but May Impede Cash Flow Retained earnings are perceived to offer the advantage of low cost but may impede cash flow. Business executives were asked to volunteer the principal advantages and disadvantages of using retained earnings to finance growth. 5 Over one-fifth (23) volunteer responses related to low cost or low interest as the principal advantage of retained earnings. Other advantages volunteered, in declining order of importance, are retention of control or limitation of third party influence (18), no debt on the balance sheet (15), and ease of access (10), as shown in table 3.2A. 5 With respect to using RETAINED EARNINGS to finance growth what are its principal advantages and disadvantages? 10

Table 3.2A: Principal Advantage of Using Retained Earnings to Finance Growth Low cost/ no interest 23 Limiting third party influence/ retaining control 18 No debt on the balance sheet 15 Easy/ accessible 10 Growth/ building net worth 6 Not as risky as outside financing/ reduce liability 5 Other 9 Don t know 8 Refused/ no response 7 Percentage of We do not use retained earnings excluded from calculation 4 Impeding cash flow appears to be the principal disadvantage of using retained earnings to finance growth, according to 18 of participants. Other disadvantages are reduction of profit to shareholders (11), risk of using own money (11), and that it limits growth to available capital, as shown in table 3.2B. One-fifth (22) of mid-cap respondents nonetheless volunteer that there are no disadvantages of using retained earnings, as shown in table 3.2B. Table 3.2B: Principal Disadvantage of Using Retained Earnings to Finance Growth Impedes cash flow 18 Reduce profit to shareholders 11 Putting your money at risk/ using your own money 11 Limits growth to available capital 8 Reduces equity base 5 There are no disadvantages 22 11

Other 8 Don t know 6 Refused/ no response 10 3.3. Ambivalence about Tier One Bank Interest Rates Respondents were asked open-ended questions about the advantages and disadvantages of turning to Tier One banks (tables 3.3A and B) as well as comparable feelings about merchant banks and governments, reported later. Interest rates emerge as an issue, dividing respondents into those who see the large banks as providing superior or inferior rates. Mid-caps are nearly equally apt to volunteer that Tier One interest rates are a principal advantage (19) 6 as they are to volunteer that Tier One rates are a disadvantage (25). Other evidence of some polarization in attitudes towards the large banks is that 9 of respondents see no advantages in financing from Tier One banks while 12 see no disadvantages. Security (13) and availability (13) are notable advantages of using Tier One banks to fund expansion while restrictions (20) and inflexibility (12) are notable disadvantages. Table 3.3A: Principal Advantage of Using Financing from Tier One Banks to Finance Growth Lower interest rates 19 Tier one banks are more secure/ stable/ offer more services 13 Availability of larger amounts of financing 13 Less paperwork/ easier/ faster 11 Easy access to funds 7 6 With respect to using FINANCING FROM TIER ONE BANKS to finance growth, what are its principal advantages and disadvantages? 12

Using outside money/ not tying up capital 6 There are no advantages 9 Other 2 Don t know 10 Refused/ no response 9 Table 3.3B: Principal Disadvantage of Using Financing from Tier One Banks to Finance Growth Interest rates 25 Too much control on your business/ too many restrictions 20 Inflexible/ slow/ impersonal 14 There are no disadvantages 12 Other 9 Don t know 10 Refused/ no response 10 3.4. Merchant Banks are More Flexible but May Not Offer Best Interest Rate Respondents were asked questions about the advantages and disadvantages of merchant or small banks paralleling questions about the large banks. Better service emerges as the top advantage of merchant banks. Onethird (32) of respondents volunteer 7 service-related features such as personal and flexible as the principal advantage of merchant banks. 7 With respect to using FINANCING FROM MERCHANT AND OTHER SMALLER BANKS to finance growth, what are its principal advantages and disadvantages? 13

Merchant bank service receives three times as many mentions as the next nearest advantage, easier access to financing (11), as shown in table 3.4A. Interest rates (22) and insufficient capital (17) were volunteered as the main disadvantages to using merchant banks to finance growth, as shown in table 3.4B. Table 3.4A: Principal Advantage in Using Financing from Merchant and Other Smaller Banks to Finance Growth More flexible/ personal/ better service 32 Easier access to financing 11 Lower interest rates 7 Availability of larger amounts of financing 6 Same advantage as the Big 4 banks 4 There are no advantages 9 Other 4 Don t know 16 Refused/ no response 12 Percentage of We have no experience with the smaller banks excluded from calculation 19 Table 3.4B: Principal Disadvantage in Using Financing from Merchant and Other Smaller Banks to Finance Growth Interest rates 22 Not enough capital 17 Too much control on your business/ too many restrictions 12 There are no disadvantages 13 Other 14 Don t know 11 Refused/ no response 11 14

Percentage of We have no experience with the smaller banks excluded from calculation 16 3.5. Government Programs Offer Lower Interest Rates at Expense of Bureaucratic Burden Government programs are perceived to offer the benefit of lower interest rates at the expense of red tape. One-quarter (25) of respondents volunteer that relatively low interest rates or flexible terms are the principal advantages of using government programs to finance growth. 8 This is especially true among mid-caps interested in moderate growth (36 vs. 20 among those seeking high growth and 20 among those adopting a holding pattern). Sizeable portions of mid-caps have no experience of government loans (21) or see no advantages of using them to finance growth (24), as shown in table 3.5A. Meanwhile, an extraordinary 47 of mid-cap executives volunteer that redtape, including too much paperwork, compliance, disclosure and an overall slow process, is the biggest disadvantage of financing through government programs. Another 7 also point to administrative problems, e.g. that the process is too slow or time consuming, as shown in table 3.5B.[C1] 8 With respect to using GOVERNMENT PROGRAMS to finance growth, what are its principal advantages and disadvantages? 15

Table 3.5A: Principal Advantage of Using Financing from Government Programs to Finance Growth Lower interest rates/ flexible terms 25 More likely some competitors/ sectors get approved for 11 financing Potential for free money or grants 8 Easier access to funds 5 There are no advantages 24 Other 11 Don t know 8 Refused/ no response 9 Percentage of We have no experience with government loans excluded from calculation 21 Table 3.5B: Principal Disadvantage of Using Financing from Government Programs to Finance Growth Red tape too much paperwork/ compliance and disclosure 47 Government control of your business/ looking in your books 9 There are no disadvantages 13 Other 9 Don t know 12 Refused/ no response 10 Percentage of We have no experience with government loans excluded from calculation 16 16

4.0. Growth in the Minds of Mid-Cap Executives 4.1. Ambition Half Committed to High Growth, Many to Moderate Growth, 14 to No Growth Respondents were asked to rate on a 7-point scale 9 the extent to which their company would like to grow or expand. Almost half desire high growth (48 score a 6-7), more than a one-third desire moderate growth (37 score a 4-5), and 14 do not embrace growth (scoring <4), as shown in table 4.1. Table 4.1: As you may know, companies vary in their desire to grow or expand. Using a 7 point scale where 7 means would like to grow as much as possible and 1, the opposite, to what extent would your company like to grow or expand? MEAN 7 6 5 4 3 2 1 DNK 5.3 35 13 22 15 7 3 4 1 4.2. Profitability the Biggest Motivator for Growth Psychological Motivators Far Behind Mid-caps are motivated to expand above all for reasons of profitability, as shown in table (4.2A). Other less important motivators are to increase market presence and fortify a sense of purpose among management. Over half (56) of respondents who indicated that they want to expand 10 say they are motivated above all by a desire for increased profitability, as shown in table 4.2A. A sizeable proportion of respondents (20) say they are motivated to expand in 9 (Q1) As you may know, companies vary in their desire to grow or expand. Using a 7 point scale where 7 means would like to grow as much as possible and 1, the opposite, to what extent would your company like to grow or expand? 10 [IF ANSWERED Q1>3], which of the following best describes the motivating factor to expand your company? 17

order to increase market presence. A near equal proportion (15) sees expansion as a tool to mobilize staff. Only 8 of respondents say they are motivated to grow so that they could increase the value of the company for a potential buyer, suggesting that the future rate of new IPOs may not be immense. Table 4.2A: [IF ANSWERED Q1>3], which of the following best describes the motivating factor to expand your company? [ROTATE] Become more profitable 56 Increase market presence 20 Strengthen the sense of purpose among management and staff 15 Increase the value of the company to a potential buyer 8 Other * Don t know/ Refused 1 Over one-quarter (28) of the minority (n=46) who say that growth is not a major priority feel that increased sales are not necessarily associated with corresponding increases in profit. 11 Other reasons for why growth may not be a major priority include: satisfaction with the status quo (15), lack of foreseeable demand (11), lack of financial resources (11), lack of skilled personnel (11), and no benefit in terms of making the company more attractive to buyers (11), as shown in table 4.2B. 11 [IF ANSWERED Q1<4], Earlier you mentioned that growth was not a major priority of your firm. Is this because 18

Table 4.2B: [IF ANSWERED Q1<4], Earlier you mentioned that growth was not a major priority of your firm. Is this because [ROTATE] N=46 Increasing sales would not necessarily increase profit 28 Not interested/ no need to expand happy/ satisfied 15 No more foreseeable demand for your product or service 11 Increasing sales would not necessarily make your company more attractive for a potential buyer 11 The company lacks the financial resources to expand 11 The company lacks the trained or skilled personnel to expand 11 Don t know/ Refused 13 4.3. Growth Factors and Challenges to Consider The Goal of More Customers and the Concern about Finding Good Staff Expansion of customer base is the most important consideration when midcaps think of how to grow. In response to an open-ended prompt, 23 of respondents volunteer that the expansion of their customer base or market share is the single most important consideration when they and their executive teams are thinking of how to grow the company. Profitability is the second most important consideration (18) followed by manpower (14), financing (13), and maintaining customer service (11), as shown in table 4.3A. Manpower and staff emerge as intriguing considerations in the minds of respondents. When respondents are asked unemotionally to identify their most important considerations, human resources emerges in third position (table 4.3A). HR-type considerations jump in importance when respondents are asked about the challenges they face (table 4.3B). Among the challenges faced by midcaps, finding qualified staff and finding capable management are the first and third highest volunteered by respondents. 19

Table 4.3A: When you and your executive team are thinking of how to grow the company, what is the single most important consideration in your thinking? Expanding customer base/ market share 23 Profitability 18 Manpower 14 Financing/ cash flow 13 Maintaining customer service 11 New product introduction 5 Economic conditions/ strong economy 3 Not thinking of expanding 2 Other 7 Don t know 3 Refused/ no response 2 Table 4.2B: Which of the following poses the greatest challenge with respect to the growth or expansion of your company? [RANDOMIZE] Hiring qualified staff 22 A crowded, mature, or saturated market 18 Having a capable management team 16 Increasing demand for your product or service 15 Accessing financing or capital 10 Government or regulatory barriers 9 Accessing raw or primary materials or supplies 6 Other * Don t know/ Refused 5 20