Diversifying beyond your core competencies and generating new business in new sectors: Even well-positioned medium-sized companies are failing to meet the challenges of new markets. What exactly makes diversification problematic? Is it the principle itself? Does diversification fail in specific industries or simply because of how it is implemented? Two experts – Dr. Stefan Frings, partner at enomyc, and Dr. Jochen Markgraf, partner at Seitz Rechtsanwälte – examine this question from a performance management and corporate law perspective.
You have been working together for two years and have supported several projects together: Dr. Frings, you are a consultant in restructuring and performance improvement, partner and head of strategy at enomyc. Dr. Markgraf, you specialize in corporate law and insolvency law, are a partner at Seitz Rechtsanwälte, and advise on insolvency-related restructuring and reorganization. Do you always agree?
Dr. Stefan Frings: We view projects similarly, albeit from two different perspectives. Our firms work on projects with a similar spirit, so the cultural fit is very good. Our clients notice this too. For me, the performance-related component is primary, while for Mr. Markgraf it is corporate law. We work together in a very solution-oriented and pragmatic manner.
Dr. Jochen Markgraf: I am a lawyer and banker by training. My arguments toward stakeholders, banks, and companies overlap with those of Mr. Frings. What we definitely have in common is a clear focus and a very clear approach. Because, both economically and legally, all cards must be on the table. Only when all the information is available can solutions be designed for companies that are ultimately legally enforceable.
You actively follow the diversification strategies of German SMEs. What trends are you currently observing?
JM: We are currently seeing a clear trend toward the defense industry. It comes from various sectors, including automotive, chemicals, technology, and IT.
SF: Yes, many companies in mechanical engineering, vehicle and special vehicle manufacturing are indeed being drawn to the defense industry. A few years ago, we observed a similar trend toward biotechnology. At that time, many companies were seeking to collaborate with BioNTech, for example.
So diversification can prove to be very promising. But when do you think it really makes sense?
SF: If companies have good products, expertise, and ideas, it always makes sense to look for growth opportunities. From a business perspective, however, diversification is often seen as a remedy to avoid tough or necessary restructuring measures that would be more likely to result in the restoration of a competitive cost structure. I find that very difficult; we see it often. Of course, it is much more pleasant for management to communicate that the focus is now on growth and new markets. However, before a diversification project is considered, some very fundamental questions need to be asked.
JM: Diversification is part of a company's business development. Sometimes there is even a need to diversify – just think of products such as the combustion engine: if you only manufacture and supply parts for it while electric cars are gaining an ever-larger share of the market, you have to expect your own market to shrink. Diversification therefore makes a lot of sense in order to create independence from individual core areas of the company. However, it must not be an end in itself. It only makes sense if – for example, when expanding the company into an additional industry – the launch is well planned, economically sound, and legally secure.
Dr. Frings, you say that fundamental questions should be asked when considering a diversification strategy. What should companies focus on and what exactly should they be able to answer?
SF: My academic teacher, Prof. Wildemann, always said: “Look at how the successful ones do it. What are they doing differently or better?” If companies want to tap into new markets – whether with existing or new products – they should also follow the logic of the Ansoff matrix and ask strategic questions:
- Do we have the right products?
- Do we have the necessary skills for the specific application or industry? I advise companies to conduct a skills analysis to determine what they need and whether they can deliver everything. Even more important is the question:
- Do we have market access? For example, you can't just take sales teams from the furniture industry and put them in the medical technology industry. It's a completely different industry, a completely different type of sales, a completely different approach.
- What potential does the market offer?
- What does it cost to enter the market? Do we have the financial resources to do so? The issue of financing should not be underestimated. For example, entering foreign markets takes much longer. We have seen companies that wanted to enter the US market with a line of credit from their local bank, but encountered very strict regulations there. Approvals can take a long time. Companies need to build up reserves so that they don't run out of financial resources in the meantime. This leads to the following question, where Dr. Markgraf's legal expertise comes into play:
- What risks do we face? The question of risk assessment in particular is often not answered, or only inadequately. In my experience, particular emphasis should be placed on the topic of risk minimization. This includes questions of liability, but also financing.
Dr. Markgraf, what is your advice at this point?
JM: We advise companies to treat the expansion or restructuring of their business—depending on its size and scope—as if they were starting a new business. When starting a new business, the first step is to draw up a business case and check its plausibility. The financing of the start-up and ramp-up phase is examined, along with the necessary investments and the legal framework within which this should take place. The same applies to diversification when venturing into new industries. We also generally recommend a comprehensive review of how the expansion should be implemented under company law. It often makes sense to set up the new division as a separate legal entity.
Why is this important?
JM: If the project fails, it is usually easier to terminate a business if it is in a separate entity. In addition, such a separation ensures that the core business is not affected in this case.
What are the liability risks if there is no legal separation?
JM: If one division generates losses, the other division must absorb these economically. In the worst case, this can pose an economic threat to the entire core business/company. In this case, the loss-making division must be closed down outside of insolvency law, provided that this can still be financed by the core company. This is very complex and sometimes costly in terms of both labor law and contract law, not least in the context of internal financing. In the worst case, the entire company could face insolvency. Against this backdrop, if the divisions are not to be separated under company law, it must be examined how the new entity is to be financed. When designing and implementing the financial structure of the new entity, care must be taken to ensure that the risks are both manageable and, where possible, limited. This can be achieved, for example, through well-thought-out contract drafting.
What contractual and structural decisions are crucial in this case?
JM: Even in the event of a separation under company law, a financially sound concept is required – i.e., no excessive guarantees or patronage for subsidiaries. There must also be a clear separation of business areas and, consequently, of employees. The structures must be tightened up: For example, when should which payments be made and repaid? Here's an example: We had a case where the parent company financed the subsidiary through various loans. The loans were granted several times a year. The problem was that whenever the subsidiary had its own financial resources, it made repayments to the parent company. A few months later, however, loans were granted to the subsidiary again. As the subsidiary got into more and more financial trouble, they started thinking about bankruptcy. The problem was that because of the loan repayments to the parent company, there was a big risk of the loans being challenged in bankruptcy. This means that if the subsidiary went bankrupt, the parent company would have had to pay back the money it got to the bankruptcy trustee.
If a company decides from the outset to establish a separate legal entity for a new division, what additional points must be included in the planning?
JM: In addition to the points already mentioned, a tax audit is of course essential. It is also imperative to determine how the company will be structured in terms of labor law. Furthermore, the basis on which services are exchanged between the companies must be clearly defined and documented. Existing structures can be bundled and, like responsibilities, distributed between the companies and business areas. This starts with simple issues, such as who is responsible for payroll/accounting for the new unit and which department handles invoicing. It must also be clarified in which IT landscape the new company will be integrated. The contracts for day-to-day business—including supply agreements and terms with new customers—need to be looked at closely and evaluated: Are the contracts really effective, and if so, in what form? Why is all this so important? So that, in the worst case, the subsidiary can be separated from the parent company as smoothly as possible.
And in the best case?
JM: In the best case, companies can also involve partners or strategists. This allows capital, contacts, and expertise to be channeled into the subsidiary, minimizing the company's own risk. A joint venture can also simplify market entry. This allows the project to be set up on a stable footing from the outset. In the best case, however, it could also be easier to sell the subsidiary.
If that is the case, why don't companies generally take this route when they want to generate new business in unfamiliar territory? Are there advantages to not establishing a separate legal entity within the company?
JM: Not establishing a separate entity has the advantage of lower costs. There is less effort involved in setting up and administering the company. This also allows for a faster start.
To begin with, you fill a few positions from the parent company. No new management positions need to be filled. There is also no need for a new start-up, different accounting, or different financing; this is all handled through budgets from within the company. Corporate governance also remains the same and the communication effort is minimal.
Do you always recommend setting up subsidiaries? Or is it sometimes more profitable to operate a new business area within the company, directly from the main company?
JM: Once a certain planned size has been reached, we always recommend starting up or spinning off a separate unit. This is also the case if the new business is to be run seriously and not just as an insignificant economic experiment. However, if there is very close integration between the new and old divisions, then a separate legal entity may not be necessary. This must always be assessed on a case-by-case basis.
Dr. Frings, you have already formulated six important guiding questions for reviewing diversification strategies in terms of performance: What additional points should companies consider?
SF: Based on our project experience, transparency is a key success factor. Only when a company knows which customers and which products are making it money can it address strategic issues. We see companies that lack product contribution margin calculations and customer-related profit and loss statements. This raises the question:
- Do we know the value drivers and value destroyers in our company? Technical expertise is not usually a problem in German SMEs. The problem is that companies often try to transfer experience from their traditional industry to new industries. In doing so, they neglect the rules of the game and regulations. The next question is therefore:
- Do we know the habits, regulations, and rules of the new industry? The specifics of the new industry are often overlooked because they are simply unknown to companies that are diversifying. An example from the automotive sector: Suppliers who equip large OEMs with parts should be aware in advance that product development usually has to be pre-financed. If this is not part of the contractual situation, suppliers can take on major financial risks. Another example: If the parts are not called off by the new customers as specified in the business case, this automatically leads to financial difficulties. These are important industry insights that are often overlooked.
- Have we defined clear milestones? Companies should define certain checkpoints that they can use to honestly assess whether the planned project will succeed. This is done in every development process. If it turns out that the plan is not working, it is often better to abandon it than to continue down a path that is unlikely to succeed and fraught with risks. We see companies neglecting to set and question milestones. Admitting that a project has failed is very difficult – there's no question about that. Nevertheless, this insight is essential and abandoning a project is no disgrace: if it's not working, it should be terminated in good time. But the all-important question is:
- Do we have a business plan? A realistic and rather conservative business plan should be drawn up for several years, in which you assess, without optimism, what you can achieve, what it will cost, and what diversifying will bring. Once you have answered this question honestly, not much can go wrong.
Let's assume that the damage has already been done: The newly founded division was operated directly from the main company and is now no longer profitable. What exit strategies are available to companies?
SF: There is no universal answer to this question. The issue is too complex for that. First of all, companies must admit that the path they have taken was wrong. Then the costs and benefits of an exit must be calculated dispassionately in a planning calculation. The problem here is that negative products often still deliver a positive contribution margin. Of course, it must be ensured that fixed and structural costs are also reduced. In addition, delivery obligations, delivery periods, and contractual framework conditions must be analyzed.
Can companies exit cleanly?
SF: There is no silver bullet. As a rule, the consensual approach is the most effective. This requires negotiation, solutions must be offered, and funds must be made available.
JM: I completely agree. Ultimately, there is no option but to try to agree on closing the division with all stakeholders. This often involves coordinating with the banks to determine how much money can be used for the closure. Termination agreements must be negotiated with customers and employees. Works councils must be involved. Communication must also be very precise here, because it must be made clear that the remaining division will continue to operate successfully. Such a closure is regularly accompanied by a certain degree of uncertainty among all stakeholders. This must be minimized accordingly.
What is often the bitter lesson learned?
SF: That well-intentioned growth strategies have often led to threatening corporate crises. The complexity leads to lengthy processes. There is a high level of stress within companies. The communication effort is also very high. Overall, the mistakes that happen in this context are very costly.
What observations and recommendations would you like to share in conclusion?
JM: We are no longer able to reliably assess how banks are positioning themselves. In pre-insolvency consultations, I have observed that banks – quite rightly – are demanding expert opinions much more quickly than usual and are generally making tough demands. In some cases, chief restructuring officers have to be appointed in companies. Banks are also increasingly shying away from industries and business models that are characterized by excessive risk.
SF: That's exactly the point: industries can lose their appeal, putting pressure on financiers to pull out of deals. This is a major issue. The keyword here is “early risk detection” and the call for banks to ask their customers the uncomfortable questions at an early stage. We have cases where it is clear that if decisive action had been taken five years ago, companies would have been spared a lot of trouble. Prevention is always better than reaction. That applies everywhere. However, in order to engage in early risk detection, you first need to know your own company. You need transparency in your figures. Commercial management is a model for success.
Thank you very much for talking to us.
Dr. Jochen Markgraf is a partner at Seitz and head of the Düsseldorf office. One of his main areas of expertise is the restructuring and reorganization of companies in insolvency, particularly in the automotive, retail, and industrial (supplies) sectors. He has particular expertise in corporate finance and a large network of long-standing contacts with various banks, financiers, auditors, and restructuring consultants. His experience and network make him a highly sought-after contact in crisis situations – for companies and banks alike.
Dr. Stefan Frings has over 25 years of experience in top management consulting, particularly in the areas of restructuring and performance improvement. As a partner and Head of Strategy, he is responsible for the Cologne office. He supports companies not only strategically but also operationally and has successfully implemented numerous projects in Europe and beyond. Frings studied business administration at the University of Cologne and received his doctorate in economics from the Technical University of Munich.
