Second Stage Growth Companies – A Case Study

While the start-up phase of a company’s life can be make or break, the next step in the evolution of a growing business can be even tougher.

Breakthrough Clinic gives one company at a crossroads of expansion the chance to gain free advice on the possibilities for growth from an expert business adviser.

Castle Contracting – Company history

Castle Contracting is a civil engineering contractor specialising in structural repairs, founded on a shoestring by Alistair Ogilvy and his wife Karen in 1994. Based near Edinburgh, it’s become a thriving enterprise, employing about 50 people and undertaking a variety of contracting work, including structural repairs to the external envelope of buildings and also civil engineering projects such as bridges. Major undertakings include a £1 million contract for Kingston Bridge in Glasgow and one at £2.25 million for Tay Bridge in Dundee. Turnover for 2005 was £3.75 million and figures for 2006 are expected to hit £5 million.

Alistair has extensive experience in contracting, having previously launched the Middle Eastern operation for what became contracting giant Cementation Foundations Skanska. When a colleague left to set up his own company in London, Resin Bonded Repairs, he asked Alistair to join him to handle the firm’s contracts in Scotland.

‘It was a tough decision,’ recalls Alistair, ‘which Karen and I deliberated for at least six months. We had two kids just about to start school, so it was an important crossroads at a crucial time.’

The family took the plunge and at the end of 1984 set up RBR Scotland. ‘It was the first time I’d ever lived or worked in Scotland,’ Alistair points out.

‘Our clients were local councils and large industrial companies such as BP and Shell, as well as property managers and, of course, main contractors for whom we became subcontractors.’

The opportunity arose to acquire a Manchester-based company, which manufactured overcladding panels for use in old building restoration. ‘Although it was a manufacturing company, not a contracting company, it was a good fit with our existing business,’ says Alistair, ‘so we acquired the firm, which became a subsidiary of RBR Scotland.’

Sadly, this didn’t work out as well as hoped. ‘The manufacturing subsidiary was one of a number of contractors working for Euro Disney that got caught up in project delays,’ recalls Alistair. ‘We pulled out all the stops to get the job done but then ended up in a wrangle over payment, which hit us hard. That, coupled with a pay dispute on another large project, meant the cash cow that was RBR Scotland couldn’t continue to fund the problems of the subsidiary.’

At the end of 1993, the subsidiary went bust, taking the parent company with it.

‘It was an unfortunate affair but we learnt some important lessons from it,’ reconciles Alistair.

Alistair and Karen bounced back to form Castle Contracting at the beginning of 1994. ‘We remortgaged the house and set up in the spare bedroom.’

It was a brave move, but their previous experience came in handy. Key members of the team from RBR Scotland were keen to join Castle and previous suppliers and customers were happy to continue working with Alistair through his new company. His contacts in the industry proved invaluable at bringing in business, helping put Castle on a sure footing upon which it has been building ever since.

The challenge of being a second-stage growth company

Four years ago, Castle branched out from servicing building repair contracts into work on civil engineering structures such as bridges. These civil contracts are large projects and tend to be long-term, several years in some cases, whereas Castle’s building contracts are higher margin but shorter-term. The expansion into civil work gives two complementary areas of service that provide an important balance and security.

Alistair says, ‘One of the lessons of our experience with RBR Scotland was that because most contracts were short, the volume of work fluctuated from month to month, and if several contracts ended at once you experienced a huge drop in revenue. These peaks and troughs play havoc with cash flow and so forth, so we’ve taken steps to iron them out, and continue to do so. And to manage risk still further, we don’t want Castle to be dependent upon one type of customer or one area of work.’

To this end, Alistair has undertaken a review of the business and the market and plans to develop Castle into a group of specialist civil engineering operations, each one focusing on a particular area. These will either be set up as divisions of Castle or as separate companies. Each will be managed and partially owned by an individual or group who have expert knowledge in that specialism. These outfits will manage the contracting process while the main company undertakes the administration and other general business functions.

Because Castle finds there is often an overlap between one specialist civil engineering contracting process and another, by combining these offerings the company hopes to gain significant competitive advantage. The challenge is to develop this business model to address issues such as recruiting and retaining key personnel, tax issues, share ownership and transfer. These developments will also need to be financed, which adds another layer of complexity to these strategic considerations.

Breakthrough Clinic’s Advice

Alastair Rae, a partner at the Edinburgh office of PKF (UK) LLP, visited Castle Contracting to find out first-hand what challenges it’s currently facing. Here, he offers his advice on the best strategy for putting proposed expansion plans into practice.

You have to admire the drive of people like Alistair and Karen. It takes courage to start a business in your spare room, funded by personal borrowing, and it takes energy and commitment to grow that business year after year.

Following a strategic review, Alistair now plans to create specialist business units to broaden Castle’s capabilities and complement the current offering. There are many factors to consider.

The right people

Castle is a people business. Its real product is the capability of its personnel, so having the skills the business needs, embodied in dedicated people, is critical. Good management is always in short supply, but even more so in a buoyant sector where poaching of staff is prevalent. Castle must design its reward strategy to attract and retain the best people to give it competitive advantage in the recruitment market and in its sector.

Members of management are currently incentivised to perform and Alistair plans to overlay a share-based retention plan onto existing arrangements. This requires care.

You see, people prefer cash. Ideally, cash they will get regardless of performance. Human behaviour is influenced by incentives, however, and linking a substantial part of cash reward to appropriate performance measures is proven to work. Any competitor could trump this offering, though, because the employee isn’t locked in long-term.

The demise of final salary pensions and flexibility of alternative schemes has effectively removed pensions as a retention mechanism, leaving share schemes and options as effective golden handcuffs. Under new accounting rules, both arrangements can create a substantial charge against profit. Awarding shares will also deliver a current tax liability to the recipient, whereas an option scheme can be designed to defer the tax liability until the exercise date. The added benefit of options is that management must perform to earn the options, then perform again to make them exercisable. However, share schemes with a predetermined exit could create a drain on cash flow at a time when key staff depart. Alignment of reward and business strategy is therefore vital.

The business structure

Extensive group structures are common in this sector, as businesses seek to mitigate risk by housing functions in individual companies. However, this mitigation can be weakened if funding arrangements are not similarly ringfenced. Furthermore, the presence of subsidiaries will invoke associated companies tax rules, catapulting Castle into tax-inefficient marginal rates. There’s always a trade-off to be made when considering risk versus cost, something many growing businesses have to weigh up.

For Castle, an added concern is how the new business structure will work alongside the retention element of the proposed reward strategy.

The necessary funds

Castle has adequate working capital to fund short-term organic growth at current rates and to accommodate project performance bonds. However, without additional funding, Castle’s growth rate will slow as management is forced to select projects based on available cash. For an organisation of this size additional growth capital is likely to come from a business angel or regional venture capital fund. Both will demand growth and an exit route, and in return angels can bring valuable management input at critical times, but funding any exits would impact heavily on the business and must be planned. It’s difficult to fund growth and incentive schemes during the exit of a funding partner. Many a trade sale of a growing business is forced or accelerated by multiple demands on capital such as these.

Given the significance of these factors, Alistair and Karen are right to take time choosing their strategy.

Marc Barber

Marc Barber

Marc was editor of GrowthBusiness from 2006 to 2010. He specialised in writing about entrepreneurs, private equity and venture capital, mid-market M&A, small caps and high-growth businesses.

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