Before I jump into this blog post, I would like to make a shameless plug for the Healdsburg Community Nursery School's annual online auction fundraiser. You should bid on items because (a) it's a great charity that provides affordable child care in a co-op setting; (b) it has so many great deals; (c) you need to buy gifts for the holidays; and (d) it is a great source for uncommon and spectacular wines at a great price. On to the blog post...
Well, I’ve thrown a lot out at you in this series of blog posts. The grape market cycle might be grinding to a halt! A recession is coming! The labor market is tight and poses a risk to future profitability! That’s a lot of doom and gloom.
But now I’m ready to shift gears. What can we do to prepare for the possible materialization of these risks? I have three basic suggestions:
Improve your liquidity. Analyze how much cash and access to cash you need vs. how much debt service you can afford and develop a plan to get there.
Diversify your assets and/or business model. Diversification of revenue streams will reduce your reliance on any one source of sales and, thereby, increase your business’ resilience in the face of an uncertain future.
Get lean. Getting lean does not necessarily mean reducing expenses. The point is to trim out fat (expenditures with low or negative ROI) and build muscle (activities that are identifiable, repeatable and scalable pathways to greater profitability.)
Squirrels tuck away acorns to prepare for the winter, while homesteaders turn their hogs into charcuterie and preppers invest in “beans, bandages and bullets.” For a winery or vineyard owner, these strategies would do very little to help their business weather a recession or the ups and downs of the grape market. Instead, you need to determine what level of liquidity your business needs, make a plan to get there and execute on that plan. Before I get into tactics and strategy, I’m going to switch into lecturer mode for a bit to go over some basics of liquidity.
Elements of Liquidity
When I mention liquidity, what I mean is a company’s ability to meet its cash requirements. At its most basic, this refers to its ability to pay for things like labor and financing. But I am also referring to a company’s capacity to pay for new projects and investments, fund pivots in its business model and to finance expansion. Liquidity is not directly dependent upon your income statement. It is a function of assets, access to debt and cash flow.
No, I’m not talking about wine. Well, yes, I am, actually, I guess. Let’s start over and get to the point… Your most liquid asset, that which most readily meets your cash needs is, unsurprisingly, cash. Cash equivalents, like short-term CDs or bonds that can be readily sold at market value, are generally considered the next best thing. When I mention liquidity, I really have this asset category in mind: cash on hand.
Other assets can contribute to liquidity, too. While a piece of land cannot be quickly marketed to meet cash needs, inventory sometimes can be. When assessing liquidity, you can consider such assets, but you should make conservative assumptions about what their sales price and liquidation timeline would be. I imagine that if a winery calls a distributor and asks them to buy a shipment of wine COD, that distributor is going to require a hefty discount and even a COD order would require time for delivery of product and settlement of funds. On the other hand, receivables can often be sold to third parties, (still at a discount), to quickly boost cash reserves.
Another factor in assessing liquidity is your access to credit facilities. If you have $100,000 of unused capacity in your line of credit, that theoretically increases your liquidity by $100,000. I say theoretically, because credit is inferior to cash for two reasons. First, when you access it, you incur additional financing charges, which reduces liquidity by decreasing ongoing cash flow. Second, bankers can and may reduce your line of credit during adverse economic conditions or when your finances become tight.
Similarly, though your hard, illiquid assets can be used as collateral to access credit, banks may be reticent to do this in recessions or when your company most needs the money, due to tight cash flow. In fact, some loans can be “called” by banks. If this is the case with any of your loans, you need to understand how this could create its own crisis during a cash crunch.
Perhaps the most important aspect of liquidity is your cash flow. Positive cash flow can be used to increase cash and cash equivalents, of course. Along with collateral, it is also one of the main determinants of your ability to take on loans. Measuring and forecasting cash flow separately from income is a basic function of running a business. The difference between the two is that income assigns value to all assets, like receivables or inventory, while cash flow looks only at cash.
When analyzing your cash flow to assess your liquidity, you should gauge how volatile and variable your expenses are and how volatile your revenue streams are. Variable expenses are those that rise and fall along with revenues. Harvest costs are about as perfect an exemplar of a variable expense as possible. While costs per unit of production may vary by year, they can generally be reasonably estimated as a ratio of production and will rise and fall as production rises and falls. Fixed expenses, on the other hand, are more problematic in a downturn. If you have a long-term, fixed-rent lease on your tasting room space, this is the amount you owe even if a downturn decreases sales.
Volatility is a separate issue. For instance, the cost of trucking grapes is variable – it correlates very closely with the size of your harvest. This expense can, however, be volatile, because the price of gas, as you can see from the United States Energy Information Administration chart below, can rapidly change. Between 2002 and 2008, gas prices more than doubled and then fell about 20% the next year.
Volatility is even more relevant to revenue streams. If you sell grapes without long-term contracts, your revenue streams are more volatile than if you have a contract indexed to Crush Report Prices, which is more volatile than if you have a long-term contract with set prices or an inflation escalator. Similarly, wineries may find that some accounts or channels are more volatile than others (restaurant sales vs. club sales, for instance.) Assess this volatility when assessing your liquidity and, if you are concerned, consider volatility when formulating your business tactics and strategy.
The Importance of Liquidity Right Now
OK, now that I’ve laid out the basics, let me return to my main message here. We have a lot of uncertainty on the horizon. At some unknown point we will be hit by a recession of some unknown severity. Vineyard owners are facing the possibility of this coinciding with a cyclical fall in demand relative to supply. And labor costs may continue to rise, even while revenues drop.
Improving your liquidity now will help you to face these unknowns. For one, having cash means being able to survive lean times. More than this, it allows you to fund organizational pivots and new iterations to your business model. Maybe a recession would be an opportune time to release a new brand at a lower price point. Brand development is going to cost money. Or, if a recession leads to layoffs and you have the money, maybe you can hire your first dedicated, outside salesperson at a palatable base salary to expand your brand.
Maybe consumer tastes shift away from Cabernet Sauvignon and you’re a vineyard owner who planted Cabernet Sauvignon on land that would be better suited to another variety. Liquidity means being able to pay to bud over to that other variety, if need be.
Additionally, when grape prices fall, vineyard land prices usually fall. Recessions reduce all asset values. If you are liquid enough, you can buy vineyards at cyclical lows or production facilities at once-in-a-generation lows. Maybe you can buy your tasting room when your landlord needs the money and be lease-free for perpetuity.
These are not fantasy scenarios. I worked with a group of investors that acquired a vineyard in 2011 and sold it for over twice that price a few years later. Look at the story of Entertainment Properties Trust. They splashed out tens of millions of dollars to buy winemaking facilities and some vineyards at a peak in prices. The Great Recession hit and those properties started to hemorrhage money. They sold them all at massive discounts to the purchase price just in time for the wine market to start an aggressive recovery. They scalped themselves, but their counter-parties either sold at high profits or bought in at unbelievably affordable prices (or maybe both).
How to Increase Liquidity
Later in this article, I will discuss how to assess your situation and calculate your liquidity needs. Assuming you’ve done this, there are various ways to boost your liquidity. None of these are ground-breaking, but many of them could require dramatic action or have negative side-effects and should be considered only after serious analysis.
Decrease Your Leverage - Or Increase It
By paying off debt, you reduce cash outflows. In some cases, this may be a useful way to increase liquidity. On the other hand, for many companies, it makes more sense to increase access to credit. Of course, these are not mutually exclusive strategies. Depending on your banking relationship, you may be able to pay down your debt, after increasing your line of credit.
Opening up new credit facilities or increasing current ones should allow you to tap into funds when you need them. You do need to understand, however, under what conditions your bank can reduce or close those credit lines or call in loans. The probability of such actions occurring tends to rise in times of financial stress – when you most need credit. For this reason, you may want to look at alternative types of financing, such as lease-backs, where you sell an asset and sign a long-term lease on it to free up working capital; barrel financing; or even, if appropriate and possible, negotiating better credit terms with vendors.
Sell Off Inventory
Obviously, the best way to raise money is to sell the product you produce. With a possible looming crisis, however, you should consider clearing out stagnant inventory or simply accelerating sales of slower-moving products. It may be time to remind yourself that the market price of your inventory is the buyer’s willingness to pay. Your cost or your competitors’ price may inform the market, but don’t determine market price and buyers may not care about them at all.
Wineries may want to take a look at whether you should sell some slow-moving, bottled inventory at a tough-to-stomach price in a market where it won’t cannibalize your full-price sales. Those in the bulk wine market may balk at a price offered for that bulk wine, but if it’s not going to rise, it’s time to sell. That library wine release you have every year? Now may be the year to pump it up with some discounts and make it a big one.
Sell Off Other Assets
Your business may have assets that can be converted into cash without hurting your business model too much. You could sell a vineyard at today’s highs and buy grapes or bulk wine to replace supply. In fact, you could sell now and buy a vineyard in several years, when prices are lower. You may be able to sell a production facility and lease it back or become a custom crush client.
Have you been thinking of selling one of your brands? It might be time to do it while you can get a good price. You can also sell your receivables to enhance cash flow. It’s very uncommon in the wine industry, as far as I know, but, especially for customers who you wouldn’t mind losing (i.e. who pay too late or too little), it could be a reasonable stopgap.
Invest in Yourself
Similar to paying down debt, you may be able to make investments that improve cash profits. While looking for these types of investments should be a continual process, now may be the time to dive deep into projects you’ve put on the back burner. For instance, maybe it’s time you get actual quotes on how much a mechanical pre-pruner costs and calculate what it could save you in labor costs. If the savings outstrip the financing cost (hopefully at a fixed rate), then go for it.
Take on Outside Investment
Partnerships and outside investments do not lack for downsides. However, if you feel that you may be in a situation that would lead to such investments in a downturn, it would be best to sell equity while the situation is rosier and you would be giving up less equity for more money. Other situations may also warrant soliciting outside investments. For instance, if you have a clear path to improving margins by funding growth that could be sustained in rocky waters and you already have a great deal of leverage, an equity investment may present the best path forward.
In a sense, boosting cash and credit resources is a blunt tool for weathering a financial or cyclical downturn. It is at least partially predicated on the idea that future troubles will be temporary, instead of constituting a new normal. And even temporary conditions can outlast your expectations. Far better to build a business that can thrive, or at least sustain itself, in a variety of situations. One of the keys to this is diversification.
If you have an investment adviser, you’ll hear the word diversification a great deal. Savers buy mutual funds to make sure that their life savings aren’t all dependent upon one company’s success. They also buy bonds to make sure that some of their investment is growing even when stocks are down. Real estate, commodities, alternative investments - there are many ways to diversify your financial assets.
The same goes, to some extent, for your wine industry holdings, although your holdings should align into some sort of coherent strategy. As these investments are far less accessible, fungible and liquid than those in your 401(k), you do have fewer options.
Vertical integration in the wine industry is not uncommon. Growers decide to start a brand, wineries buy vineyards, crush facilities sell shiners, etc. Deciding to vertically integrate is a big commitment. It can mean operating outside of your core competency and disrupting cash flow. In general, taking on new projects just before a downturn is not wise.
There are situations, however, where it makes sense. For instance, if you are selling grapes and already have strong cash flow, look into making bulk wine. The prices for bulk wine and grapes are not always correlated and producing both could increase your resilience. If you are going to consider this, read this article of mine to help you with the analysis along with this blog post.
If you are a winery with strong online sales, but worry that your distributor may underperform for you in a downturn, you may want to get into retail the only way you can: open a tasting room. Again, this has its own risks. At this point, I recommend vertical integration only when it makes sense for your specific situation and you have strong evidence that it will be beneficial and has a high probability of success.
By horizontal diversification, I am referring mostly to diversification of revenue streams: customers, price points, channels, varieties and regions. Whether you are a winery or a vineyard, having a varied customer base decreases the chances that all customers slow buying during a downturn. Furthermore, having already established the relationships, you may be able to shift focus toward valuable relationships to help buoy your sales.
Similarly, there is a diversification benefit to selling into different channels. Direct-to-consumer wine sales may not perform the same as off-premise sales in future conditions. Brokered grape sales and word-of-mouth sales may not shift in the same way.
For both wineries and growers, there can be great potential in selling at different quality/price points, selling different varieties and selling product from different regions. If cheaper bottles are selling well, it would be good to have a foothold in that market, of course. On the other hand, premium product may hold the line better, in some cases. For example, Sonoma County Cabernet Sauvignon prices grow not only faster, but more steadily, at the top end of that market, which could provide stability in a downturn.
This is a subject I’ve preached about for a long time and can rant on about forever. The main takeaways are that (a) diversity across price points, regions and varieties increases business resilience and (b) you can quantify the extent of and benefits of such diversity to help guide your decisions.
Often, when people think of financial advisers helping them boost profitability, they think in terms of cutting costs. I don’t like to think in these terms. Not everyone will be healthier if they lose weight. Instead, we should aim to be fit. The same goes for our businesses.
All expenditures should boost profits. They should all, ideally, have a positive return on investment. You buy printer paper because, without it, your business would fall apart. Therefore, investing in printer paper has a positive return on investment. With a looming downturn, now would be a good time to start tracking how you spend your money.
This first step, of gathering data, is the hardest. It involves much more than collecting or reviewing receipts. You need to determine how much money is being spent on what and for what goal. Money spent on employee meals, for instance, must be measured differently than money spent on meals with distributors.
This is best done through a formal financial planning and analysis process. When you spend money to generate revenue (sales and marketing), decide first what metric you’ll use to measure success (bottles sold, e-mail list sign-ups, etc.) This should be based on an evidence-based estimate of what it takes for this spending to have a positive ROI. Next, decide what thresholds you need to see to eliminate, reduce, retain or increase this spending.
The more granularity you have in your tracking of expenses, the more you can find to improve in your spending patterns. The key is that your process should create feedback between operations and finances. An accountant is unlikely to understand the full benefit of winemaking experiments, while a winemaker is unlikely to understand the impact the costs of these experiments have on the business. Your process should aim to remediate these disconnects. Your primary goals are to eliminate unnecessary expenses; reduce inefficient expenses to an efficient level; track changes in ongoing expenses; spend money where the benefit outweighs the cost; and increase spending on programs that will continue to produce positive ROI when scaled up.
I know, easier said than done. So, how do you do it? Well, I can’t answer that here. You’ll either have to answer that question yourself or give me a call. At any time, the sooner you develop a process to keep your company in shape, the better. Staring into an uncertain future, though, should add a great deal of urgency to this mission.
Assessing Your Company's Resilience
All of the suggestions above entail changes that could be risky. Most will be appropriate only for a slim segment of the industry. Some should be enacted right away, if you’re not already there. The first step, though, is to figure out what you need and how much of it. Following are my suggestions for doing so.
The Bare Bones Basics
Review your financial statements and your projections. You should be reviewing your financials on a regular basis: monthly, quarterly or annually. At the very least, this should include a profit and loss statement and a balance sheet. In addition, it really should also include an income statement and cash flow statement.
You should also produce forward-looking projections. How far out they should go and how granular, is a balance between effort and benefit that you will have to determine. You should also consider how likely your projections are to be accurate at different time horizons and levels of detail. I have some clients for whom I maintain five-year monthly financials projections, with over a dozen worksheets, each of which has around one hundred line items or more, and feed into summary sheets and valuation breakdowns. This is pretty much the top end of what you might consider.
As I just mentioned, I would strongly recommend that your company, as a matter of course, institute a formal financial planning and analysis process that occurs at regular intervals. At its most fundamental, FP&A is a process for developing and revising budgets based on information and forecasts about income and expenses. This process should integrate information from operations and provide feedback to operations that can improve performance. You can learn a bit more about FP&A here, but right now just understand that it is a good way to track your level of liquidity and anticipate your future liquidity needs.
One thing I dislike about business plans and financial plans is that they are typically static and based on point forecasts. These two factors mean that they often disintegrate upon contact with reality. By static, I mean that they are generally not crafted to be regularly updated to integrate new knowledge or changed conditions (for an alternative, read about business canvasses: Wikipedia and Dorf.)
The other issue is that they rely on point forecasts. A point forecast is a statement like "revenues should reach $X by Y date." That’s a pretty specific claim for a non-prophet. I like to look at things in probabilistic terms. If you roll two six-sided dice, your most likely outcome and your average, expected outcome are both 7. But there is a 1/36 chance you get a 2. We should think of our business’ future in these same terms.
To stay on the topic at hand, your most likely anticipated outcome is not the only possible outcome. Things may go better or worse. You should think through the different possible futures, assign probabilities to them and look at what type of liquidity needs and positions are associated with each outcome. Then adjust your plans to account for these.
How exactly you do this is a huge question and touches on the core of my practice as a wine industry forecaster and financial consultant. I could, but won’t follow this section up with a whole book. I will, however, share a few ideas and tips that I think many of my readers may be able to implement.
Keep in mind, though, that this need not be complicated. You can simply discuss possible outcomes and, on your own, or as part of a team, come up with percentage chances that each might happen. You can think through as many scenarios as you’d like, but most organizations, for better or worse, think in terms of Good, Bad and Worst-Case Scenario.
Doing a good-bad-worst case analysis is a type of scenario analysis. Scenario analysis can be an effective way to improve future planning. In addition to good-bad-worst case analyses, you should consider situation-specific scenarios. What would a recession look like for your winery? What would a downturn in the grape market cycle look like? What would it look like if you had to lose a key employee? What would it look like if you expanded production, using lower-priced grapes, in a downturn?
I recommend three principles for scenario analysis: obtain multiple perspectives; use direct, but broad prompts; and paint a picture. Obtaining multiple perspectives is simple: consult with multiple people within and outside of your company.
When asking these people for their perspectives, use clear prompts: “What do you see as the biggest threat on the horizon? What is the most disastrous scenario that has a greater than 5% probability of occurring? What will we be talking about in 3 years that we’re not talking about now?”
Once you get your responses, have the person who brought up each scenario paint a picture. The hardware that is our brain is trained to be optimistic, as a shield against depression. It also estimates probabilities and importance based on familiarity with a situation. This means that it is a poor tool for anticipating future, unprecedented threats. One way to combat this is to hear out scenarios in a narrative format. By imagining the scenario, you will be more likely to assign a reasonable chance of occurrence to it and more likely to properly estimate the scale of the event’s influence on your company’s operations.
Finally, after you’ve done this work, you can model the effects of these scenarios and decide how best to plan for their possibility. Do they break you if they occur? Is it worth it to make some changes now to prevent that? Or do they present opportunities to make positive changes to your business? Is it worth it to plan for that possibility now?
Sensitivity analysis is a mirror image of scenario analysis. While the goal is largely the same and the process is similar, the question is phrased differently. Instead of asking “what does our business look like in X situation?” we ask “what situation makes our business look like X?”
A relevant example would be to ask “At what point can we not service our vineyard loan?” Then you look at what yields and prices for your varieties, considering your cash position and expenses, would put you in that situation.
Sometimes the question is relatively simple, “At what price of labor does it make sense for us to purchase a mechanical harvester?” You may, however, need to make the question two-dimensional. This is the case when you look at what combination of price and yield is required to get the desired return on a vineyard. One easy way to deal with a two-dimensional question is to use ranging analysis, as is common in UC Davis Cost Studies for vineyards. The examples below come from page 24 of this Sierra Nevadas cost study.
Sometimes, a question has several dimensions. You may need to understand how prices between two varieties correlate, consider changes in labor rates and take into account correlation between higher expenses and lower yields in years with greater disease pressure. In these cases, the best solution is to use computerized simulations.
Computerized simulations, also known as the Monte Carlo method, sound really fancy. But they’re not as fancy as they sound and anyone with solid Excel skills can implement some version. Simulations allow you to look at the likelihood of various variables achieving a given value (price = $1,000; expenses rise by 3%, etc.); integrate the correlation between the variables; apply probabilities to these outcomes and then simulate reality thousands or millions of times, with multiple assumptions "in motion." These calculations will show you the likelihood of various ultimate outcomes (bankruptcy, 6% return on investment, positive benefit from the decision, etc.)
I have found this to be a very powerful tool for solving a wide variety of business questions. Two caveats: First, it can only solve purely quantitative problems or the quantitative part of a problem. That being said, you can turn subjective problems into quantitative ones by assigning probabilities and/or values to them. For instance, Outcome 1 has a 30% chance of occurring and/or is worth $100,000 or 30 points, while Outcome 2 has a 70% chance of occurring and/or is worth -$50,000 or -15 points, etc. The other caveat is that the simulations are only as good as your assumptions, (i.e. garbage in, garbage out.)
For those who are interested, I will lay out a very basic, technical framework.
Step 1: Decide the possible outcomes you will analyze. These can be discrete (good case, bad case, worst case). Or they can be continuous (a range of prices or yields).
Step 2: Decide the probability distribution of each outcome. For instance, you may say good case or better = 40%; bad case or similar = 40%; worst case = 20%. Another, more realistic approach, is to assign a standard, normal distribution and calculate a standard deviation and mean variable. You can also use various other standard distributions or empirically-derived distributions.
Step 3: Insert a correlation formula, if necessary. This is complicated, but still do-able in Excel, though you may need to enable iterative calculations and create a multi-dimensional workbook (i.e. linking formulas across sheets).
Step 4: Generate random numbers to determine, in each simulation, what each variable will equal.
Step 5: Repeat until the distribution of outcomes stops changing meaningfully.
Step 6: Assess your results.
There is a Method for Every Problem
The past five suggestions are far from exhaustive. They’re not always great for more subjective problems or those with little data to go on. For such problems, like estimating customer attrition if you broaden a wine's appellation when you have no data, I would strongly recommend looking at using the Delphi Method, which is a process for providing structured group feedback to bring everyone together to forecast the future. For competitive analysis, you may want to use role-playing / wargames. When I am uncertain of what methods might work, I reference J Scott Armstrong and Kesten Green’s Methodology Tree for Forecasting. I’d recommend giving it a look.
When you are trying to assess what the future will look like in different scenarios, there are a few guidelines you should always follow:
Designate an official Devil’s Advocate whose job it is to poke holes in your plans and to bring up situations that you are not considering. Ask her to assign probabilities and use narrative descriptions to ensure that the group (or the manager) takes her objections seriously. You may want to rotate who this person is during the process. Keep in mind that, since reality is not always solvable, the Devil’s Advocate may bring up situations that are uncomfortably difficult to address.
Create a clear demarcation between the projection process and the planning process. For instance, if you are trying to figure out how much you would need to trim winemaking costs to survive depressed demand, then figure this out. Then figure out how to plan for it. Without a clear demarcation, your winemaker will have a strong incentive and bias toward making sure the projection process doesn’t demand a major reduction. Your plans may then shatter upon contact with reality.
Get as granular as you can. While keeping efficiency in mind, break things down into as many parts as is reasonable. Your projections of the way, say, labor cost growth will effect profitability, will be more accurate if you look, not just at the top-line cost of labor, but at the different types of labor or different operations that involve labor.
Gather all of the information you reasonably can to inform projections, analysis and decision-making. Try to use different sources of information to gain different perspectives, (customer intentions data AND salespeople’s projections or county crop reports AND the USDA Acreage Report.) Try to avoid biased data and correct biased data when it is necessary to use it. Similarly, whomever is gathering and aggregating data should have no personal incentive to inject bias, intentionally or subconsciously, into the process. Finally, avoid collecting irrelevant data (if you have decide that your prediction of future prices will be based on acreage numbers, then do not consider tonnage.)
Well, yet again, I bloviated well beyond my intention. The number one takeaway here is to thoughtfully prepare by reviewing evidence and planning and adapting for uncertain times ahead, before those times are upon us. I hope this post lived up to its billing as a survival guide. And if you think you could use some help, I hope it inspires you to contact me.