Downsizing is never a light topic to broach, but for businesses that are financially compromised or experiencing a reduction in demand, it is important to fully understand before any strategic planning can begin.
Downsizing is often tied to a reduction in headcount. Headcount is more than just a number, which is why downsizing should be approached with the utmost care and consideration. Knowing why a company should downsize, what kind of risk is associated with doing so, and how to avoid common mistakes is key to increasing the likelihood that your reduction efforts will be successful.
Use this guide to get a better understanding of the implications of downsizing and help inform your strategic planning as it relates to both maintaining your business and preparing it for sale.
Reasons to Downsize
Typically, downsizing is a last resort for companies that are struggling to overcome:
- Financial instability that compromises the long-term viability of the company
- An expected lengthy reduction in demand for products and services
- Recessionary obstacles
And while these are the most common reasons for downsizing, there are positive reasons for downsizing as well.
Companies looking to outsource activities to improve efficiency may downsize their workforce, however this is a strategic expense management decision, not a last-ditch effort to improve numbers. Hiring third party providers to offer the same (or better) results at a lower cost is a smart business decision that allows leadership to lean on experts without taking on the overhead costs associated with hiring in-house.
Similarly, companies experiencing reduced profitability amid increased revenue numbers may also choose to downsize. Downsizing in this scenario puts businesses in a place to dial in profitability and strengthen the organization.
Understanding the Risks of Downsizing
While corporate downsizing has become commonplace, critics (including employees that have withstood downsizing efforts) cite the following risks:
- A decline in employee productivity and performance
- Decreased employee morale
- Reduced job satisfaction
- Higher employee turnover
- Damaged company culture
- Reduced customer satisfaction
- Stifled creativity and innovation
- Reduced profitability
- Decreased revenue
- Costly legal fallout
- Damaged brand reputation
With these types of unintended consequences, it is obvious how downsizing could derail a company’s future potential. In fact, a five-year study published by the Harvard Business Review revealed that publicly traded companies that downsized their workforce by 3% or more were twice as likely to declare bankruptcy than ones that did not downsize.
Why did a fatal outcome result for these companies? The study concluded that companies could not rebound after downsizing lost critical employee knowledge. Financial and physical resources did not compensate for the knowledge gap created by vacant employee roles.
Downsizing Mistakes to Avoid
The biggest mistake a company can make when downsizing is hindering long-term viability for short-term gains. Businesses that try to fix short-term cash flow struggles with downsizing instead of addressing the root of their profitability problems will likely find themselves in successive rounds of downsizing, resulting in a downward spiral.
Even when downsizing is necessary to “trim the fat” from an organization, cutting too deep and too fast can still cause the company to stumble and fall in the long-term. Given the high probability of negative outcomes for businesses that downsize due to the knowledge gap that results, it is crucial that key employees be retained. Key employees should not be identified by title or salary level, but rather the unique and indispensable knowledge they possess about the company’s operations, offerings, or audience. Cut strategically to ensure there will be enough people in each department to keep the company running because the cost of re-hiring later is likely going to be much higher than just holding onto employees.
Communicate clearly with employees so they know what to expect. Provide regular updates to keep people from guessing because uncertainty due to poor communication can breed distrust and resentment.
Use downsizing as part of a larger strategic plan rather than making downsizing the entire plan. Take other efforts like eliminating waste, selling excess inventory, renegotiating existing contracts, requesting more flexible payment terms, and delaying capital investments as well to tackle financial woes from multiple angles.
Selling Your Business
While most downsizing efforts are done to course correct a troubled business, it can also be used tactically to prepare your business for sale.
This is an especially salient topic right now as many business owners are questioning what the future will hold for their companies. Pandemic-related barriers have caused many business owners to consider whether now is the time to get out. Additionally, Adam Burroughs explains,
“There is a sense from some that there’s probably going to be some changes in the tax law in the near future. If the Biden Administration changes the capital gains rate at the highest bracket, that could affect those who are selling a business in a significant way, and that’s creating uncertainty. Sellers are able to get a very favorable capital gains treatment rate — a business sold today will often be impacted by a 20 percent tax burden. If the tax laws change in the way that some expect, the burden might be 39.6 percent. That difference is driving some owners to work to take advantage of the current tax rates to avoid what could become an additional 20 percent hit to their post-transaction gains.”
Whether you plan to sell to a third party, business partner, or family member, downsizing may be part of the sales process. Streamlining can allow you to get a better price for your business because reducing overhead while maintaining profits paints a picture of financial strength and stability.
If you are considering selling your business, do not wait to start planning. On average, it usually takes 3-5 years to prepare a business for sale, especially if your goal is to reap the maximum value of the business from its sale.
Whether downsizing is a lifeboat to whether the storm or a means to relaxing on the beach, financial planning and analysis (FP&A) is the cornerstone of any downsizing discussion. If you are considering downsizing and do not have experienced financial leadership at the helm of your organization, hire a fractional CFO to lead your FP&A efforts before and after downsizing or restructuring.