Value Creation: A Paradigm Shift

  • by

Key Takeaways

  •          Value creation requires a paradigm shift for many owners in how they manage their companies.
  •          A value creation mindset can appeal to both growth-oriented and exit-oriented owners.
  •         A value creation mindset can inspire owner-managers to take their businesses in directions they never would have perceived before.

 

The Income Mindset Versus One of Value Creation

Many entrepreneurs start their business out with one focus in mind: growing profits and minimizing taxes. In the early stages of a small business (that often time more closely resembles a job rather than an enterprise), entrepreneurs first worry about gaining traction with revenues and secondly after-tax earnings. Even as the business grows from a “main street” business to the Lower Middle Market, this mindset of after-tax earnings is pervasive with most entrepreneurs. For a lifestyle business owner (happy with the current size of the business), this mindset may suit them well, as the perception may be there is no need to fix something that is not broken. But as your company continues to grow, so does its complexity. And as you age, the need to think about harvesting the wealth in your company becomes paramount since such a large percentage of your personal wealth is tied up in the business. This is where a value creation mindset can help you achieve your personal, financial, and business goals.

When one employs a value creation mindset, they are expanding beyond the idea of a business simply being a job but rather it becoming an entity that has multiple stakeholders such as family members, employees, suppliers, customers, along with the local community in which the Company resides. Under a value creation mindset, decisions are not just made for the sole benefit of the owner or their immediate family, but are taken with consideration of other stakeholders. Financials transform from a backward-looking tax-driven exercise done solely for compliance to a forward-looking exercise performed to create visibility and help provide owners with foresight. In addition, cash flows (rather than net income after tax) becomes the primary driver of business decisions since it is the true key to understanding and managing value. Under a value creation mindset, projects become processes, since there are always action steps that can be taken to improve a business. While planning is still important under a value creation mindset, action and relentless execution are the cornerstone to accelerating value over time. As a compliment to this, measuring your results consistently, learning from that data, then pivoting based on that new information is the cornerstone to increasing shareholder value.

An income-oriented mindset focuses more on the here and now which can lead to short-term decision-making that temporarily can improve results but will destroy value in the long-run in the long run (for example, a failure to invest in more efficient machinery or strong key personnel). A value creation mindset, on the other hand, may forego immediate benefits to create efficiencies and strategic advantages that may only accrue in the future. When later selling your business, due diligence will shine a light on these oversights, which may ultimately impact the valuation or even the transferability of the owner’s business in a negative way.

Transferability: Infrastructure & Process

Every owner has potential multiple exit options theoretically available to them but the more economically strong a business, the more options available to an owner. One of these options may be to keep the business since the owner has found renewed vigor in running a now successful and satisfying business enterprise. More options means the owner has more leeway to achieve their goals whether they be financial (e.g., maximize after-tax cash on the sale of a business), business (e.g., grow the business to be the number one in its class in the geographic region), or personal (e.g., consideration for family members involved in the business).

Companies with transferability have certain key characteristics:

  •           The Company itself has processes that are independent of the owner, thus allowing the owner to take a step back while the Company continues to generate profits.
  •           The Company’s processes allow for repeatability. This means that employees can be trained to perform tasks and processes that have been shown in the past to achieve certain business objectives.
  •           The Company has an adequate infrastructure to support the organization in achieving its objectives.
  •           The Company has written short, intermediate, and long-term goals that are reviewed on a periodic basis.
  •           The Company monitors its progress in achieving these goals through using key performance indicators that are tracked and reviewed in a timely and consistent basis.
  •           The Company has visibility in its financial position (especially in its cash flows) and operations (production bottlenecks can be avoided).

Owners should be incentivized to review the above list and start implementing these today if there are shortcomings.

Value Creation—Growth vs Succession

Does value creation matter if you are more of a growth-oriented owner versus one geared toward transitioning your business either internally or externally? What about owners looking to exit as soon as possible? Can a value creation mindset help them? The answer is yes to all of the above. Let’s take a look at this in more detail.

Every owner will eventually exit their business, whether it’s voluntary (sale, internal transfer, orderly liquidation) or involuntary (forced liquidation, death, shareholder dispute, divorce). Thus, the question for any owner is when will they transition out of their business, how much control will they have over this process, and what after-tax value will they extract upon transition? Some of this risk can be mitigated through a strong shareholder’s agreement (which can address issues such as divorce, shareholder dispute, and shareholder death). Notwithstanding these situations, both growth-oriented and exit-oriented owners are differentiated by the timing of their exit. A growth-oriented owner may today have no compulsion or interest in transitioning their business to others but a value creation mindset is important if they wish to scale up the business since an infrastructure and supporting processes are required to create sustainable growth. An owner more interested in exiting their business is motivated to maximize their after-tax proceeds from the succession of their business, something that can best be accomplished through growing and monitoring the value of the business over time. Even the “sell now” owner who is highly motivated to move on from their business as soon as possible can put some “window-dressing” on their business and increase its value and transferability.

Value Creation—A World of Possibilities

One of the primary advantages of a value-creation mindset versus an income-oriented one is that once you understand the true power of value creation, the entrepreneur’s mind can open up to the vast business possibilities for their business. For example, organic growth can often be difficult even for large, public companies. This is what fuels the M&A market as companies seek growth through acquiring other businesses. Other possibilities include licensing intellectual property; engaging in alliances, partnerships and joint ventures; or creating new product or service lines based on customer-facing feedback. The key takeaway is that once you understand the true value-drivers of your business, opportunities to grow your business may present themselves in unforeseen ways.