Many small and medium-sized business owners start off with two objectives in mind: pay themselves a reasonable wage and minimize taxes. This approach is suitable to a person who is more of a “lifestyle” owner, however, as the business grows a greater focus is needed on value creation rather than tax minimization. The reason for this is simple: whether the owner’s focus is on growth or eventual business succession, managing their business with a value creation mindset creates advantages for owners over those with a more income-based focus. In this post, we will explore what value-based mindset entails and what advantages accrue to owners who employ such an approach towards running their businesses.
What is Value?
To understand what a value-based management approach is, we must first define how we generally determine the value of a business. With the exception of extremely asset-intensive companies, the following expresses a simplified formula of the value of a business:
V = CF/(K-G)
Where CF represents cash flow, K represents the discount rate (or risk), and G represents the long-term growth rate. While this formula is overly simplistic, it can illustrate the three main factors which impact the valuation of any business and highlight to business owners the three prongs of value creation: the size of cash flows, risk, and growth.
Size of Cash Flows
You’ve heard the expression “cash is king” and nothing is truer in the valuation of a business since cash flows represent the true economic benefits generated from a business. While there are multiple definitions of cash flow (EBITDA, EBIT, or Seller’s Discretionary Earnings amongst the most commonly used), the concept is similar regardless of how it is calculated. What is important to understand is that while accounting or tax income may be important for their own specific purposes, they do not necessarily represent the true economic situation of the business. For example, a profitable business (based on net income) may in reality be a cash poor operation. Such a situation could arise in a capital-intensive company with fully depreciated equipment where the owners have made little to no investment in new, more modern equipment. This situation can be worsened depending on how working capital is managed or whether top-line revenue growth is being generated at the expense of eroding gross margins. In a future post, we will take a deeper dive into cash flows and explore these concepts in greater detail so owners can get a better grip of their business’ finances.
Cash flow is the real blood of any business and, holding other things constant, the more that can be generated by business in a sustainable way, the higher the valuation of such operations. Managing cash flow rather than simply top-line growth means managing gross margins, operating expenses, working capital, and for more asset-intensive business, capital expenditures. In particular, an understanding of the nature of your operating expenses (are they variable or fixed? discretionary or compulsory?) is an important part of this process. By spending more energy on managing cash flow, an emphasis on lasting quality (and hence shareholder value) is given more weight than ramping up sales through non-sustainable or low-economic strategies.
The next factor in the valuation of a business is risk (which is often in valuations measured in the form of a discount rate) so part of any value creation project must incorporate an element of de-risking that business. However, not all risk is under the control of an owner. Below we break down the various elements of risk that may go into a discount rate, which measures to total risk of a specific business.
- Risk-free rate—This is the baseline rate of return required on a riskless asset such as a long-term government bond (where the effective risk of default is almost nil). Investments providing returns lower than the risk-free rate would not be seen as attractive in the open-market.
- Equity risk—the risk of owning equity versus other forms of investments such as debentures, bonds, and t-bills. In general, equity is considered riskier than all of the aforementioned instruments, although it is possible for specific bond or debenture to be riskier than a specific equity investment.
- Industry risk—Some industries are riskier than others due to competitiveness or macro-economic factors. This riskiness needs to be reflected in the overall discount rate.
- Size Premium—In general, smaller companies are often seen as riskier than larger companies from an investor’s perspective. Middle market companies (with market caps of $1 million to $250 million) will have the largest size premiums compared to the largest public or private companies, which often have market caps in the billions of dollars.
- Company specific risk—This factor specifically correlates to the risks associated with an individual business.
While business owners have little control over the above risk factors, they do have control over company specific risk and this is the area on which they need to focus to de-risk their business. While we will later take a deeper dive into company specific risk, in general, de-risking your business involves:
- Building predictability;
- Building repeatability in processes;
- Strong communication between owners, management, and employees;
- An infrastructure that supports the company’s current and future size;
- Accountability and measurement of key performance indicators;
- The right people in the right places doing the right things;
- Written plans encompassing both the long, medium, and short-term time frames;
- Contingency plans;
- Succession plans; and
- Experience of the owner and management team in the industry.
While some value-drivers are not controllable by entrepreneurs, the growth rate of the company’s cash flows is within the control of the owner-manager. Owners can facilitate growth through:
- A strong sales and marketing system with effective customer feedback loops;
- Prudent investments in human, physical, and intangible capital;
- Strong financial management allowing for timely visibility on future cash flows;
- A management operating infrastructure that allows for superior execution, decision-making, and repeatability; and
- A strategic business plan which provides your company a competitive advantage.
Growth can be generated both organically (through internal generation of new revenues) or externally through strategic acquisitions.
Value Acceleration—A Summary
Value acceleration can be applied to any business since the formula given above is universal in application, regardless of the size of the business or the industry in which it resides. Middle Market owner-managers should apply these concepts to their own Company’s strategic plans because they give any company certain advantages:
- It will increase the value of the business;
- It provides the owner-manager with more exit options;
- It can help the owner-manager step back and take a more strategic role such as that of a true CEO or a Chairman of the Board, thus allowing more time to spend on desired activities;
- It is a potential wealth-increasing strategy.
In future posts, we will examine all aspects of value acceleration and how it can be applied to a Middle Market business.