Last weekend, during a dinner with long-term friends, the discussion shifted to work. The topic suddenly then narrowed to the value of organisations and what creates value—probably because one friend was steadily growing his food business and another had taken the first steps into selling his construction company. Both were employing 20-35 odd people, both owned the business with their respective brother and both brilliantly fit the profile of an SME entrepreneur. They had built a product and knew how to make money with it.
What I realized is that their perception of value creation wasn’t the same as mine. Value for them was about the company being compatible with their personal projects. An enabler to lead the life they wanted. While for me, as an outsider, value had always been about longer term financial maximization while supporting some social higher goal. Let’s forget about the latter and focus on the former. What are the generic drivers for value creation? And how can my friend use this to maximize the value of his business to sell his company at a higher price?
Drivers for value creation
I can’t explain value creation without using some financial terminology (sorry about that!). First, let’s make some assumptions: a) the owner’s focus is on financial value creation in the company and not e.g. personal comfort; and, b) value is not the same as rising share prices or stock market prices. These assumptions taken, the generic drivers for value creation are:
- Cash generation ability. The amount of money a business makes with its normal operations, taking in account costs and corrected with taxes you can’t avoid. I tend to use NOPLAT, the net earnings before interest and taxes after making the adjustments for taxes. Obviously, more equals more value.
- Reinvestment in the business. The amount of money generated that needs to be used to keep the cash generation at the same level. The lower it gets, the more value a company has.
- Growth of the tax generation ability. A company with growing cash generation is more valuable than one constantly earning the same.
- Cost of capital. What it costs to use funds in your organisation. Known as WACC (weighted average capital cost).
A fifth driver is the latent values in assets owned by the company. Typically, “old” buildings or written off stock have some value in them without appearing in the balance. I consider this fifth one different because this driver lacks day-to-day impact. It only works in shotgun mode: you can do it only once. Putting the four drivers in an equation would yield you something like this:
How to add value using these drivers
The classic optimisation is to reduce costs and maximise revenue. I don’t think I need to illustrate this one. A good recent tool for companies who’ve done their traditional homework is to use analytics to find pockets of opportunity. The other one is related to unavoidable taxes. Unavoidable taxes are those taxes in a given fiscal year you need to pay. But sometimes it just helps to slightly tweak some operational choices to benefit from a better fiscal regime. This might give you a couple of percent points in value and is typically why some companies choose to open new operations in certain countries over others.
Optimizing your operations to lower the required investment is another useful tactic. Replacing repetitive and standardized tasks by automation typically falls into this area. Cheaper, less maintenance, lower total cost of ownership, improved output or services are key players here. Another thing not to overlook is taking a radical step and overhauling certain processes to be more effective.
Capital structure (and associated costs) is another often-overlooked optimisation in SMEs. Of course, during an M&A, the cost structure will be overhauled for a better one.
Growth is the one we had a nice discussion about. My friend was struggling with certain staff issues and felt he didn’t need to grow anymore. I won’t judge that, but I do know that growing the cash generation capabilities year over year does make a difference for the price a buyer is willing to pay!
Assets and latent value. Companies with IP are more valuable than companies without. Companies with valuable off-balance assets are worth more than those without. Companies with cash in the bank are worth more than one without. Companies with a negative tax, social, or ecological balance might be worth less. A very polluted asset might, for instance, be susceptible to ecological legislation and thus have a latent clean-up cost.
Growth is often a difficult subject in SMEs. Some struggle, others have cracked the nut. The essence of the story is that entrepreneurs successively face similar issues during their quest. The first struggle is about making money, the second one about delegation, and the third is about maturing the internal processes and keeping the company on a profitable path. All of these struggles are clearly tied to growth.
My friends clearly are in the delegation stage. They still take care of (almost) all managerial issues and struggle with staff-related issues. The last statement might need some explanation. A quick thought exercise will explain it. If every member of your staff has an energy draining issue only once a year and you employ 35 people, you end up spending time solving these issues most weeks. And more often than not, solving these issues does not contribute a lot of value to the organisation. (Similar to most administrative and legislative changes burdened on an SME.)
Growth would thus probably mean “adding a small management layer”. This implies absorbing the cost of resources that won’t be offset until another step on the growth curve has been taken—and all of this conflicts with personal and business objectives, hence the decision to sell the company.
Is my friend’s company in an optimal shape for value-creation? Clearly not. Is it in a good shape for selling? It probably is. A potential buyer who could benefit from economies of scale or can create value through vertical integration would be my preferred party. Certainly, that party should have a well-oiled machine ready to take over the supporting management tasks and has the operations focus on what they do best.