Many of us have heard the saying, “If you don’t know where you’re going, you probably won’t get there.” When it comes to building value in a company, this couldn’t be more true.
“Building a successful business — one that yields the greatest value to stakeholders — is hardly a random event,” says Jeff Stark, audit partner at Sensiba San Filippo. “It is the result of careful planning by business owners who understand which factors truly create value.”
Smart Business spoke with Stark about five critical factors for successful companies to create value.
Business owners have a clear plan, which they relentlessly pursue.
In order to maximize value, successful businesses must have stakeholders who are ‘one-minded.’ Business is very much a team effort, and a clear goal will help focus everyone’s energies.
Building consensus is very much a top-down process. It is important to determine which strategic track your company is on. For example, building a company for acquisition is a very different process than building a business to hand down to the next generation. Stakeholders need to know where they are headed so they can make smarter, better-informed decisions. Maintaining consensus is not always easy. Businesses can often be crippled by ‘analysis paralysis.’ Without clear, agreed-upon goals, decisions are often second-guessed, and the company must expend time and energy to get everyone back on the same page.
Stakeholders buying into your plan will give you the confidence to succeed in selling your value to customers. Consensus creates value at all levels, from making better hires to collectively working to overcome setbacks.
The business correctly values its products and services.
A second way of increasing value is making sure products and services are sold for their true value. Value is too often defined as how much it costs a company to produce the product or provide the service. Successful companies critically evaluate how much their products and services are actually worth to their customers.
Every company must have someone who can get in front of a customer and explain why a product or service is valuable. Asking for and getting the value of the product or service as it relates to the customer is critical to the process of generating value.
Many companies have a culture that takes a lesser view toward salespeople. Successful companies foster a sales culture and help employees recognize the value of the products and services they provide.
The company is in the business of relationship management.
Relationship management encompasses all of the relationships outside of the employees or customers of the business. These include vendors, bankers, attorneys and others who are essentially on the company’s business team. These relationships add value to the business. These ‘outsiders’ can give you valuable perspectives that you wouldn’t be able to get from people more intimately connected to the business.
Companies should focus on building solid relationships and not be overly concerned with ‘chiseling down the fees.’ The company should consider fees in light of the greater value it receives from key relationships.
Developing key relationships brings value to organizations. Oftentimes, simple acts, such as paying invoices on time or providing reports to lenders as promised, can make their lives easier, ensuring that the relationship will bring value when needed most.
Things must be written down and must be easily retrievable.
Documentation of key business activities can add significant value to a company. This is important for two reasons. In acquisitions, documentation often increases the value of target companies. When key business practices are written down, the acquiring company has more certainty that the institutional knowledge is safe. On the other hand, there are countless cases where lack of documentation has led to the collapse of an acquisition.
Businesses can also create value through operational improvements. Processes are refined and improved, but without documentation, value is often lost. When things are written down, they become real. There is suddenly tangible proof that can be accessed by internal personnel, outside accountants, the IRS, or anyone else who needs it. This becomes invaluable from an operating perspective, not to mention situations of disaster recovery.
The company must have an attractive, well-defined culture.
Culture means different things to different companies, but all companies should take the creation of a responsible business culture very seriously. Building a culture often starts with setting the tone at the top. When you build a culture that is open and honest, you have a better situation than one that is closed and secretive.
While some things need to be kept secret, sharing of information is almost always beneficial for the company. Business leaders should share the firm’s goals, challenges and successes with their teams. When everyone is aware of the target and how to meet it, more team members become involved in helping to reach goals.
Creating an attractive culture can improve performance, foster creativity and lead to greater contributions toward innovation. Companies should develop a culture that can adapt and take advantage of new ways of doing business. If a culture is stagnant, there can be missed opportunities for making the business run smoother and more efficiently.
This leads to a larger point about the nature of high-value businesses: The business may belong to you, but it is dependent on other people helping you achieve your goals.
Jeff Stark is an audit partner at Sensiba San Filippo, a regional CPA firm based in the San Francisco Bay area. Stark specializes in increasing values of venture-backed technology firms. At SSF, he has helped prepare companies for acquisitions upwards of $100 million. Reach him at (408) 286-7780 or email@example.com.
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Venture capital (VC) backed portfolio companies are highly susceptible to macroeconomic, industry and unique risks. In addition, VC fund ownership interests in portfolio companies are subject to risks, including market factors. How these parties address risks can significantly impact the value of companies and fund interests therein. An enterprise risk management (ERM) process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress. A well-defined ERM framework can protect and create value for the portfolio company and its parent VC fund.
“How a portfolio company addresses risk can have a significant impact on the harvest value of a business as well as interim mark-to-market valuations,” says John T. Alfonsi, CPA, ABV, CFF, CVA, CFE, a managing director of Cendrowski Selecky PC.
Smart Business spoke with Alfonsi about portfolio company risks and how they impact valuation.
Where is risk addressed in a portfolio company valuation?
The most common method of valuing a business is the ‘income approach,’ which requires a valuation analyst to project a business’s future cash flows, then calculate the present value of the sum of these cash flows by employing an appropriate discount rate.
When using the income approach, a valuation analyst must address risk in two primary areas: projected future cash flows and the discount rate. Effective ERM processes can help portfolio companies increase value by affecting the estimates for these quantities.
How does risk impact projected future cash flow?
Projections contain risk: There exists a risk that the portfolio company will not achieve the projected figures. As such, the process by which portfolio company management and the VC fund project future cash flows can impact a valuation analyst’s assessment of the business. A key risk is information integrity, the quality of information generated through monitoring and data assimilation. Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections.
Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment. While VC-backed companies are often nascent firms, the development of a robust internal control environment is an essential component to maximizing value. Potential strategic and financial acquirers, as well as investment bankers who may take a portfolio company public, want to see control environments supported by strong culture focused on mitigating risks. This culture will be evaluated by valuation professionals when they examine projections.
In analyzing historical projections, a valuation analyst should examine the variance between historical projections and a business’s actual performance as well as the business’s ability to reach milestones in a timely manner. If a strong correlation exists between projected and actual performance, a valuation analyst can be confident in current projections, if the process employed by the organization in making projections remains constant. If a strong correlation does not exist, the analyst must examine the variance between past projections and actual performance to discern whether bias existed in past estimates and may exist in current projections.
What about risks in the discount rate?
The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. In determining the discount rate, there are two sources of risk to be quantified: systematic and unsystematic. Systematic risk is the risk one must bear for taking on a risky investment in the market, which encompasses all available risky investments, including public and private equities, real estate, foreign currencies, etc. However, systematic risk is estimated by calculating the return to public equities due to availability of data. The ERM process has little impact on systematic risk unless the business’s performance is heavily tied to market performance, as was the case with Lehman Brothers and Bear Stearns in their final days.
Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates. Company-specific risk encompasses all other risks, including (but not limited to) size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health. This last component of the discount rate is one that portfolio companies can impact, and commensurately increase or decrease their valuation. Identifying and minimizing company-specific risks through an ERM process can positively impact the value of a business, as a company subject to less risk is more valuable than one subject to greater risks.
How can ERM processes mitigate company-specific risks and increase value?
An ERM process should quickly gather and assimilate high-quality information for use in the organization’s decision-making process, allowing the organization to rapidly assess the impact and likelihood of risks associated with changes in its internal and external environments. Early assessment and mitigation can help preserve value and cash in the business as well as allow it to capitalize on risky events when competitors do not react as swiftly to environmental changes. By capitalizing on risky events, portfolio companies increase the chance of improving their market share or establishing an industry-leading position. The ability to successfully mitigate risky events should be recognized by a valuation analyst through lower estimates for company-specific risks, leading to higher valuation estimates.
John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, is a managing director of Cendrowski Selecky PC. Reach him at (248) 540-5760 or firstname.lastname@example.org.
Private companies that create value have five things in common: They have a strong culture, a specific strategy, clarity in their business model, quality people and they meet certain financial markers that indicate whether the organization is successful, says Mario Vicari, director in the Audit & Accounting Group at Kreischer Miller, Horsham, Pa.
“Decisions about who you are as a company, how you compete, your market position, how you organize your business model and the quality of your team are key factors in creating value for private companies,” says Vicari.
Smart Business spoke with Vicari about how these factors drive value and how private firms can position themselves to attract and retain capital.
How does a company’s culture impact its value?
Every company’s view of its culture is different, but ultimately, key leaders should answer these questions: What are you passionate about? What makes you different from other companies that provide similar products or services? What really matters to you at the end of the day? And, how do you make your core beliefs clear to employees? In essence, how do you walk the talk?
Culture and core values set the foundation of the firm and drive high-level decision making. Without knowing who you are and why you exist, a company lacks direction and has a difficult time gaining buy-in from stakeholders, including employees, vendors, clients and end-users. Before you can build a company, you must know what you believe in and who you are.
The highest-performing companies have this written down, and communicate it and live it with their employees. A strong culture is what binds the company together and makes it unique.
Where does a company’s strategy come into play?
A business must know its position in the market and how it can best serve the right customers. How will you compete in the market? What is the definition of a perfect customer for your business? How will you differentiate your company from others in your space? Will you compete based on price or value?
A company’s strategy is often linked to its history and has to do with its core strengths. Identifying what you are really good at and focusing on markets that play to your strengths are critical. Also, the best companies are crystal clear about the definition of an ‘A’ customer and focus like a laser on that target customer. Part of determining positioning is to identify the specific markets and customers you will serve.
It is important to be discriminating in making these choices. The best companies know that they can’t be all things to all people.
Why is the business model important?
The business model represents the way the company organizes itself to fulfill its strategy. Ultimately, a business model answers the question, ‘How will you uniquely fulfill the promise of delivering value to the marketplace?’
It is about how the company organizes itself to execute its strategy. Do you fulfill the promise of what your culture says you should be doing, and how do you fulfill the promise you make to your customers? Once you know who you are and how you will compete, the business model outlines how your people and processes will achieve company objectives.
A business model is the coordination of activities within the business that addresses how you will go to market and deliver value to the customer.
How does a company get its people on board with the culture, strategy and business model?
Behind every strong organization is a group of talented leaders — a team. Often, private companies that don’t grow are hampered because the CEO is the smartest person in the room; they don’t hire people who are better than themselves.
In the best companies, CEOs surround themselves with very high-level skills in critical parts of the company and allow these people to lead. Companies that create value are constantly assessing whether they have the right people in the right positions in the company, and whether each person is delivering his or her maximum potential.
Strong company executives make tough decisions when people aren’t performing. A business cannot execute plans without really strong people, and great companies are not afraid to make a change if key people are not measuring up.
What financial metrics indicate that a private company is creating value?
Ultimately, margins and cash flow drive value. These metrics indicate whether a company has strength in pricing and whether it is managed efficiently. If good margins and returns on sales are produced, the cost structure is solid and the business is likely in a niche where it can compete on a value proposition and not solely on price.
Other metrics that are important reflect efficient allocation of capital — return on equity and return on assets. The best companies can do more with less, and they are careful about allocating capital to get the highest returns on their assets and equity.
Capital is scarce and hard to create in private companies, which is why it is so valuable. The private companies that create the most value are discriminating in their capital allocation decisions.
Mario Vicari is a director in the Audit & Accounting Group at Kreischer Miller, Horsham, Pa. Reach him at (215) 441-4600 or email@example.com.