In my years of talking with small business owners and executives about the performance of their businesses, they are overwhelmingly focused of profit as their measure of success. This is understandable to a great degree, because so much of the public discourse regarding the performance of businesses revolves around profit. However, I would argue that the role of business leadership is to create wealth for business owners and that business wealth is a function of the value of the business. Consequently, rather than a sole focus on profit, owners and management should have value creation as their priority.
People start small businesses for many reasons, including being their own boss, the thought that they can provide a product or service better than their employer, taking control of their time, doing work that is more their passion or for reasons not of their initiative, including termination, acquisitions and divestments. Some business owners do not have significant growth objectives for their business. These are lifestyle businesses, which exist primarily to provide a job and a regular paycheck for the owner. If you ask most business owners what they ultimately want out of their business, they will likely discuss some concept of value realization through a sale, or an arrangement that provides them an annuity for a period of time prior to and ultimate sale. Yet, most business owners do not manage for value, but for profit, and are surprised when a prospective transaction suggests a lower sales price than they anticipated. Therefore, to realize the best opportunity for value from the business, managing for value creation is a necessity.
Before I continue, it is important to distinguish between values based management and value based management. Values based management concerns the clear identification of and adherence to the values of an organization such that the culture of the business is defined by those values and all business decisions are made within the context of business values. Value based management is managing and leading the business in order to create value and wealth for its owners. In a corporate environment, the operable mantra is that the role of business management is to maximize shareholder value.
In order to engage in value based management, one must understand how a business is valued by valuation professionals and by potential buyers. In many cases, the valuations by these two entities can differ significantly. Within this context of potential variations in value, business leaders have two broad challenges: Manage what they can control to create value and be aware of valuation issues beyond their control.
Business valuation involves an assessment of past performance and future prospects of a business. The standards of valuation can range from a liquidation scenario to fair market value to investment value, which provides a premium above fair market value. Valuation is based on three general criteria: assets, income and comparable companies in the market that have previously been sold or recently valued.
The asset approach to valuation takes into account the value of tangible and intangible assets in the business. Tangible assets include receivables, inventory and capital assets. The value of these assets are offset by a number of factors including liabilities and the ability to ultimately monetize the assets. For example, the monetization of receivables depends on the reality of collecting those receivables. Intangible assets on the balance sheet typically include patents, copyrights and trademarks. But other, non-balance sheet assets are considered to be intangible in the valuation process, such as key employees, customer information, vendor relationships, and market-leading processes.
Income-based valuation methods essentially derive value by capitalizing some measure of income performance. That is, the measure of income is divided by a capitalization rate, which is the minimum expectation by a buyer of a return on investment. Income performance can be net profit, but more likely, cash flow will be used in this valuation methodology. Cash flow of a business is derived from operations (profit and changes in the balance sheet), financing activity (long-term debt, short-term debt, lines of credit and equity infusions) and investment activity (capital expenditures). If a business pays a dividend, this will reduce the amount of cash available to the business. To get a quick sense of the value of the business, some analysts will use EBITDA, which is an approximation of cash flow. EBITDA means earnings before interest, taxes, depreciation and amortization.
Finally, a market valuation compares current sales prices or recent valuations of businesses comparable to the business in question to derive a value for the business in question. However, this method can be problematic, as businesses are rarely comparable in all valuation-related senses. Thus, this methodology is more appropriate as an order of magnitude for the value of a business.
Value based management, then, includes a strategy for creating value, uses governance, culture, leadership and communication to influence value based management and periodically measures the potential value of the business. Implicit in this approach is a focus on the general criteria that professionals use to measure the value of the business: assets, cash flow and competition. In fact a comprehensive valuation takes into account these, and every other characteristic of the business. Profit, then, is rarely the sole determinant of value.
Business owners must be clear about whether they have a true enterprise that can create business value and wealth for themselves. Carol Roth, author of The Entrepreneurial Equation – Evaluating The Realities, Risks, and Rewards Of Having Your Own Business, describes a business as an entity that sells goods and services to customers and is not dependent on the owner for its success. Roth adds that if a business owner is not trying to create equity value, then they are not building an enterprise that has value to a potential buyer and facilitates wealth for the owner. Consequently, value based management is critical to meeting the long term value objectives and exit strategy of the business owner. That is, the business must grow, be profitable, generate cash and have the systematic capability to operate without the day-to-day involvement of the owner.
One of the concepts consultants try to impart to their clients is to work on the business, not in the business. Many business owners view such admonitions with disdain, but it is ignored at their own peril. The degree to which a business owner is indispensable to his/her business is a measure of the discount in price a seller will demand in order to buy the business. If a business owner focuses on value based management, leveraging business assets, including employees; prioritizing cash, rather than profit; and building an enterprise that has intrinsic value beyond its apparent market value, then the business owner has a better opportunity to increase business value and, with a sale of the business, enjoy the wealth that results from the efforts of the owner and his/her leadership team.