Entrepreneurs start businesses for many different reasons. But anyone who has accepted risk, put out enormous energy (so called "sweat equity") and endured other opportunity costs has at least the goal of success. In our capitalist culture success is measured by marketplace acceptance, and marketplace acceptance generally translates into value that can be measured and realized.
The management-consulting firm I founded in 1986 has encountered businesses of all shapes, sizes and forms, and has been called in as analysts and expert witnesses in more than 200 complex business disputes. We are often asked by company leaders to explore their strategic alternatives with a view to creating, maximizing, sustaining and realizing value. Questions asked often include how to operate the business in the near to intermediate term if the objective is to sell or merge the company or, in the alternative, to take it public. Fortunately for us, value is created the same way, regardless of the ultimate objective.
Looking to the end is important because it is possible to create value in the short run with the promise of market share, even when a company produces losses (as in the case of, for instance, certain dot-coms and other technology or biotech start-ups). This is because market share is expected to translate eventually into sustainable profits.
Characteristics of Value
In my opinion, businesses should always be run with a view to being as valuable as they can be at any point in time. Accordingly, my firm and I drive our clients toward the value-creating business metrics. We have identified common characteristics of relatively more valuable businesses at three different stages and compared them with their less valuable counterparts. This comparison is based on a partial and not exhaustive list--the reader can undoubtedly identify additional characteristics.
At all stages, businesses have greater value when they have the following:
- Adequate capitalization
- Well-regarded investors
- Experienced management team
- Unique technology or service
- Ability to innovate
- Rapidly expanding market.
Once they are past the start-up stage, their value increases when they also have:
- Leadership or, later, dominant position in market
- Important customers
- Effective operating teams
- Strong gross margin
- Projections of positive cash flow and high return on equity.
By contrast, lesser value is related, at all stages, to the following characteristics:
- Poorly capitalized
- Unknown investors
- Inexperienced management
- Commodity technology or service
- Stable or contracting market.
Value also goes down when a developing or established company has:
- Unimportant position in market
- Weak customers
- Ineffective operating teams
- Inadequate gross margin
- Projections of continuing cash-flow deficit and low return on equity.
What Is the Question?
Businesses that strive for the characteristics of relatively-greater-value companies should always be more valuable than their less focused competitors. And those that push toward greater-value characteristics in emerging, rapidly growing markets should create the most value over time. The question is: How much value has been created at any point in time?
In my view, markets are key to creating and realizing value. This view can be tested by asking how much profit a business will record, assuming its costs are brought to zero. The answer, of course, is the revenue; without revenue there is no profit. And in the end, without profit, no value is created.
It is not hard to choose which metrics to aim for in order to create, sustain, maximize and ultimately realize value from energy and capital deployed over time. It is harder to actually achieve the desired result, which is why so many try and so few actually succeed.
Tools of the Trade
There are accepted tools that our firm and others use to estimate value. The tools include discounted cash flow analysis, comparable company analysis and analysis of recent transactions. These tools generally give a range of values from which some estimation of company value can be made.
Discounted cash-flow analysis starts with rigorously challenged projections of the company's future (including profit and loss, capital required and other elements of cash flow) and applies a risk-appropriate discount rate to future cash flows so as to calculate a net present value of the business.
Comparable-company analysis looks at the implied valuations of similarly situated businesses in the public marketplace and uses information from these comparable companies to value the business at hand. Analysis of recent merger and acquisition transactions involving comparable companies (e.g., same SIC code, same business model) uses recent transaction pricing to infer a value.
Value Is Not the Same as Price
Entrepreneurs often ask for some "rule of thumb" they can apply to their business to estimate value. An example would be five to seven times EBITDA (earnings before interest, taxes, depreciation and amortization). But these rules of thumb all include underlying growth-rate assumptions. Because industries have differing growth rates and profitability, these rules must be industry-specific. That's why old-economy companies have a very difficult time acquiring new-economy companies; the expected growth rates drive extraordinary pricing for new-economy companies. Moreover, in some industries, value may be otherwise measured. For example, I am involved in one industry where the metric appears to be $2 million per engineer.
Even more important, value is not the same as price. Price can only be determined by going to market and engaging potential investors or buyers. Because of the risk to the business inherent in this maneuver, it should only be undertaken when a liquidity event is required or desired, and then only with great care.
Creating, maximizing, sustaining and realizing value require the drive and vision of the entrepreneur. Combining this drive and vision with the rigor that results from focusing on the metrics that successful, valuable businesses have in common increases your opportunity to achieve the desired result.
R. N. Hankin Founder and Chief Executive Hankin and Co.