Value Creation Program

The Importance of Value Creation

Overview

Many business owners focus on increasing profits and the return on the capital they have invested but pay little attention to factors that increase the value of a business. This can be a significant lost pportunity and can jeopardize the prospects of their business – both during their reign and after their successor assumes control. For example, when the owner, or his or her estate, sells the business it will probably attract a much lower sale price if strategies to increase the value of the business have not been implemented. Paying no or little attention to increasing this value could also jeopardize the prospects of their business – as it may not be able to secure the additional capital it needs or may need to pay a lot more for it.

Whereas some handsomely profitable businesses have no market value, some sell on low multiples and others on high multiples. In some cases, increasing profits does not increase the value of the business at all. In others increasing sustainable profits increases the value of the business but does not increase the value multiple the market would apply to the business. For many small-to-medium sized enterprises, it is a lot easier to significantly increase the value of their business by increasing the value multiple than it is to increase sales and profits. For example, it can be a lot easier to increase the value multiple by 50% from 4 to 6 times than it is to increase sustainable profits by 50%.

Whereas some handsomely profitable businesses have no market value, some sell on low multiples and others on high multiples. The challenge for business owners is to increase the value multiple the market would apply to the business.

Some business owners may be inclined to think that as they do not plan to sell the business in the foreseeable future or at all, the value multiple is not relevant. That would be a mistake. Many businesses have been sold, and many have closed due to the business suddenly and unexpectedly losing the owner of the business – adversely affecting those left behind.

Other business owners may be inclined to think that the value of the business is not relevant because on their departure, whether sudden or planned, control of the business would transfer to a named successor, such as an adult child working in the business. That would also be as mistake. Such business owners should ensure that the business is set up to increase the successor’s prospects of success, and that his or her departure will not be a nightmare or create headaches for his or her successor and that the business will not suffer from the business owner’s departure.

Furthermore, by attending to the factors that increase the value multiple the business is more likely to achieve its potential and more likely to survive troubling times. That is because it is more likely to secure the loans it needs (from the banking sector and private markets) and is more likely to raise the equity capital it needs (as the investment opportunity will be more palatable to passive investors).

It should go without saying that business owners should strive to increase profits and the value multiple.

The value calculation

Overview

The value of a business is basically determined by  calculating the present value of the money the best buyer would expect the business to generate for it and  other debt and equity capital providers (including the price it would expect to sell the business for), less the  amount of capital needed to run the business. The present value of those future cashflows is determined by applying  a discount factor to them. This factor is the return the buyer requires as compensation for the risk assumed. That’s for  taking the risk of earning a below-market return and losing  some of or all its investment. Prospective investors will rank this expected return-for-risk against other investment opportunities.

The core considerations for generating value:

It is important for the business owner to provide documents and other evidence showing:

  • A thorough understanding of the business and covering amongst others, what market needs it is satisfying, how it is doing so, what its competitive advantage is, how sustainable that competitive advantage is, what its marketing strategy is, and so on.
  • The likelihood of management sustaining the current level of revenues and profits, their potential to grow revenues and profits and confidence the owners can reasonably have in their plans to achieve such growth – to what extent, how quickly, what capital investment is required, how likely is it that management will achieve that growth, and so on.
  • The level of risk the business is exposed to and how leadership is managing those risks – this includes market,  supplier, product, personnel, and regulatory risks.
  • The quality of the team – management and other personnel.
  • Whether the business is being run like a well-oiled machine – whether it is run professionally with documented  systems and processes being adhered to and improved.

Rogers Morris’s value creation program

Rogers Morris offers numerous modules, each designed to assist business owners to increase the value of their business by, among others, increasing its sustainable free cashflows, improving its growth prospects, reducing its risks, getting it to run like a well-oiled machine independently of its owner/s, and by assisting decision-makers make wise decisions.

Rogers Morris Advisory also assists business owners to determine whether and to what extent they could benefit from an advisory session on the topic covered in any module. This it does by posing questions for the business owner to consider in relation to the module concerned.

The modules generally start by summarizing what the module is about and why it is important and include strategies for the business owner or the leadership team to implement and conclude with an action plan.

One can subscribe to the whole program or subscribe per module. To assist one make this decision, Rogers Morris has provided a list of the modules, a short explanation of each and a list of questions that may help in assessing how beneficial the module could be for the person or party concerned.

Rogers Morris also suggests you get an indication of the value of your business and the consequential value multiple (Value / EBIT) the market would apply to your business. Then calculate the additional value you would get if the program were to assist you increase your business’ value multiple by 50% from say 2 to 3 times, or from 4 to 6 times. Then compare that difference in value against the cost of the program. Sure, there is no guarantee the program will create that value for you.

Many business owners are either satisfied that their company is generating a return at or above market or have resigned themselves to accepting that, for whatever reason, their company is generating a sub-standard return on capital. They generally believe that they know their business well, that it is operating efficiently and effectively, and that it is maximising shareholder value. But is it?

Let’s take an example from the world of competitive sailing. “Anthony” has been sailing for over 50 years, has owned and skippered keelboats for over 20 years, and has raced his current boat (a 40’ performance cruiser) for over 10 years. His regular crew are also well-experienced competitive sailors. There is no doubt they know how to sail the boat, but are they sailing more efficiently and effectively than the other boats? Are they close to optimising the performance of their boat? They probably believe so because, over the years, they have collected lots of trophies. But are they? Since they race against boats of different makes and models, they compete under handicap systems. Anthony would say his boat doesn’t rate well on the IRC (International Rating Certificate) system, so he only considers his boat’s PHS (performance handicap) result. The problem with this (PHS) measurement is that you can have the worst boat, the worst crew and be the worst skipper and still win.  So, although Anthony and his team are all well-experienced sailors and have performed well on the measurements they consider, they may be sailing well below the boat’s capability and not know it. The same applies to businesses.

Many managers of SMEs and divisions within top-tier listed companies say that they are ‘happy with the performance of their business’, thereby implying that they are not interested in exploring opportunities to improve performance.  If you were a shareholder of such a company, would that approach sit comfortably with you? Probably not! Shareholders prefer management to continually explore opportunities to increase shareholder value. Many once-dominant companies have fallen because their leadership was too complacent or too arrogant to consider business opportunities or notice developments within their market. Even minor improvements can lead to substantial gains. For example, in the world of sailing, the top performers recognise that a mere extra yard of speed on a leg can give them an inside overlap rounding a buoy, which translates into a 2 to 3 boat-length lead on the next leg. A small change to the rig set-up can enable a boat to sail a couple of degrees higher, which can also put a boat 2 to 3 boat lengths ahead. As a result, the top-performing sailors continually look for ways to improve performance. They recognize that small changes can bring about large improvements in performance. The same applies to top-performing management teams.

Let’s take another example from the world of competitive sailing. In this case, the one-design Etchells class, where the boat size, shape, weight, and other dimensions are the same as are the sails’ sizes and shapes. Both professional and well-experienced amateur sailors, skippers and crew are regular participants. They can all do the job and unlike most other sports, participants can compete at the top level without being blessed with some or other superior physical attribute. So why is it that some boats consistently finish regattas in the top quartile, some in the last quartile, and so on? As with the business world, some go through the motions to get things done, and others are arrogant, thinking that because they have been sailing for so long, they know everything. The top performers, including the legends of the sailing world, constantly measure (the right metrics), monitor, refine, systemize, and risk manage. They also establish and refine policies and procedures, set goals and strategies, and continually look to see what others are doing, whether any new technology has been developed, and so on. If a top-performing boat gets passed on the course, the skipper and crew want to know how the other boat did it, what they did differently. They find out, then make changes to ensure they don’t get passed again. The management teams of top-performing businesses do the same.
Our modules show controlling shareholders how their business can become a top-quartile performer and how management can significantly increase profits, return on capital, and shareholder value. We do this by covering a wide range of relevant topics.

Many of the modules cover topics relevant to increasing profits. However, it is unlikely, but not out of the realm of possibility, that any will result in an immediate and material increase in profits. It is more likely that the business will enjoy increasing profits over an extended timeframe. Therefore, starting the process sooner rather than later is essential.

Some modules are more specific to increasing shareholder value, increasing the value of the ownership interest in the company, without necessarily increasing profits. This raises the question – When should you attend to these aspects of your business? The short answer is – NOW.  While you may have no intention to sell your business for many years, it is prudent to know the value of your business and to ensure that it is attractive to the party (or class of buyer) who would see the most value in it, and to b be willing to consider offers that are well above the value to you of your business. You wouldn’t want to miss a once in a lifetime opportunity to sell your business for a lot more than it is worth to you. If you plan to retire or sell your business, you should start the program a decade before you wish to exit the business – before you stop working in or on your business. Buyers of SMEs generally include in the purchase price an earn-out over 2 to 3 years. It generally takes about 18 months from the time you decide to sell to the sale being finalized, about 2 years to adequately prepare the business for sale, prospective buyers will want to review the financial statements over the past 3 years, and you should allocate about 18 months to work through the program. To get the best price you should ensure the financial statement show your business performing optimally at that stage of its life.

Having spent about a decade in the corporate banking arena in the late 1990s, early 2000s, Mark (the founder of Rogers Morris) discovered that the unlisted market offered a plethora of opportunities for significant investment outperformance as compared to larger listed companies. He also recognised that the SME market offered opportunities for significant value creation. Some were undervalued due to being seen to be dependent on the owner or being seen as amateurishly managed. These companies present easy opportunities for significant value creation. A mere size increase also creates shareholder value in the SME market. For example, two similar businesses targeting different geographical markets, each valued at 4 times EBIT multiples, could together be valued at a 6-times multiple. In this case, by merely aggregating the businesses, one increases the value of both by 50%. Further significant value creation comes from having a larger, more professionally run business: These businesses are more likely to secure debt funding without the owner/s having to provide personal guarantees. This significantly reduces the amount of capital the owner has at risk, thereby significantly increasing the return on capital exposed.  For example: In the case of a company valued on a 6-times EBIT multiple, if 50% of the business’ value is funded by a loan (without shareholder guarantees) at 5% interest, the value of the owner’s investment increases by 70%.

Since realising that the SME market offers opportunities for significant shareholder value creation, Mark spent most of the past two decades focusing buying or investing in companies within this target market. During that time, he analysed many companies from both the buy- and sell-sides. This experience improved his knowledge of this segment of the market and of the prospective investors and gave him further insight into the opportunities for shareholder value creation.  It also led him to realise that the owners of many of the SME businesses on the market get a much lower price than they could otherwise have got, had they also focussed on increasing the value of their businesses. This included businesses having a track record of generating annual profits of well into 7-figures but having no value to an acquirer.

Rather than just focusing on the buy-side, Mark has decided to help the owners of SMEs significantly increase the value of their ownership interests in their businesses.  Hence, our offering the advisory modules.

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