How to unlock value in privately held businesses?
Pulling the levers that offer the best return for the least amount of effort or risk to capital.
To begin discussion around unlocking value in any business, a recap of how we measure value is required:
Value is created when a business generates free cash flows. Business valuation today is the estimated value of the free cash flows generated, discounted by
the risk to the capital used.
A valuable business grows faster cash flows (and hence valuation), with lower risk than its peers. In other words, the growth in valuation of a business is measured by whether its strategy is working or not.
Most business owners think of strategy almost entirely in terms of revenue growth or market positioning, but this is a mistake. There are other levers we can pull when unlocking the value of the firm, and best strategy is to pull levers that offer the best return for the least amount of effort or risk to capital.
Most small firms, however, have no idea which levers to pull. To illustrate this: think of your own, or a client’s business. Can you immediately identify which of the following projects offers the highest potential increase in free cash flow generation, or your valuation overall?
- Growing Sales?
- Reducing Cost of Sales?
- Reducing Operational Expenses?
- Improving Working Capital Management?
- Reducing Risk?
- Improving the Capital Structure?
It’s not that easy, is it?
Knowing where to allocate resources and focus efforts is at the heart of the strategy industry. Big companies strategise very differently to small companies, and are measured by rising market capitalisation relative to their industry, or overall market index. Not only do the ‘Fortune 500′ companies have highly qualified people fulfilling the roles of CEO, CFO, and COO (who jointly implement strategy), they also have boards, well informed industry analysts, and expensive consultants.
Having come from the strategy consulting world, (the author previously worked for Bain & Co), I can attest to the fact that much of the value placed on consultants is their work for similar companies elsewhere, and that they bring comparative improvements to bear.
This information is hard to get and provides valuable strategic insight, even for big companies. Small companies can’t afford expensive consultants, don’t have analyst coverage and typically the strategy planning and implementation role falls onto one person. This person probably doesn’t understand finance enough to do a Discounted
Cash Flow (DCF) valuation, so there is no clear starting point from which to measure strategy. Most importantly, there is almost no benchmark data from which the business can discern its position either under- or over-performing relative to industry peers. In other words, the typical smaller business is operating in a strategy vacuum. With no clear starting point or sense of performance, there can be no clear understanding of what achievement may be possible.
So what are the pragmatic steps that a business and its advisers can take in order to unlock value through the best strategy?
The steps are:
1. Build a financial model of the business, with future projections for five years. (More strategic thinking is forced this way than sloppily extrapolating current financials two years ahead. It’s worth the effort.)
2. Discount the project free cash flows back to a DCF valuation, and start to use this as a long-term target for your firm.
3. Take each of the projects from the strategic choices list (see above) and explore where you can make improvements. For example, how much could you grow revenues? Can you cut cost of sales? What about OpEx?
4. If possible, compare the firms’ performance in each of these areas to industry benchmarks, so you know where they’re relatively weak or strong.
5. Focus your analysis where performance is weaker than the best of industry peers. Through this you’ll understand which projects have the highest impact on free cash flows, hence valuation of the firm.
6. Allocate all resources to projects that offer the highest returns, for the least effort, in the shortest space of time.
7. Track progress and repeat this exercise every one to three months, or more frequently if you’re running low in cash.
8. Keep most, if not all, your resources allocated to the big impact projects until the goals are achieved. The business will now be in a far better position, able to grow more easily, and enable you to focus on the ‘higher hanging’ fruit.
The good news is, that’s strategy in a nutshell – it will enable you to unlock value in almost any firm.
The bad news is that you’re going to encounter some problems along the way:
- People don’t understand the value of a DCF valuation.
- Those that do will argue at length about the discount rate you use.
- Reliable relative performance benchmarks for smaller firms are rare.
- Performing these calculations is heavy work for a smaller firm, and it may not be significantly profitable, unless it’s your own business.
- You’ve got to keep pushing performance, adjusting targets, and implementing. This isn’t a one-off exercise. It’s a commitment.
Let me help you through the first hurdle: helping people understand the value of a DCF valuation. My standard example is as follows: “Consider the unlikely event of two businesses in the same industry having identical financials simultaneously. If you value the firms using any profit multiple-based valuation method you’d get a result suggesting the same worth. If you value them using Net Asset Value you’d get a different result but they’d still be worth the same.
However, even though their financial performance is currently the same, they face different futures and different risks, which only the DCF valuation method takes into account. Thus a DCF valuation for the two firms would not only be different but would also be most informative and valuable.” This simple test shows that a DCF is where the value lies (if you will excuse the pun). The next trick in a DCF is in determining the discount rate to use.
For large privately held companies (that is those with sales less than R100 million) it’s worth working from their listed counterparts to calculate a synthetic Beta, apply this to the capital structure and work backwards to a full DCF. This is for expert use only and relies on data from many similar listed companies (which there generally aren’t). Expert valuations require intense work and cost more. Valuation is a line of business where doubling granularity comes at four times the price, yet only a marginal increase in accuracy.
For smaller firms the bottom line is that they carry all sorts of risks: extreme customer and supplier concentration, lack of systems, dependence on one key location, poor cost control, and lumpy cash flows. The quick hack is to use a discount rate of around 30-40% for the equity portion of your Weighted Average Cost of Capital. Anything less and you’re doing everyone a disservice. If your client starts to squeal at a valuation that’s possibly lower than what they’d expected, then remind them it’s a starting point from which to measure improvement, which is the whole point of the exercise.
Author: Gareth Ochse, B.Com (Finance, Economics), is Co-founder and CEO, ValuationUp.