Continuing the deep dive from an original by Sean Hutchinson from SVA Value Accelerators Methodology, Sean gets right down through the financial accelerator component. He covers three things about the power of the financial accelerator – financial transparency, lowering the cost of capital, and the importance of knowing when to stop funding things that are ripping economic value away from the shareholders. Sean also touches on higher valuation, explaining how to talk with a lending institution, the Feed-Starve principle, and transferability options. Ultimately, creating value can be interpreted as the wealth of the owner, but what it should be is the value it has to shareholders and the whole company.
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Financial Accelerator Methodology Detailed: Creating The Path To Higher Valuation with CEO/Partner Sean Hutchinson
Creating The Path To Higher Valuation with CEO/Partner Sean Hutchinson
We’re doing a continuation deep dive from an original podcast with Sean Hutchinson from SVA Value Accelerators Methodology. We’re going to go through the financial accelerator component.
Our Value Accelerator consists of discovery plus seven 90-day sprints. We’re talking about a two-year project. Why do we put financial acceleration toward the end? We’ve gone through decision making and culture, risk reduction and productivity, the company of the future, and sales and marketing at this point. What we’re trying to figure out in the financial accelerator is how to efficiently fund it all at the lowest cost of capital possible. Often, the financial strategy and the organizational strategy are not aligned. You can have a good foundation of strategy, a good operational foundation and a good productive, efficient process. If the financing strategies don’t line up with it, you keep running into these blockades that ultimately are not going to serve you. Financial acceleration is also importantly about creating shareholder value for the owners. Ultimately, when we talk about value creation or value acceleration, what we’re doing is accelerating shareholder value. We’re creating transferability options for the owner that they did not have before.
When you say transferability options, what that means is we have a buyer out there and the business owner wants to sell.
That would be an example of an outside transfer, but the business has to be able to transfer also to the inside if that’s the way it’s going to go. Employee ownership, management ownership, partnership, or transfer to family. Those are the four inside options. The outside options are to sell to a third party, recapitalize the business which brings in a partner that takes part of the ownership, or liquidate. When I’m talking about transferable value, I am talking about being able to efficiently transfer the ownership of the business at the highest value possible. Most businesses when we start working with them are not transferable at all. If you put a value on the business, it’s probably more of a fair market value or an IRS tax value than a true market representation. Our position is nobody would buy your business. Particularly, Mr. Owner or Mrs. Owner, if you would look at your business from the outside and say, “I don’t think I would buy that business,” then it has zero value. The IRS is happy to put a value on it, especially within your estate. They got their own valuation approach. Even if yours is not transferable, they’re going to say that it has value and they’re going to tax you on it. We are always talking about transferability and value in our work because we think that that’s the acid test. Will it transfer from one party to the other efficiently at the highest value possible?The balance sheet tells an incredibly powerful story about the business. Click To Tweet
Financial acceleration is a big part of that. There are lots of aspects of financial acceleration that we could take into account, but there are two that we want to look at in our financial accelerator that we think to matter the most in this particular context. One is determining the true cost of capital for the organization. The cost of capital is critical. Part of the reason public companies can continue to grow and become more and more valuable as they g is that they have access to low-cost capital. Which puts a lot of juice in the equity because shareholders get a lot of leverage, which means that investors should get a higher return. Private businesses do not have access to low-cost capital. Many private businesses aren’t totally bankable. They might be able to get a line of credit. They might be able to get an equipment loan of some sort, an asset-backed loan, but it’s hard to get the amount of financing that they need to reach their goals.
When you go through this process with the business owner and you’ve gone through all the steps and you’ve gone to the financial accelerator portion, when that owner talks to a lending institution, does that change the behavior of the lending institution?
Absolutely, and there are a couple of pieces of that. One, we have a better story to tell. That’s important. The relationship between the owner and their bank honestly has got to be healthy. The trust in that relationship will be based partly on, in most cases, how trustworthy the owner is and to some degree whether they can financially guarantee the debt. It’s also about the story. The old style of banking was to get to know your customer. The bank gave the banker time to do it. You had a smaller portfolio of customers. You went out, you learn their story and your goal as a banker was to help the owner get from where they are to where they wanted to be. That was the role of the bank. Now, it’s not so much. Commercial bankers are loaded up with 200 customers. They probably have time to check in for ten minutes twice a year and there are all kinds of other pressures on them to develop new business rather than deal with the existing customers. The system has changed so much that the relationship between businesses and their bankers or owners and their banker has deteriorated, which is a problem.
We always tell our clients that in order to increase equity returns, you have to get lower cost capital. That means your banker is your best friend because the cost of equity is always higher. Some owners don’t want to use bank debt. They don’t want to hold a lot of debt on their balance sheet, but then they turn around and loan themselves their own money on an after-tax basis in many cases. The expectation of the return is got to be at least 12% to 15% in private business. When I asked owners, what do they want to get back for their money, for their investment because they’re in private business and it is high risk in many cases, they’ll tell me, “15% seems like a good number. That would be my minimum.” Every time they put a dollar back into the company, the expectation is that the dollar is going to produce 15%. Then the business has to generate a 15% return on that dollar plus it has to generate additional cash to grow. There isn’t any leverage in that financial strategy except the owner takes more risk by putting their own dollar back in. It’s been devalued already by tax and inflation. In my view, we’d be better off creating a financial environment in which the bank can say, “We can get behind that story and we’re going to do it at 3.5%.”
In that case, the company has additional liquidity. Granted, the balance sheet is going to look different. There’s going to be a payment and it will come right off the income statement and reduce profit to some extent. Those things are going to be there, but from a capital structuring standpoint, from a financial management standpoint, the company that uses debt judiciously and at the right cost is long-term going to be a much better company. Most private businesses are underleveraged. I don’t see many that are overleveraged honestly. I’ve seen a few in my career that borrowed way too much money. Maybe the more serious cases were not just borrowed too much money but borrowed it for the wrong reasons. Now, they’re in double trouble. Businesses that use debt for the right reasons, with the right goals in mind, and established financial systems that can track the value of that investment over time, which we would call in a technical term, economic value analysis, which folks that are in our industry or in the financial industry are going to understand right off. To put it in simple terms, what are the activities within your company that are creating economic value and which ones don’t? That’s what it comes down to.
Economic value very simply is, did it produce a return in excess of the cost of capital? You’ve got to make the spread. That begs the question, “Is the balance sheet structured in a way, both now and proactively into the future, that is aligned with your strategy?” If you say, “Here we are at point A and we’re going to use the capital to move to point B. This is the financing strategy we have to fund that movement. Our balance sheet or income statement looks like this. By the time we get to B, they’re going to look like this. If they don’t look like that, we might not be able to fund B to C. We’ve projected that they should end up looking at B like this, and if they do, then we’re going to be able to fund B to C. At C, they’re going to look like this, and that will get us to D.”
Much like we were talking about in the Company of the Future discussion, it’s incremental financial management. That sequencing of, “We’re going from A to B. We have to be able to fund it. It’s not going to happen by accident. We need a clear strategy and we need to do it at the lowest cost of capital possible.” That’s step one. That takes looking at the balance sheet history, the current balance sheet, and future balance sheet. We’ve worked with a lot of owners and their financial teams that honestly do not look at their balance sheets very much. They spend a lot of time on the income statement. Profit and loss, they’re focused on that and rightly so. The balance sheet and the cash flow statement, there is some attention to the cashflow statement, but cashflow analysis sometimes is a little more complex than owners would like. At the end of the day, it’s how much did I pay out? How much did I bring in? This GAAP cash flow statement doesn’t always resonate, and I get that. If someone asked me to look at the financial health of a business or to begin to estimate the value of the business or the value potential of a business, the first thing that I will ask for is the balance sheet.
I will not ask for the income statement yet. I can tell them right off the bat, with a little digging, whether the business is healthy enough to increase its value in the future just by looking into historical balance sheets. The balance sheet tells a story about the business that is incredibly powerful. Unfortunately, I think it’s an underutilized tool. A lot of times the financial staff, who are in many cases quite capable, look at the balance sheet a lot, but there are other people in the organization that need to see it and understand it. I would argue in financial acceleration for financial transparency. That’s a controversial subject as you can imagine. In general, transparency of any kind in business helps increase its value because it is a community activity. Everybody in the organization has got to be enrolled in the idea of creating more value. Wherever they fit in that process and that sequence, they’re getting involved in creating more value. Creating more value can be interpreted narrowly as putting more money in the pocket of the owner. I don’t think that’s what it is. Value acceleration is about creating shareholder value, but it’s also about creating a whole company opportunity.
We like wealth. Wealth creates opportunity. Wealth in business helps everybody. If we have money, we can do more. We need to be attuned to the financial needs of the organization and align it with the strategy. There needs to be a certain level of financial transparency within the organization because organizations that are transparent outperform their peers who aren’t. That’s because one, the owner and executive team have shown a lot of trust in people to engage with the financials, learn to understand them, understand their contribution to them, and why it’s important. Think about how money works in an organization and how important it is. The next time you ask for $50,000 to go out and do that or whatever it is you want to do, buy a new piece of equipment, how does that contribute to the long-term economic viability and wealth of the company?
If you’re not involved in that conversation or invited into that conversation, it’s not going to be on the table for you. The trust factor is one thing. The knowledge factor and the ability to understand action and how it relates to money is a big advantage that ultimately converts into a financial advantage. Think about public companies. Private owners get nervous about people knowing about their financials. You don’t have to show everybody everything. We’re not saying show every salary. It doesn’t matter, but they need to know the underlying basics. If you think about a public company, it’s all there. They can go read the 10-Q, read the 10-K, whatever they want is there yet the companies don’t fall apart. They’re probably better off with that level of transparency because people have access to the information that they may need in order to do a better job of understanding where their contribution might be. I advocate for financial transparency as well as operational transparency.Transparency of any kind in business helps increase its value. Click To Tweet
The other part of our financial accelerator that I probably am the proudest of is what we call Feed-Starve Analysis. If you think about your company as a set of tiles, each tile representing something that you do, something that you sell, a division, you would divide your company up into discreet activities, places, and things. Let’s call those economic activities. Let’s say that you put all of those up on the wall and they form a mosaic. Some of those titles are going to be differently shaped and bigger, smaller, whatever it may be. It’s going to turn out like a mosaic would be, a hodgepodge of stuff, all interrelated. If I go to an owner and I say, “I can tell you from experience that if you put twenty tiles up on the wall, five of them are going to be adding economic value and fifteen are probably either going to be neutral or taking it away. Tell me which five that are adding value.” Unless they have sophisticated financial analytics in some cases and a deep understanding of how money traces through an organization in particular ways according to what it does, they are not going to be able to answer that question. As a shareholder or a leader of an organization, that is an uncomfortable place to be because you don’t know what to feed and you don’t know what to starve.
You’d feel stupid about putting money in a division that doesn’t do anything.
If you knew about it and consciously continued to fund it, that’d be malfeasance. When we talk about leadership, the essence of leadership is knowing what not to do or deciding what not to do. The same principle applies, Feed-Starve. One of our other sprints we introduced earlier in this this in our rapid risk reduction and productivity sprints. It is a framework for deciding what to say no to and what to continue to support or even ramp up support for financially. Visually, this looks like a bar graph. Up the left-hand side is a return on equity. This is a shareholder measure. On the bottom side is the total capital base of the company representing all of the things that it does. How much money does it need to fund its operations every second? What’s tied up? At some point, on that bar chart is going to be a dotted line that goes from left to right and that is going to represent the minimum return on equity that the owner expects to get for their dollar.
Imagine that the company does eight things. There are eight bars on the bar chart. Let’s start on the left with our highest value activity. The ones we like are tall and thin. Why? Tall means they’ve exceeded that dotted line, the return on equity. They’re efficient also because they’re skinny, which means they’re not using much capital. It’s highly scalable activity. It doesn’t require a whole lot of reinvestment, which means it’s efficient and you can do more of those things with less capital. If you want to expand that, you don’t have to put millions and millions of dollars into it. You can incrementally continue to drive that up. Tall and skinny is great. Out of eight, maybe you have two or three that exceed your target ROI.
Number two, maybe still above the dotted line. We like that. Number three, just exceeding or just not quite hitting. What are we going to do about that? If it’s just below the dotted line, are we going to feed it or are we going to starve it? The challenge to the team would be, “We’re going to feed it, but you have to figure out how to make it get above that dotted line. Make it more efficient and drive the return up.” I love the fact that it gets real at that point because you can’t escape the financial results. Whatever they are, they are. They’re either bad, good or otherwise. You’re getting into interesting conversations that benefit the shareholder or shareholders but also ultimately create wealth within the company.Wealth creates opportunity. If we have money, we can do more. Click To Tweet
Let’s talk about the ones that are marginal. Let’s say four, five, and six are below the dotted line. In looking at those activities and analyzing them, maybe you see some life in number six. Even though it’s underperforming, because you’ve done the strategy work and because you’ve done the productivity work, you can look at that one and say, “It’s aligned with what we believe is our long-term company of the future. We believe because we have an agile strategy, we think we can take number six and turn it into a winner and we can do it within a year. Here’s our 90-day agile strategy plan.” We’ve identified success factors. We’ve identified risks. We’ve got our resources lined up. We can take that one and make it a winner. Five is marginal. Maybe it’s not underperforming. We don’t know how to cover the white space between the top of that bar and the dotted line target ROI. Quite frankly, it’s probably going to take a lot of work and I don’t know that we can ever push it to where we want to be. Somebody’s got to have a conversation about, “Are we going to starve it or feed it?”
In those discussions, it should be apparent that it needs to be starved. What does that mean? There are implications to starving. People may lose their jobs. However, if the organization is attuned to talent and workforce management, you never want to lose talented people. You always want to have created a culture and environment in which you could reposition them relatively easily. What you want to do is shut down that activity and move the capital that it was consuming over into the higher return activities and move the people there too if you can. You’re going to need the people there most likely, or you say, “We’re going to shut that down, but we’ve got a new idea. We’re going to go buy a company and then we’re going to take that company and we’re going to blow the lid off. We’re going to need some good people in order to do that.” What that’s creating is a more efficient capital base. It’s allowing you to invest your money where its most effective for the shareholders.
Here’s the story that I see a lot. The short, fat, gross under-performers seem to be a majority of the time the thing that the owner considers to be the heart and soul of the company. The sacred cow or it’s the reason the company was started. It’s a value sucker. It’s killing value in the company because no matter how many high return activities you get, you got this activity that’s sucking the life out of the company. It’s also creating negative conversations and negative culture. Everybody knows it’s a loser. Nobody wants to be associated with it. The leadership perception in the organization is being negatively impacted because everybody’s looking at that and looking at the owner or the CEO and saying, “Why are we still doing that? I don’t understand why that’s even a part of this conversation.” Leadership looks like they’re failing the test of, “The essence is knowing what not to do.” Feed-Starve is a pretty complex financial analytical process because most companies don’t understand in the beginning what capital they are investing in each activity. Part of it is defining the economic activities and there are lots of ways you can do it. Is it each product? Is it a division? Is it a market? Is it a set of customers?
Whatever that might look like, trying to understand the current situation is about understanding where the company is moving in the future. It doesn’t matter how you analyze that, as long as it’s aligned with and applicable to where you’re headed in the future. That’s what you want, alignment between those two things. The power of the financial accelerator, there are three things that we’ve talked about. We’ve talked about financial transparency, which begs the question of financial education. I don’t think you should ever give information to anybody who doesn’t understand it or seek to understand it. You need to work both of those things if transparency is going to be effective. We’ve talked about lowering the cost of capital, which is about understanding the balance sheet, income statement, and cashflow together. Aligning that and restructuring of the balance sheet with incremental steps along the way towards your company in the future, so it supports the strategy.
The third thing is to stop funding the things that are ripping economic value away from the shareholders. One of the realizations that come out of that exercise is that you can have a profitable division that is producing negative returns, another example of counterintuitive financial or value management. It helps if a division or an activity is a profit-making activity. If it’s taking a lot of capital and barely producing a profit or even a handsome profit, the relationship between the capital base and the profit is what hits the dotted line or doesn’t. You got to reduce the capital exposure. I did not say it was return on investment, it was a return on equity. That’s the dotted line. We’re talking about creating a capital base that is both equity and debt. If you’ve got a skinny tall bar, the smaller amount of capital the bigger the return. If you add debt to it, that increases equity returns as long as the debt is used for the right reasons and at the right cost.
If you have a skinny tall bar, the question you have to ask is, “Do I have all of that market?” If I have all of that market, then you either have to go outside your market or you got to figure something out.
You might be feeding something that’s not going to go any further. We can run that as long as it’s creating economic value. We don’t want to lose it necessarily, but we don’t want to put more into it.
If 80% of the company’s a fat-wide column and 20% is a high performer, you go do the math of 80% times what the poor performer is doing and 20% times. You go, “It’s overwhelming. There’s almost nothing that 20% division can do.”
As you add debt to the capital base, which expands the amount of capital that you have at a lower cost, that tall skinny one gets skinnier because you’ve added debt, now you have less equity at risk and your return on equity will increase. In that particular case, financial acceleration is in part about reducing the financial exposure of the shareholder.
For a company owner that has an accountant or CPA firm that’s doing their books, would it be reasonable to expect that the business owner could derive the information you’re talking about from standard accounting methods that they’re doing now?
Only if they break down their financials into the buckets that they’re going to use in order to determine whether they need to feed it or starve it. A typical financial statement will not tell you where economic value is being created in your organization. It’s not designed to do that. It will tell you your assets, liabilities, and equity in the organization. It’ll tell you whether you’re making money or losing money. It will not tell you whether those activities that create those two financial statements are creating shareholder value. They may be creating shareholder equity, but that doesn’t break it down into its component parts.The essence of leadership is knowing what not to do or deciding what not to do. Click To Tweet
For the business owner who is reading this and wants to direct his accountant or CPA firm to start creating the data, what would they instruct them to do?
The first thing they have to do is have a conversation about what is it that they’re trying to analyze. Break that down into component parts. You could say, “I don’t want to narrow it down quite so much. I’m going to do one set on products. I’m going to do one set of markets. I’m going to do one set on divisions of the company. Let’s see where we are.” I’d go to my finance team and we’d sit down and talk about what it is that we’re trying to accomplish. I don’t think that you need to get the accountants involved. They could be helpful because they could potentially say, “We know what you want to do. We’re going to go through and we’re going to classify in a different way each one of these expenses. Eventually, we get to the point where we can get some information out of it.” There are two other conversations though that need to happen. One is how much capital is tied up in the company and what capital is it? What is the owner’s expectation for return on equity, which is an expression of how much risk they want to take?
As an owner gets older, as they enter their Baby Boomer years it’s perfectly natural for them to not want to take a more personal financial risk. It’s tough to grow a company without taking personal financial risk. I have a client who has gotten to the point where they do not have to personally guarantee any of their debt, which is great but they’re a decent-sized private company. They’re $225 million in revenue now. I would argue that even though taking on debt exposes the owner through a personal financial guarantee to financial risk, spending their own money with a higher expectation of return is as risky at the end of the day. It’s the same thing, but it’s more expensive money. The corollary would be for me, let’s say you’ve got an early stage business and you’re trying to decide whether to raise money from venture capitalists. Venture capital money is extraordinarily expensive, high on the rank of capital expense. You’re talking about 40% to 60% money with disadvantageous terms. You could do that and you may need to do that. Owner’s money is probably coming in at a stated value of 15%. If they looked at the risk in their own company and where they could get investment returns elsewhere with much lower risk, it’s probably higher at the end of the day.
If you had an outside advisor who said, “Let’s get down into the risk profile of the business. What do you deserve for making that investment?” Their money is pretty expensive. I don’t know that the business is necessarily built to meet that expectation. They’re exposing themselves to the lack of return. They’re tying up a lot of capital that can be used for other things. That’s why I say to our clients that their banker is probably their best friend in a growth cycle. They may not want to take on a whole lot of debt late in their career, late in their ownership. If they’re 65 or 70 years old, it may not be time to refinance the company. However, being able to finance the company is going to be an absolute requirement for being able to transfer the equity to another partner. If you don’t have a bankable business, it doesn’t matter whether you have a debt on it the day of transfer. If you don’t have a bankable business, it’s going to transfer at a lower value every time.
It’s only worth what someone will pay for it and what someone will finance it.If the organization is attuned to talent and workforce management, then the last thing you want is to lose talented people. Click To Tweet
That’s true, but you can do things as an owner that will increase the amount of money that someone will pay for it. We have to be careful not to get into the passive kind of, “The value of my business is what somebody else will pay for it,” but you’re in control as the owner of the things that you need to do to drive that price up. Some people take that statement to be, “There’s nothing I can do. It’s going to be somebody else’s number.” The whole purpose of our Value Accelerator is to turn that argument on its head. There are many things that you can do to make your company more valuable. You won’t be able to totally dictate the value to the marketplace. You can set yourself apart so that in a crowded market, you’ve got everything that a buyer would look at and say, “This is a good bet and as a result, I don’t need to get 20% from my money. To get that company, I’ll take 12%.”
A lot of the things that we talk about, I honestly think that’s missing in the inventory or vocabulary of a lot of business owners. They don’t know what they can do and they don’t know that there’s stuff that they can do.
That may be the case or they’re so busy that they can’t get to it. I talked to many owners who are fascinated and excited to be able to have some say in their value destiny. That it is in their control to some degree. If you have a life event that forces you to transfer in a down cycle of the marketplace, that’s unfortunate. In a normal market, there is a difference between a valuable company and a not valuable company. We can look at them and trace not valuable and valuable to certain aspects. We can move the needle and there are building blocks that you need in order to do that. That’s why we’re in this business. When people ask me what the mission of our business is, I can say it in two words, “Abundant prosperity.” That’s what it’s about. Not just for the owner, even though the owner has engaged us. I want to see prosperity through the entire organization. At the end of the day, if an organization can create that much prosperity consistently on a sustainable basis, it’s by very definition a more valuable company.
I think about the community contribution. Employment, new jobs, opportunity, and training that come from a good community of good business.
Owners care deeply about their communities. They’re totally tied in. They know that they play a huge part in the vitality of the community.
They didn’t do it by themselves. They’ve got the employees and the community that can help them with them and they’ve contributed and want to give back. I think about why this ended the financial side and the end of the acceleration process. If you don’t have the other parts in place, you don’t know what else you can do to get leverage. You have to have those other things in place. Thanks a lot, Sean. I appreciate it.
About Sean Hutchinson
Over my 25+ years in business, the best lessons I’ve learned have been from business owners who have generously shared their stories of success and struggle and allowed me to offer insights and guidance based on my experiences.
We share a bond. I’ve founded five companies, all of them with partners, some more successful than others. I’ve led a fast-growing global company as a very green, but hard-working and quick-learning, 34-year-old who every day had to make big decisions with big implications. It became the largest firm of its kind in the world. And, maybe most importantly, in this case, I’m the 3rd Generation heir to my family’s 60-year-old custom millwork manufacturing business. I’ve sat in the owner’s chair many times and I love being an entrepreneur.
As one of the three founders of SVA Value Accelerators, my role is once again to fulfill the responsibilities of the Chief Executive Officer. I focus mostly on strategy and growth – in other words, our Company of the Future. And that’s where I help our clients too – working with owners and their leadership teams to imagine what could be, can be, and will be their Company of the Future. I see my work as transformational, not transactional. Whether an ownership transition is near or on the far horizon, it’s all about getting owners “Ready for Next” by creating a constant state of Transition-Readiness.