High-quality revenue is generally considered to be sales that are, profitable, sustainable, and predictable.  Businesses with high-quality revenue often trade at higher multiples than their peers with lower quality revenue, particularly when the buyer plans to continue to operate the business as a stand-alone entity.  That’s because it lowers the risk for the buyer, and there are often more buyers willing to bid aggressively in a well-run, competitive sales process.
This article provides some ideas that business owners may want to consider implementing, that can improve the quality of their revenue in advance of a sale and to increase their chances of a successful outcome, once in the market.

The highest-quality revenue comes from contracted sales with recurring revenue.  This type of revenue can usually be relied on by a new owner to generate cash flow which allows for the use of more debt financing and less equity to finance the transaction.  Longer contracts are better, assuming it generates profitable sales with reasonable pricing adjustment mechanisms and is with a reliable and stable payor.

Subscription revenue is also a very high-quality source of revenue and one of the reasons why Software as a Service (Saas) companies trade at such high multiples.  Anything a company can do to generate at least a portion of their sales as recurring service revenue will help drive value and the business’s marketability.  This is especially true in circumstances where the service is scalable, there is a low cost to service new customers and when the market opportunity is very large.

Lengthy customer tenure with very low customer churn rates is also generally considered to be a source of high-quality revenue.  All too often, companies emphasize programs and strategies to acquire new customers, and while important, retaining key customers is often more important when it comes to the value of your business when selling.  This is especially true in B2B companies where customers are difficult to acquire and costly to lose.

It’s often been said that you can’t manage what you don’t measure.  Companies that have a robust CRM (Customer Relationship Management) system in place to manage the entire organizations’ interaction with customers can address customer concerns early to improve retention.  They also help identify ways to increase sales with existing customers.  Taking this a little further, understanding your company’s Net Promoter Score (NPS), and the actions you can take to increase it, can drive value.  NPS is simply a tool that measures customer satisfaction and the likelihood they would recommend your product, service or company to someone else.

Simply putting more resources and a disproportionate effort in retaining customers that are growing rapidly can be an excellent way to grow the business.  However, it is important to make sure that this strategy is not taken to the extreme, as customer diversity is also an important component of revenue quality.  Whenever there are a lot of sales coming from only a few customers, a buyer will price the risk of defection into their offer.

Besides a diverse customer base, sales into unrelated markets, based on geography or market segments sometimes can be a driver of revenue quality.  However, there are limits to this strategy, particularly when diversifying revenue too thinly.  Focus should be directed towards markets that are not dominated by well capitalized competitors, and on the most profitable customers, products, product lines, etc.  The market should also be able to benefit from your business’s core competencies.

Most people understand that product, and/or product-line diversity can an important way to improve revenue-quality.  However, products and services that are low cost relative to the customers’ total expenditures are higher quality sources of revenue than the reverse.  Under these circumstances, customers tend to be less sensitive to pricing, and therefore gross margins can be higher.  Gross margins can be a proxy for high-quality revenue.

Some of the lowest sources of quality revenue are tender/bid business or a one-time project-related sales. In the case of tender or bid sales, it is also often the lowest margin.  Large-ticket, capital expenditure reliant business is difficult to predict, and volatile cash flow makes aggressive pricing for buyers a difficult proposition.
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Every business, regardless of the market it serves, has room to pivot and refocus on higher-quality revenue streams that will drive its value and marketability when it comes time to sell.

Most Private Equity deals in the lower middle market are structured where at least a portion of the sale proceeds paid to the seller(s) are rolled back into a new capital structure of the company, alongside the equity provided by the PE firm. This provides a source of financing for the Private Equity buyer and lowers the amount of equity they need to invest, but more importantly, it demonstrates that the target company’s founders, owners, and/or management are confident in the business’s future.  When combined with an ongoing role in the new partnership, it is an opportunity for the seller to contribute to the business’s future success without taking on all the risk themselves.  Of course, besides the fact that the seller does not receive “all cash” at the close of the transaction, it has many other financial, legal and, tax implications that should be clearly understood by the seller.

The first consideration that is usually top of mind with sellers, is whether the PE firm will take a majority or a minority equity position in the newly capitalized business.  Some entrepreneurs are accustomed to making all the key business decisions and can be uncomfortable in giving up control while staying involved.  On the other hand, many PE firms that participate in the lower-middle market are not able to take non-controlling positions, and those that do, only do so in special or specific circumstances.

From a practical standpoint, whether the PE firm has a major minority position (i.e. at least 25-30% ownership), or a majority, it will only be successful if both sides have a common vision and clear alignment on strategy.  The last thing a PE firm wants is to have a falling-out with legacy owners, based on a major disagreement on the strategic direction of the company.  While disagreements can occur during the common ownership period, it is important to get off to a strong start, so that those disagreements can be worked out respectively and amicably regardless of who is in ultimate control.

It is also important to clearly understand the respective roles and responsibilities of each party.  Most PE firms will say that they don't want to run the business, but what that means from a practical standpoint, can vary from firm to firm.  Rarely will a PE firm be a truly passive investor.  The best outcomes are usually where an entrepreneur is looking for the professional support and experience that is provided by a PE partnership, and where both parties are focused on building value for an eventual full exit.  Entrepreneurs need to be comfortable with the added reporting, planning, and governance that usually accompanies a PE deal.

One of the key benefits of rolling equity is that the lower risk for the PE firm can translate into a higher value the PE firm is willing to pay.  And of course, if during the period of common ownership, the capital and resources provided by the PE partner can help scale the business and build value, the value for the legacy owner’s rollover stake can be much higher when the business is sold down the road.

Often the PE firm will use some degree of leverage to finance the deal as well. While many business owners view debt as risky and have avoided its usage wherever possible, its use along with the shared risk taken by the PE firm can further enhance the legacy owner return on their rollover equity.  For example, if a PE firm structures the deal with 50% debt, and legacy owners agree to a 25% equity stake, funding the rollover portion requires only 12.5% of the pre-tax net proceeds.

A PE-backed business also can often negotiate preferred terms with lenders that legacy owners can benefit from. Furthermore, if the new business partnership is highly successful, legacy owners can sometimes benefit from dividend recaps, sale lease-backs of assets, or other refinancing deals that provide cash disbursements to all shareholders.

There are also often significant tax deferral benefits for the portion of the equity that is rolled.  Engaging an advisor that is familiar with the tax implications of equity rollovers in your jurisdiction is critical.  Normally the PE firm will be open to structuring a transaction to help reduce or defer taxes when it has a neutral impact on them.  There also could be significant tax implications if the deal is structured as an equity sale vs an asset sale.

The legal implications can be complex, and it is critical to have legal counsel that is experienced with PE rollover transactions and how they should be structured.  Besides the obvious legal implications of majority/minority positions, preferential voting and liquidity rights can be sources of consternation.  One way to ensure that the interests of the PE firm and the rollover equity shareholders are aligned is to structure the shares on a pari passu (equal footing) basis.

The key is finding both tax and legal advisors that have deep experience in getting PE deals done.  All too often, advisors without enough experience in rollover transactions with PE firms are so risk-averse and so protective of the sellers' rights, that a successful close is not possible.
Rounding off your “A” team with the marketing expertise and deal experience of an Investment Bank and/or M&A Advisor will help ensure you have multiple PE firms to consider rolling your equity with, by running a professional, competitive process and determining “what’s market.”

Those of us working in M&A have all seen the proverbial “hockey stick” projections presented by an overly optimistic seller trying to generate interest in their business.  Usually it is accompanied by some vague explanations with a year over year growth target of “insert inflated figure here”.  Buyers typically view a seller’s financial projections with a degree of skepticism, and most will build out complex valuation models to determine a reasonable price they can afford to pay, based on their own assumptions.  In this blog article, we attempt to make the case on why you should be careful about how you present your expected growth potential and financial projections to build rapport and credibility with a potential buyer, and thereby enhance your position in the negotiation process.

The reality is that the best predictor of future performance is past performance.  Your negotiating position is enhanced if you can demonstrate that when we did “this”, the outcome was “that.”  For example, if you can demonstrate that your recruitment, onboarding/training, compensation and management of new salespeople can typically generate increased sales from “x” to “y” over a specified time period, then it follows that if you repeat this process, you could make a reasonable prediction that is credible.  Other examples abound, such as marketing and advertising spend, capital expenditures, acquisitions, new product introductions etc.  All are most credible when you can demonstrate a track record on execution.

Including projections based on a strategy that you have little experience in executing, is likely to be discounted to a large degree by a buyer.  These are more likely to be considered ideas than true projections.  While ideas are helpful in creating optimism on what may be possible for a new owner, any tie-in to the financial projections should be layered-in and presented more as speculative potential, rather than true projections.  It’s important to separate what is doable based on track record and what is possible based on new ideas, wherever possible.

One area that is often missed is the inclusion of the additional working capital, additional expenses and/or other investments that will be required to execute the plan.  Details missed on the expense side simply weakens the seller’s credibility and negotiating position.

The best approach is to have a robust business plan incorporated into your core business processes, well in advance of a potential sale or exit.  This may mean taking the management team and perhaps even a cross-section of key employees off-site to develop, review and revise your plan.  Of course, incorporating KPI’s (key performance indicators) to measure and track your progress towards your strategic goals will be helpful when negotiating with a buyer.  The most important aspect, is to be able to demonstrate to a buyer that you “plan the work and then work the plan.”
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You never get a second chance to make a first impression! The same principle applies to a potential buyer.  When sharing financial projections with a prospective buyer, it is important to get the negotiations off to a good start by having credible financial projections.  In fact, some would argue that no projections are better than those that are vague or even worse, unobtainable and/or unrealistic.

I continue to be amazed about the misconceptions some private business owners have surrounding the Private Equity (PE) industry and how they typically operate.  Perhaps it has been the negative media coverage on the greediness of Wall Street (or Bay Street) and the perception that investors promote the use of unethical tactics to line their own pockets at the expense of workers, the environment and society in general.  Perhaps it is the perception that PE firms use too much debt to finance their transactions, or that by working with them will create too much conflict around major decisions. Maybe it’s the perception that they add little value or won’t pay what a business is worth and are simply focused on buying cheap and flipping businesses for a profit.  This blog article addresses these misconceptions and provides private business owners some “food for thought” on whether they should include a “PE recap” as an exit option worth considering.

Any concern around tactics driven by greed is likely as much of a myth today as it was a reality in the past.  It is true that the typical “corporate raiders” of the 80’s bought distressed businesses to outsource operations and liquidate assets despite its impact on other stakeholders.  Most modern PE firms nowadays focus on backing entrepreneurs to help them build a better business, and to share the financial rewards with them through aligned incentives.  They also often put plans in place to reward staff and lower-level management to create alignment across the organization.

It is also true that some deals are highly leveraged and can put the business at risk if things go south, however this is much more likely to happen in the “mega-deal” space, than it is in the lower-middle market.  Lower-middle market PE firms carefully assess the cash flow risk associated with any investment and use conservative amounts of debt to leave some “wiggle room” should things not go as planned.  Also, as the debt is paid down and the comfort level around the business improve over time, they often invest additional equity to help accelerate growth.  So, while it is important to get off to a good start whenever a PE group invests in a business, the risk of debt-induced insolvency or restrictions on funding attractive opportunities is quite low.  It is also not uncommon for some PE firms to use all equity to fund deals, particularly in high growth businesses that need capital to capture attractive opportunities or to establish leadership market positions in growing industry segments.

Selling all or part of your business to a PE firm will often mean some significant changes in how major decisions are made.  Most PE firms do not want to run the business, but everyone has a different viewpoint on what that means.  To the PE firm, that means that they won’t be fielding orders from customers or making hires for the plant floor, but they expect to be involved in strategic decisions.  For example, hiring a new sales manager or CFO would likely be expected to trigger an in-depth discussion, as it would in any respectful partnership.  The key here is to have clearly defined roles and decision-making processes agreed to upfront, as the level of passive versus active involvement is highly dependent on the PE firm and the skill set of the management team.

Finally, the spread between the value paid by industry buyers (strategics) and PE for quality firms is often very narrow or even nonexistent.  In some instances, strategics pay more for rare assets that are a perfect fit for their business by sharing with the seller a portion of the expected synergies.  However, on the flip side, PE firms only make money when they successful invest the capital entrusted to them by their investors, and many have large amounts of uninvested capital to deploy.  This has driven up competition between PE buyers and between PE buyers and strategics in recent years.

The primary objective of most Private Equity firms is to put their investment capital to work by 1) buying/investing in good businesses at a reasonable value, 2) working closely with the management team by supporting and helping them to build a much larger, more profitable business within a few years, and 3) monetizing their investment by selling it once it is worth a lot more, and finally, 4) returning the capital to their investors at an attractive rate of return.  For sellers, the opportunity to roll equity in a professional partnership with a PE firm can be very attractive even if they sell their initial stake at a slightly lower value than what the highest bidding strategic will pay.
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In the end, it is quality businesses run by entrepreneurial owners, with aligned incentives and clearly defined roles and responsibilities that produces a successful outcome for all parties.  Considering a sale to a PE firm, with an equity roll, can be an excellent way to implement a two-step exit plan for entrepreneurs looking to maximize value, but only for those that are patient and open to changing how they operate and how they make key decisions.

You never get a second chance to make a first impression! It has been said that it takes the average person about seven seconds to form an opinion of you that never changes.  The same principle applies to a potential buyer of your business (although it is likely to take a little longer than seven seconds!).  In this blog article, we outline some key considerations when sharing financials with a prospective buyer and how EBITDA addbacks impact a buyer’s viewpoint on value.  Addbacks are positive or negative adjustments to earnings that aim to reflect the business’s “maintainable earnings” for a new owner.

From our buy-side advisory engagements, we often see two scenarios. 1) where no addbacks have been included, and the internal or audited financial statements, or sometimes even the tax returns are the first numbers a buyer sees, or 2) where the addbacks are so broad and all-encompassing, that they negatively impact the buyer’s first impression of the business.  The risk for scenario 1, is that you may miss out on a non-recurring expense that is not reflected in a preliminary offer. It most often happens when the seller is not actively selling the business and is simply responding to an interesting inquiry.  The risk for scenario 2, is perhaps more serious.  It is natural that the seller wants to present the business in its most favourable light to get the best offers. The issue, however, lies more in the pending consequences during the negotiation stages that can lead to a disappointing outcome.

With unrealistic addbacks, your best buyers may now view everything you share throughout the negotiations with a more sceptical lens based on their perceived first impression of your credibility.  The negotiation process can be thought of as a balance of power, that changes as the process progresses.  It is critical during the first impression stage, that you present yourself, your business, and your financials with credibility.  That means EBITDA addbacks with clear justification and documentation that can be verified and articulated with well-thought logic around your assumptions backed by real facts.

Owner benefits are the most obvious, and often the easiest addbacks to identify and justify.  While some private companies have very “clean” financials, others have the country club expenses, cottage maintenance, kid’s salaries and the owner’s home renovations embedded throughout the statements that need to be adjusted.

Including addbacks such as the full salaries for key owner/management may seem logical, if there are no plans to stay post-transaction.  However, from the buyer’s point of view, there will still be expenses associated with the business’s management.  Adjustments should be based on the business’s needs and valid assumptions on market salaries, by using outside sources, such as salary surveys for the industry and/or region.  If the company is owned by an affiliated company that provides administrative, accounting, IT, or banking support, those also need to be included in an adjustment.

There are often other non-recurring expenses that should be added back but need to be clearly justifiable.  These are particularly important in rapidly growing companies and include additional or unusual expenditures on new hires, R&D, patent applications or advertising for example, where the benefits will accrue to the new owner.  It is tricky to convince buyers that these will not necessarily recur unless they can be clearly defined.

In order to get a deal to the finish line, addbacks will be thoroughly assessed by the potential buyer or buyers, and if a deal is to close, it will be based the buyer’s due diligence.  Addbacks are often reviewed by an outside firm, through a “Quality of Earnings” (QofE) review and a buyer may adjust any preliminary offers based on any material items that are discovered.  Given the increasing frequency in which a QofE is undertaken before closing, it is best to make an accurate estimate of the correct adjustments well before the QofE review, and ideally before any potential buyer sees any numbers.

In summary, the best approach to gain credibility and a good first impression with potential buyers, is to carefully and thoughtfully adjust EBITDA where the reasoning can be easily explained and justified.  Opening the dialogue with unadjusted financials leads to a potential missed opportunity to capture some value and throwing unrealistic adjustments at a buyer, just raises questions that are better left out of the negotiation process.  Adjusting EBITDA is just one of many steps business owners need to take to properly prepare for a sale of the business.

It has been often said that you can’t manage what you don’t measure. Far too often, small to medium sized business managers fail to objectively measure the long term impact of their major capital expenditures. 

​Normally, a ton of work is done up front, by choosing the right equipment, design, vendors etc., with a clear focus on the future benefits for the company.  However, often too little work is done on return expectations under best case/worst case scenarios, let alone ensuring on-going evaluation and assessment once the project is completed. 
 
The cumulative impact of your capex decisions can have a major effect on your long term profitability and perhaps even more importantly, the value of your business.  It goes without saying, that if you make a series of good capital project decisions that result in shorter than expected paybacks or higher ROI’s, it can have a very positive effect on the business value and profits. Conversely, by making a series of marginal or poor capex decisions, it can really devalue a business over the long term.

For many established businesses, a quick way to evaluate the cumulative impact of your capital expenditure decisions is to look at your historical depreciation plus capital lease expense in relation to your operating profit.  If the former has been growing faster than the later, then you are likely not setting the bar high enough on your decisions to spend capital, unless you are consciously and aggressively growing market share or investing in new business areas that are expected to have a long term positive impact.  Of course, there are ways to accelerate depreciation, based on allowable tax rates for example, that can really skew this metric and it is therefore most applicable when you use depreciation rates that match the useful life of the purchased asset.

One of the areas that managers need to consider, when making capex decisions, is their weighted average cost of capital (WACC – ask your accountant to calculate/estimate your WACC - every private business owner needs to know this number).  In order to build long-term enterprise value, the return on capital expenditures should always be higher than your WACC, even under your worst-case scenarios.  This is especially critical for expansionary projects.  It needs to be the minimum hurdle rate you use to assess the viability of every new project.

Companies with little or no debt can destroy business value by investing in projects that provide returns that are insufficient to cover their cost of capital, even if they actually contribute to the business earnings.  Obviously for companies with high levels of debt, the project could have severe repercussions should it not generate the expected cash flow.  Even so, the prudent use of debt financing can often lower your WACC, especially for established companies with a solid asset base and a positive cash flow track record. Therefore, debt financing should be considered, as it can widen the spread between the project’s return and your WACC, which builds enterprise value.

Finally, don’t forget to assess the impact of the project will have on working capital.  Like your fixed capital, there is a cost associated with working capital, regardless of its source, and therefore you need to get a return over and above its cost.  Capital projects that increase efficiency can decrease working capital as well as lower other operating costs. However, projects that are undertaken to facilitate topline growth can result in increases in inventory or receivables for example.  All positive and negative impacts to working capital need to part of the evaluation process.

Knowing your business’s track record on each major project helps your fine tune your evaluation process, and thereby provide the basis for continuous improvement.  An accurate, objective and analytical assessment of the project’s ROI needs to be imbedded into your capital decision making process, if the goal is to build real and sustained value into your business.

We all know that the actions you take today will influence business performance in the future, and therefore its marketability and value, should you decide to sell.  Many of those actions can directly influence the “quality” of the business’s future revenue.

High quality revenue is generally considered to be sales that are sustainable and predicable, are profitable and come from a diversity of products, customers, markets etc.  High quality revenue reduces risk for any new owner or management team and therefore can increase business value.
 
For a sale or recapitalization with a financial buyer, such as a Private Equity firm, family office, and private investor, the quality of the revenue is a critical determinant of value, and indeed an important pre-qualifier for many.  Many will have their own criteria on how they assess revenue quality.  Suffice it to say, that acquisition candidates with narrow product lines, and/or in singular markets with high customer concentration are often a “pass”, even if the business is very profitable.  Other financial buyers that are less risk averse or use less leverage to finance their transactions, may be interested, but only when growth prospects are very strong and/or when they can buy “cheap.”

For insider or family transfers, high quality revenue improves the probability that next generation management will have the cash flow to pay off a seller note, pay down any outside loans used to purchase the business or to redeem legacy owners preferred shares.

It may be a different story if you are looking for an eventual sale to another industry participant, or a “strategic” buyer, including those that are Private Equity sponsored (i.e. those looking for “add-ons” for a portfolio company they own).  Revenue that comes from a wide diversity of customers, markets or products may, or may not be an important criteria, and therefore may or may not be reflected in the value of an offer.

Strategic buyers may be interested in your business only because it adds something specific (E.g. a product line, management talent, your facility) to their business that will take too long or would be too difficult or expensive to build/develop organically.  If that valued attribute, such as a product line, makes up only a portion of your overall business, the rest of it may be discounted.

Consolidation strategies can create cost saving and revenue synergies for a buyer, but it is difficult for them to justify paying for redundant products/product lines that could be discontinued post-acquisition.  Forward, backward and horizontal integration strategies all impact the perspective a strategic buyer will have on the value of your business and the importance of your revenue quality.

On the other hand, if the strategic buyer is looking to buy your business and run as a separate business unit, then your revenue quality is very important.

It therefore pays to know what the key strategic acquirers in your industry are looking for.  You can discover a lot by watching and learning from the actions they take in the marketplace.  Are they buying companies for their technology, access to new markets, to diversify their product lines, for their customer base etc.?  It may be best to begin to build a relationship with them to better understand their acquisition strategies, but they may be reluctant to share much if you are a competitor or not immediately open to a sale.

You can also build relationships with investment bankers/M&A Professionals focused on your industry. i.e. those that have regular discussions with senior leadership at strategics and understand the types of acquisitions they are pursuing.

It is a mistake to assume that a strategic will always value your business higher than a financial buyer, unless you build your business and its revenue base around what would make it the perfect strategic fit.

A lot of entrepreneurs with no immediate plans to sell, simply hope that one day a big industry executive will just drop off a huge cheque. They are usually disappointed. Others hope to transfer to insiders like family or management, but don’t decisively work towards building high quality revenue streams to ensure the business can be paid for.  If a sale to Private Equity is an option you are considering, the actions you take today to improve your revenue quality should pay off by generating interest by a larger pool of financial buyers willing to compete for the opportunity to invest in your business.
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The key is to know the exit path you want to take well in advance of your planned exit and to think strategically about the quality of revenue.  The sooner you decide your optimal path, the better you will be able to shape the business’s revenue quality to ensure that path is viable.

The most valuable businesses develop, execute and modify their strategies on a continuous basis, as the business circumstances change.  Having a good strategy during challenging times isn’t enough. To be effective, it needs to be reviewed, discussed, measured, tracked and adjusted based on new priorities. The strategic plan moves the organization towards its strategic goals, only when all the great ideas developed in the strategy planning and development process are acted on by the whole team.

The tendency during challenging times is to focus solely on solving the immediate problems plaguing the business.  While incredibly important, it is no less important to have a clear strategic plan that is guiding the organization through the downturn.  That plan needs to be revisited regularly by the strategy review team, which ideally includes management plus a cross-section of key employees from throughout the organization.  The strategy review team meetings should be more than just a regular management team meeting, where day-to-day issues are addressed.

Most of us can think of a few examples over our careers where we were part of a team that really “clicked.”  Every initiative the team undertook seemed to fall into place.  If you think back to what made those teams so effective, you likely would use descriptive words like enthusiasm, motivation, honesty, eagerness, energy, co-operation, openness, reliability; all of which were largely driven by the team meetings you held.  Everyone had an equal say.  The leader or the team coach was likely supportive and encouraging, just like your co-workers or teammates.  Positive attitudes and team spirit come together by working towards a common goal and with a common purpose.  In the case of the strategy review team, the common purpose means progressing towards your strategic business goals, step by step.  And it is that progress that creates momentum and business value.

Now think of an ineffective team you have participated in.  Most would likely use very few of the descriptors used above, and perhaps a few “choice” or “alternate” descriptors as well.  While there are literally hundreds of reasons why a team can be ineffective, likely one of the most common, is that they failed to create momentum.   There is nothing more discouraging for a team meeting than rehashing of old topics, re-deciding the same priorities, and hearing the same excuses on why nothing has changed.

Your strategy review meetings need to be highly effective if you are to create business momentum and progress the organization towards its strategic goals.
Each strategy review meeting has three primary purposes: 1) to repeat, reiterate, reinforce, and sometime revise your priorities and to gain deeper team insight and clarity, 2) to review progress towards your strategic goals and identify the key barriers/challenges that need to be resolved and 3) to set your top strategic priorities and the action plans that need to be implemented before the next strategy review meeting.
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Regular strategy review meetings build and maintain momentum by keeping the team focused on what's important. They also facilitate effective information flow, which is needed to bring the strategy to life, and build a better business with resiliency to weather the tough times.

Everyone knows that the management skills to run a small but successful, entrepreneurial company, with a few employees, is starkly different from those skills required to run a larger company with more employees, locations, products, product lines etc.  As a business grows, its overall management becomes exponentially more complex.  This necessitates the need to develop and implement more robust systems such as reporting structures, strategy communication tools, work processes/operating procedures, information technology, and financial controls, amongst others. Growing your top-line sales and customer base without simultaneously building the structure and systems required to support your growing business is a recipe for failure.

When a business is small, it is not uncommon to have a very loose organizational structure. Everyone can speak directly to the boss to get the answers they need, as he/she makes all the major decisions.  As the employee number increases, many roles in the company become comparatively narrower, and the boss starts to share decision making with key managers.  It now becomes increasingly important that everyone has a clear understanding of what is expected of them, their role and how it fits within the organization’s goals.  They also need to know how they will be evaluated and by whom.  The boss can’t interact with everyone to the same degree anymore, and therefore needs a more formalized organizational reporting and accountability structure, performance evaluation system and compensation structure.

Furthermore, as a company grows and individual employee roles change, responsibility gaps and overlaps surface that need to be addressed before they become problematic.  This requires systematic training programs as employees’ responsibilities are adjusted.  It requires a clearer definition of individual roles and responsibilities as the business moves towards a “matrix” organizational structure across locations, business units, product lines and corporate functions. Managers need to have backup systems in place to ensure the business operates without interruption, as people leave, go on vacation or to deal with absenteeism.  This requires the development and communication of company-wide, consistent policies that were perhaps “understood” when the team was a lot smaller.

Some entrepreneurs can successfully transition the business to a much larger organization by learning how to effectively delegate key day-to-day responsibilities and decision-making to an ever-growing team.  They recognize the need to incorporate the right organizational systems to ensure that the business can grow without their involvement in every decision.  They manage to transform their role from a General Manager, with their finger on the pulse of every aspect of the business, to a Chief Strategy Officer, who is steering and guiding the ship in the right direction.  
All too often however, I see entrepreneurs getting stuck in a pattern where they work hard on the wrong things and can’t get break-through company performance. That can lead to high levels of anxiety and frustration.  What they really need is some honest self-assessment to determine the best path they should take to ensure the business value doesn’t stagnate, or worse, recede.  They can 1) stay-the course by focusing on maintaining a well-run small business with a sustainable cash flow, 2) consider their transition/succession/exit options, or 3) put in place what it takes to attain break-through performance.
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If break-through performance is the ultimate goal, it starts with deliberately building the right structure and systems to manage the organization’s ever-increasing complexity and by nurturing a team that is engaged, motivated and clearly understand their role in achieving the company’s growth strategy.

I can clearly remember a situation many years ago, when a business manager said to me, that once your overhead costs are covered, any sale that generates margin in excess of your variable costs, is “good” business.  The concept didn’t sit well with me at the time. The business had lackluster performance, so his approach obviously was not working.  Since then, I have realized that a business can increase its earnings while not necessarily increasing its enterprise value; which on the surface seems counter intuitive.  If increasing the value of the business for shareholders is the ultimate goal, then all earnings growth is not good growth.

So how can business value stall despite demonstrated earnings growth?  The simple answer is that the incremental earnings were not enough to cover all the operating costs plus the cost of capital (including the opportunity cost of the equity in the business).  Every business owner/manager should know what their "weighted average cost of capital" is (or WACC), in order to manage its capital judiciously. Simply growing your operating profit without considering the full cost of both the fixed and working capital will not necessarily build value into your business.

Some examples of value enhancing management strategies are given below.

1) Increase profits without tying up any more capital.  This can be in the form of improving margins and/or lowering operating costs or both, if the total capital does not increase. 
2) Decrease capital without losing earnings.  Some possible options include:
            - Lowering inventory levels or increasing inventory turns
            - Shortening selling terms or improving collection practices
            - Negotiating better supplier terms or take advantage of supplier incentives
            - Divest redundant assets

3) Divest, liquidate, or discontinue parts of the business, where the lost earnings are more than offset by the savings in the cost of capital.
4) Only invest (increase capital) in projects that provide a return that exceeds the cost of capital.
5) Reorganize the capital structure of the business to lower the overall cost of capital.

While topline and profit growth are essential elements of increasing enterprise value, profit growth needs to be disciplined and it must always exceed the cost of capital.

The astute reader may realize that I am referring to concepts espoused by practitioners of “Economic Value Add” or “EVA“: a profit metric that is netted against a charge for the WACC.  A business that focuses on increasing EVA over the long-term, becomes meticulous at managing the capital entrusted to it by its shareholders.

Other astute readers may be thinking that it is the market that ultimately determines the value of any business.  For private businesses, that typically means it can only be determined when the business takes in new investors, or when it is put on the market to be sold.  Of course, there are many factors that determine the value of any business, but remember, disciplined profit growth is typically rewarded by attracting more buyers or investors that are willing to pay higher multiples of earnings.

In summary, generating profit growth without considering whether it exceeds the full cost of capital is like driving a car blindfolded – you may be moving but it might be in the wrong direction!