Shownotes
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.
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.
Financial Accelerator: The relationship between the owner and their bank has got to be healthy. That means your banker is your best friend.
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.
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.
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...
