Now more than ever, it is critical that owners understand what drives the value of their businesses. In this opinion piece, Reed Phillips, managing partner of Oaklins DeSilva+Phillips, an investment bank focused on mid-market companies, and Jeff Pundyk, a senior advisor to the firm, say the challenge has been made more difficult by the digital transformation happening across every industry. They propose a different way for managers to pinpoint their value proposition.
The Organization for Economic Cooperation and Development (OECD) noted this week that the COVID-19 pandemic has “triggered the most severe recession in nearly a century.” As a result, company valuations are plummeting, making it even more important for business owners to understand what really drives the value of their businesses.
This challenge is exacerbated as businesses continue to work through their digital transformation, a process that can cloud leaders’ understanding of where their business’ value is derived.
Little wonder that the imperative to develop new strategies, make new investments, and to drive cultural and organizational changes can steal focus from this essential benchmark, particularly when businesses become bifurcated between legacy and emerging models while facing unprecedented external challenges.
Confronted by the extreme disruption of the global pandemic, those managers who have the clearest understanding of their value proposition will be best positioned to rebound. What is needed is a new way of thinking about the value businesses are creating.
Before digital disruption, it was easier to know the value of your business, and it was unlikely to swing wildly from one year to the next. Now, with the emergence of digital juggernauts such as Amazon, Google, Facebook and Apple, everything has changed. Companies that appear to be performing well and maintaining their historical levels of revenue and EBITDA might be surprised to find themselves worth half of what they were just a year ago. Even if your business is considered “hot” by buyers, this can change quickly and with little warning.
Companies that appear to be performing well and maintaining their historical levels of revenue and EBITDA might be surprised to find themselves worth half of what they were just a year ago.
The challenge is heightened by the need to continuously innovate in the face of accelerating change. Your company’s value is in constant flux, a dynamic that underscores the importance of monitoring it on a regular basis.
Erosion of Value
Ten years ago, for instance, a company we are familiar with was offered $150 million by a buyer. The valuation was frothy at 10x EBITDA. Rather than sell, the founder passed the company along to his children, two of whom had worked for Silicon Valley companies. They were sure they knew what levers to pull to propel the business seamlessly into the digital age and to increase the valuation even more.
Over several years, the family invested $10 million from their profits into a digital strategy, which demanded the focus of management. While this occurred, the core business began to decline – partly from less management time and partly because customers were migrating to digital formats. Soon, the core business slipped from profitability, and the digital business, which was expected to replace those profits, began to underperform. This combination caused a crisis for this business. Soon, all of management’s efforts were focused on avoiding bankruptcy.
What went wrong?
No one was actively evaluating the value being created by the digital business while the core business was largely left on autopilot. If the owners had set milestones for measuring the value of each, the alarm bells would have gone off much sooner, giving management the chance to change course.
In more than 24 years working with entrepreneurs, we have seen such situations over and over: Business owners have unrealistic ideas of what their business is worth. This is the most common reason that merger deals fail. And earnings multiples, which have become a short-hand for value, often mislead sellers who would be better off focusing on growth and return on capital rather than on imperfect comparables. A recent study by McKinsey & Co. underscores the need to focus on value creation, not higher multiples: “Business leaders must do the hard work of revising business strategies, reallocating resources, monitoring outcomes, and otherwise enhancing corporate performance over the long term,” the report says.
In fact, chasing multiples can steer corporate strategy down the wrong path. At least once a month, for example, we sit down with prospective sellers who insist that their companies are software-as-a-service (SaaS) businesses. Why? Because SaaS companies get some of the highest multiples. Most of these companies are not actually SaaS companies. They are tying themselves in knots instead of focusing on where their real value lies.
Chasing multiples can steer corporate strategy down the wrong path.
Even for those not interested in a sale, a clear view of what makes your company valuable should act as a guide for where to invest and how to think about growth.
We believe that the most important barometer for the health of a business is its value to a potential buyer and the way it changes from year to year. The easiest and best way to establish a company’s value is through a single data point: the price a buyer would be willing to pay to acquire your business. Public companies know what their value is every day because shares change hands often. Private companies do not have an equivalent yardstick, so they need to create one. This is no small task.
High and Low Priorities
We have often heard CEOs say they are so consumed with their digital transformation initiatives that understanding their value is a lower priority – especially for firms that are not thinking about an immediate sale. But the two should be closely aligned: When you know the value drivers of your business, you can steer digital transformation towards optimizing it further.
According to a recent study by The National Center for the Middle Market at Ohio State University, middle market companies with a strategic approach to their digital transformation grow faster than their peers. And while more than half of the executives surveyed said digital transformation was important, less than 10% said it was critical to their company’s strategy. This disconnect represents a failure to tie digital transformation to value creation.
Everything you do to create value in your business should be predicated on knowing the perceived value of your company by outside observers. Having this information will inform you about when and where to invest in digital transformation.
If you are spread too thin, make it a priority for a senior member of your leadership team, or get help from an advisor or consultant. Otherwise, you risk going in the wrong direction with your digital transformation. Instead of creating value, you may diminish it.
Everything you do to create value in your business should be predicated on knowing the perceived value of your company by outside observers.
When you get it right, understanding your value becomes a competitive advantage. Recently, we sold a conference business for an attractive price. Events have been a bright spot as the world has moved online because businesses still find that face-to-face interactions are incredibly effective. The outbreak of COVID-19 has turned the events industry on its heel, but this business was not sold on the strength of its ability to get people into a room. That is a commodity. The value of this business is its credibility as a programmer and its connection to its community of executives. That is the strength on which it was sold and on which it will rebuild its business as the global economy emerges from the crisis.
It doesn’t matter whether you are preparing to sell your company or not; thinking as if you are will help identify the true drivers of value. You can begin by doing a simple experiment: Imagine you would like to sell your company and ask yourself these questions:
- Who is the ideal buyer?
- How can my business add value to that company or companies?
- Where should I invest in my company to ensure that these buyers will find my business attractive?
Once you have answered these questions, compare the results with your own growth plan. Where does it differ and why? Do you need to redirect your efforts to align with what these buyers are looking for?
This is a model that has been championed by private equity firms. Before a private equity firm acquires a business, they are already thinking ahead to who will buy it in three to five years. Once they complete the acquisition, they mold the business into one that will be attractive to potential buyers. They monitor their progress constantly, often holding board meetings as often as once a month. A similar mindset will serve business owners well to help set priorities, even for those who have no intention of selling.
Why Fundamentals Still Matter
With a roadmap in place, now take a close look at the fundamentals. Do you have a realistic understanding of these well-established markers traditionally used to value a business?
- Market multiples – Is the market rewarding your type of business the way it did a year ago?
- Growth indicators – Are sales growing? Have you been able to increase pricing? Have you created new products or lines of business?
- Sum of the parts analysis – Are some parts of the business worth more than others?
- Competition – How well does the business perform vis-à-vis its competitors? Does the business have unique features that the competitors do not? Are you facing formidable competitors that might require you to reposition your business?
- Long-term outlook – Does the future look rosy or are headwinds approaching?
- Strength of the management team – Is the team managing your business indispensable or can they be replaced?
- Core competencies – What skills or capabilities does your company have that make your business work?
- Vendor relationships – Do you have contracts with vendors that add to the value of your company?
- Buyer interest – Are potential buyers interested in your business? What are the prices for comparable companies? It is important here to be clear-eyed about valuation. We recommend talking with investment bankers, M&A lawyers, accountants and consultants, as well as doing independent research.
- The market your business serves – Is the market growing or receding? What changes in the market could pose challenges for your business?
And as your digital transformation matures you need to think through a new set of markers. These include:
- Brand equity – How well do your customers and prospects know your brand? Are you using all available digital platforms to make your brand visible?
- Customer engagement – Are your metrics strong for attracting traffic on your web site and through social media? Are you doing this in a cost-efficient way?
- Customer experience – How is your business rated by its customers? Is your rating improving or declining? Is your customer experience seamless across online and offline interactions? Is it dependent on third-party providers?
- Technology investment – Is your technology up to date or in need of an overhaul? Is there proprietary technology or intellectual property?
- Business model – Do you have the right business model? Is there a legacy business model? If so, what is it worth? Do you expect the legacy model to disappear? When? Is the emerging model complementary or competitive with the legacy model? Where is the growth coming from? How are the economics of the new model different from that of the old? How has the digital business model affected margins?
- Innovation – Where is your organization a “first mover”? Are you a disruptor or are you being disrupted? Are your teams sufficiently agile? Do you have a learning culture?
- Security – Are you sufficiently managing cyber risk? Does your security match your digital ambitions? Does it account for all your stakeholders, including customers, employees, supply chain, and partners?
- Data – Do you “own” your customer data? Are you generating proprietary data that could be of value? Are you dependent on third parties for critical data?
And finally, repeat this exercise as you cross each milestone in your digital transformation and as external forces continue to shift.
Those who re-evaluate regularly will be better positioned to drive their growth strategy, manage their operations more effectively by aligning incentive plans to value creation, and have informed conversations should they be approached by a potential buyer. The economic downturn may, in fact, increase the probability of a sale as buyers look for bargain purchases, according to a recent study by Deloitte of 1,000 executives at corporations and private equity investor firms about current deal activity and expectations for the next 12 months.
Digital transformation is both disrupting business models and changing the valuation landscape. Business owners who know what their companies are worth in the digital age are much better positioned to prosper. Those who do not are leaving their value to chance.