Takeaway: Economic Value is a great tool to ensure your private company can deliver you market rate or above returns. Sadly, it is not broadly utilized by private companies.
About EPI
The Exit Planning Institute® (EPI) is an international membership organization serving the educational and resource needs of the exit planning profession. Formed in 2005 to bring together business brokers, M&A advisors, CPAs, financial advisors, attorneys, management consultants and other business advisors, the Exit Planning Institutes members, draw upon their combined expertise to better serve the needs of middle market business owners worldwide.
It’s not about your exit
On the plane ride home from the Exit Planning Institute’s (EPI) annual conference I was reviewing the notes I took and scanning the conference schedule to see if I used my time wisely. I noticed that EPI conducted only three sessions, out of a total of the 29 offered, dealing with the actual transaction of an owner’s exit. Instead EPI dedicated a majority of the conference to educating its members in three core categories: 1.) best practices in measuring, building and protecting ownership value; 2.) assisting closely-held owners in navigating family and multi-generational dynamics; and 3.) data and trends of owners and the private capital markets. I think EPI is making an important distinction in its goals for members. Because “exit” is the first word in their title most would naturally consider business exits to be their focus. But in fact, a core tenant and a primary reason EPI was initially founded was to help owners build sustainable and valuable businesses prior to an owner’s exit.
Case in point – one value enhancing tool
A case in point was a session led by Rob Slee, Chris Snider and Sean Hutchinson on one of my favorite topics – Economic Value (EV). The concept of EV has been widely used by public companies for decades as a tool to help insure company decisions are enhancing and not eroding shareholder value. When implemented correctly, it can be a powerful conduit that focuses an entire organization on value creating activities. But EV is rarely applied to middle market private companies.
Economic Value is defined as the value created in excess of the required return expectation of the company’s capital providers (shareholders and lenders). Put another way - it is the profit of the firm remaining after subtracting out the cost of capital (debt and equity) employed to produce the profit.
The return expectation of debt lenders is relatively easy to determine, but what are the return expectations of equity by privately held business owners? Or more importantly, what should the equity return expectations be? One measure of equity expectation is a recent Pepperdine Private Capital Markets report that states the compounded annual return expectations for business owners should range between 20 percent to 43 percent based on the size and risk profile of the company. Thus, owners should expect at a minimum, that the annual return of their ownership should yield somewhere in this range based on their company’s profile.
So how does a business owner achieve these returns? The tool Slee, Snider and Hutchinson suggest is applying is EV. EV increases the value of a company in three ways. First, the EV metric can assess if the company, product lines, or projects are building or destroying ownership value. Second, EV can correctly allocate a company’s limited capital to the best value building activities or ownership distributions. Finally, the EV metric can fully align management with ownership objectives by using EV in management incentive plans, project performance evaluations, and business line measurements. And just in case you were wondering what this has to do with Exit Planning, educated buyers purchase businesses using the same core concepts as EV.
Case Study – Using EV
A previous client of mine had a profitable wholesaling business that was doing $30mm in revenue with a respectable and above industry growth outlook. He engaged me to do a transactional valuation as he was being courted by a strategic acquirer and wanted to determine whether the price and terms contained in the Letter of Intent he received were fair. As part of my findings, I showed that the return he had been receiving and was expecting to receive on his private company equity investment was averaging 4 percent. By comparison, most wealth advisors would have told my client he could expect a 6% to 8% on his money in the public markets. What’s more, he could diversify his risk better in the far more liquid public markets. In essence, my client was getting a much lower return, in a very illiquid investment with a significantly higher risk by running a profitable wholesaling business. Why was he doing this? We realized he hadn’t been using the correct metrics to run his business. Had he employed EV in his strategic and operational planning, the results might have been vastly different.
My hope
My hope is that there are two takeaways from this piece. First, the Exit Planning Institute focus is first on building value for your firm, so that it may be monetized when a business owner is eventually ready to exit. Second, most business owners need to start looking at their companies from a shareholder perspective and examine it with the same financial discipline as they would their public stock portfolio, remembering that private companies are, comparatively, illiquid and risky and thus need a greater return to justify the investment (20%-43%). Every smart business owner, then, should be working to reach these marks. Getting there won’t be easy, but the tools of Economic Value can help you in the process by aligning your team to focus on what is important - ownership value creation.
By Scott Yoder, Partner of Strategic Equity Advisors LLP