Strategy and Equity Value

Never Mutually Exclusive

Strategy has many meanings. Implementing a strategy that adds shareholder value and factors in changing market dynamics is the best strategy. In this article, Carl Sheeler shares his views on “trusted advisors” and how these trusted advisors often do not have the depth or experience to assist clients in devising a strategy that will increase shareholder value. The article suggests that while these are excellent opportunities, they also require that the practitioner or group add additional professionals with the skill-set to identify opportunities and improve shareholder value.

 

In an earlier chapter of my life I was responsible for planning as part of a strategy team in the military. Then, I became responsible for corporate strategy and operational audits. I had the advanced training and experience. Both functions require a fair amount of due diligence, intellectual rigor, objectivity, and “big- picture” thinking about the many what-ifs or alternate scenarios: “If this happens, what would I need to consider in response?” To some extent, reacting to a market condition without a plan is like taking a drive without knowing how far one is going and/or knowing whether one has the necessary resources—including time and capital—to get from point A to B. Strategy requires that a company evolve, adapt, and remain proactive—that is, retain its focus as a market maker. The companies that should be proactive and strive to become or remain as a “market maker” are the $100M+ companies out there; despite their size, even these companies lose their way.

Yet, this issue of strategy should be at the heart of most company and equity valuations. “So, what’s your strategy?” This broad question does not call for a mission statement or some general musings of desired outcomes. If the industry statements are true―concerning the few companies that sell with $5 million and below in annual revenues or that most mergers seldom succeed in achieving the synergies sought―it bodes well to step back and consider these sobering factors.

While there are a number of ways to talk about a distinguishing strategy from, say, tactics to improved efficiencies or customer satisfaction, for the purpose of this article, a successful strategy involves a series of plans and steps that increase shareholder value. This is a core financial premise why most businesses are built or bought.

Consider the following: very few founders had a fully drafted strategic plan when then started their business. The number is something like 10 percent. Arguably, this 10 percent was influenced by funding sources like angel investors or venture capital or the bank wanting to obtain some assurance that the innovation translates into the ability to service borrowed capital. Few do so during the conduct and growth of their businesses, simply reacting to the vagaries of the marketplace and sometimes just being lucky to be offering the right products/services at the right price, place, and time. The next time the discussion on strategy arises, it probably will occur when it is a passing suggestion, or when the owner is contemplating some transition event like an employee stock ownership plan (ESOP) or an outright sale.

So, making allowances for the failed enterprises that are strewn across the map due to nominal or no planning, what occurred for those that “survived?” More importantly, what occurred to those few that thrive? These questions are to intimate several observations. Would companies that fail within six or 12 months have either not been started or could have survived with an adequate plan had they retained an advisor or involved an advisor who understood the industry, marketplace, and opportunity as well as the capital necessary to either turn around, shed product lines, or bring in new products and profitably grow the business? These suggestions―for an industry practitioner―seem fundamental, but this should be the norm.

Norms should not be ignored. Following the above “norm” would likely skew price multiples and discount/capitalization rates downward, if weighed against actual company and equity transactions that occur as part of the proxy of risk-weighted values. Further, if there was no strategic plan at inception, what is the probability of having a plan somewhere down the proverbial road when the founder is contemplating a transition (such as a partial or full liquidity event)?

The above comments and observations set the stage for more than a philosophical discussion. It opens up an opportunity to engage; that is, to provide objective concerns and identify missed opportunities. The first one primarily addresses shortcomings in the valuation process and the latter addresses a means to not only measure, but manage equity value enhancement. The first is tactical and technical. The second is holistic and provides a much more probable chance to make the news versus simply reporting it.

First, can the existence of a strategy and its presence or absence be measured? Most assuredly, the answer is a resounding “yes.” The analyst would want to determine whether the founder, board, and/or C-suite have an articulated strategy and how it was formed and tested. So, an examination of an ecosystem and constituencies would be a must. This means that if staff, vendors, clients, and advisors, from bankers to accountants, don’t know the strategy and may not have been involved in its formation, it is nothing more than a desire. The analyst would want to see whether the strategy is being followed and what rules exist for its revision. As an example, if the strategy is that annually, the bottom 20 percent of clients will be divested and the top 20 percent will be given a clearly differentiated level of service/product than the remaining 60 percent, this is a part of a broader strategy. It’s an ethos, and it finds itself into the culture of the organization. Paying lip service to a strategy when a quick buck might be made suggests it is not enduring.

So, culture does matter, and it’s the difference between Amazon and Walmart, Apple versus IBM, or Starbucks and no-name café. The intangible asset of goodwill is born from the culture, which reflects the vision of the company and the actions and behavior of its board and officers.

Consider Eastman Kodak. While the company was among the first to introduce digital photography, they believed that no amount of technological initiative would replace film. They must have not heard of Moore’s Law (Intel), the premise of which is that with technology, every two years the capacity and speed double. Now, Eastman Kodak had a smart C-suite and board, but clearly the “group-think bubble” prevented management from sensing a shifting marketplace demand or seizing the opportunities in the evolving marketplace. In the absence of sensing and seizing, a company is unable to transform and leverage its dynamic capabilities in an ever-changing marketplace. Effectively, Kodak’s management was concerned with “doing things right” and not “doing the right things.” This is akin to digging a perfect hole, but it just happens to be in the wrong location.

Also, consider the thousands of mergers and acquisitions that fail to accomplish the sought-after synergies; why premiums were paid in the first place. The most commonly cited reasons for these shortcomings are related to culture and governance. These reasons are not likely to be found on a financial statement or uncovered during due diligence that’s focused on accounting and legal issues. A pre-strategy review and a post-merger integration strategy would have ensured the acquiring company had not overpaid at a low relative cost to the millions and sometimes billions that have occurred in the past. It also entails finding an independent source that will not be an advocate for one or more board members (the business referral source). The folks with the funds and those advising them are not necessarily the smartest guys in the room.

Other examples that are tell-tale signs of an entity’s governance/strategy are:

1. Turnover at staff/management/executive/board levels—especially at the CFO level
2. Board independence and composition (a diverse and independent board is considered favorable)
3. Presence of directors and officers liability (D & O) coverage
4. Robust meeting minutes
5. Advisory board—with industry knowledge and relationship with various financing sources
6. Backgrounds of individuals that are serving in executive and governance positions
7. Compensation connected or disconnected to performance and marketplace
8. Time spent annually in the C-suite/board function
9. What tools and talent have been augmented based on growth
10. Improved qualifications, considering change in company or marketplace
11. Leadership within the industry (i.e., associations, networks)
12. Receptivity of outside advisors
13. Centralized relationships with key people in the industry
14. Degree of family member involvement and qualification/training

The point is that if most lower midmarket companies are “lifestyle” businesses, where the founder extracts as much as he or she can instead of optimizing performance and there is no strategy, then the price multiples may be too high and discount/capitalization rates too low. Unfortunately, this is where intellectual rigor can lapse, such as the use of rules of thumb or software-driven values as proxies of risk identification and measurement. Not only are their results suspect, but comprehension as to how they were formed is often lacking and unsupported.

Consider a home for sale where most other neighborhood homes sell for about $1 million. The seller asks $1 million; however, the buyer determines a new roof, bathrooms, and kitchen are warranted and the estimated cost to do so is $125,000. What is the likelihood of the buyer offering $1 million?

Would an offer $875,000 be reasonable if there is an opportunity cost until the improvements are made and other “issues” may be uncovered? So, the business, like the home, is sold “as is,” not what it might do, unless there is compelling documentation suggesting past historical performance is a product of innovation that drives sales.

Second, having one or more “trusted advisors” involved is not the same thing as their knowledge and their relationships being levered to maximize strategic initiatives. Most bell curves suggest that only about 20 percent of advisors have the A-level capabilities; yet most advisors think the advice they give that is commonly found on the Internet places them squarely in the “A-group.” Obviously, this can’t be. If an advisor’s involvement is purely transactional, tactical, and technical or simply ad hoc, it is highly unlikely such knowledge―while good―will be leveraged, much less employed by the company.

This can have a real impact depending whether the company is effected by a market disruption, such as 2008/2009 or is making a disruption, such as the Tesla offering by Elon Musk. This is often referred to by the acronym VRIN. VRIN is Valuable, Rare, Inimitable, and Non-Substitutable. The building of an organization that orchestrates its intangible assets into high-yielding capabilities is a market disruption and game changer. A company like this thrives in uncertainty. So, an adaptable company that builds a new business model requires the ability to recognize this as part of the strategy of an ecosystem and dynamic capabilities. This differentiator creates the competitive advantage, where well-below-norm company specific risks have to be considered thoroughly instead of robotically and where going to the median is often the norm, as the company is clearly not part of the herd.

A business owner’s most common lament is that his or her advisors don’t use tools and language they can understand. The advisors claim the owner does not heed their counsel. If the advisors are the professionals, whose fault is it? If cornered, most accountants/CPAs essentially state they don’t make the owner’s “news,” they report it. Safety from the sidelines. This is problematic as the entrepreneur has risk tolerance that has allowed him or her to have (potentially) a concentrated risk asset. Risk concentration, unabated, is worth many times over what his or her advisors are worth from the safety of billable hours or salary. It’s a lost opportunity and may condemn the owner’s future wealth.

These past paragraphs might be perceived as having lost sight of this article’s premise of strategy and value; however, it has not. Many of the same organizations and members practice valuation part-time because they are either practicing accountants or business intermediaries that are being induced to make another buck by learning how to offer exit planning services for the multitudes of owners who are contemplating one. The fact is, if the advisors operating in an Ivory Tower have a nominal operational risk background, the unsuspecting client is often paying for the advisor’s learning curve and the results are unlikely to be anything near optimal.

Third, so, what is the opportunity? Benchmarking a company’s value is the easy part. The tough part is determining the existing “gaps” in resources (tangibles, time, and talent) to leverage the intangibles in order that the founder may realize a 50 percent or even a 300 percent increase in equity value in as few as two years. This requires a well-considered strategy. After all, the owner has his or her day job and it’s insufficient to simply express, “You must work ‘on’ versus ‘in’ the business.”

The advisor’s assessment of whether existing staff is sufficient to bifurcate focus from the daily to the multi-year often requires special skills in governance and strategy and the client’s patience, aptitude, and funds to support what could be a 100 times or greater return on investment.

There are many indices available to determine the presence of a viable strategy, which clearly will have an impact on equity value—especially if well or poorly executed.

An analyst who doesn’t perform the necessary due diligence to determine strategy’s existence and impact on a company’s success is doing a disservice to the client and the advisory services industry. The AICPA has a code of conduct provision that addresses this behavior. It’s referred to as “dabbling.” It is wise to either train or serve with a professional who has the requisite experience, credential(s) and education to create value for the client or to refer such work to those who do.

Carl Sheeler, PhD, ASA, CBA, CVA, completed advanced strategic planning work from the Command and Staff War College (Quantico, VA) as well as the Land Force Training Command Pacific (Coronado, CA). He served on the general staff of USMC Lieutenant General Johnston who was General Schwarzkopf’s chief of staff during Operation Desert Storm. Mr. Sheeler was also responsible for executive development, corporate strategy, and operational audits for the then 32-million-member, 132-affiliate-club American Automobile Association. Mr. Sheeler is currently the global group leader | Family Business/Office Strategies, addressing complex issues confronting 8- to 11-figure family run closely held and public companies for Berkeley Research Group, LLC. Mr. Sheeler is completing a John Wiley & Sons book on equity value, which addresses governance/strategy issues among other variables impacting intangible values and risk. He has been a full-time valuation and litigation support advisor for 25 years, having completed 1,200 engagements and testifying 165 times. He recently presented on several national panels on the impact of strategy, governance, and culture on risk management in compliance driven financial services industries as well as on adherence to industry standards for the Appraisal Foundation in DC. Mr. Sheeler can be reached at (800) 286-6635 or csheeler@brg-expert.com.