Building Long-term Value: Plan on It

September 2014

At some point, you’ll want to craft an exit strategy. To ensure that you get the bestLong Term Value return possible, it makes sense to place an early focus on building value in your company over the long term. It’s not about short-term sales and revenue goals; it’s about the strategic steps you can take to drive consistent growth for the long haul.

“Value is not automatically created when a company increases its revenues or assets,” asserts Chris Mellen, president of Delphi Valuation Advisors, Inc., in Norwood, and co-author of Valuation for M&A: Building Value in Private Companies. “Increased size does not necessarily lead to greater cash returns or reduced risk. Even profitable growth generally requires cash investments for working capital and fixed assets, both of which reduce the company’s expected net cash flow. Therefore, growth increases value only when it reduces risk and/or creates positive net cash flows, after consideration of capital reinvestment requirements.”

According to Mellen, the key value drivers and metrics are:

  • Investment. Investment is either limited to the current market value of the tangible assets in the business, if it incurs losses or if its profits are inadequate; or the investment is the present value of its future returns if the company’s operations generate intangible value. 
  • Return. The focus should be on the spendable cash (i.e., cash available to shareholders) that the company generates after allowing for payment of all expenses and taxes and all reinvestment requirements for working capital and capital expenditures (free cash flow).

“”Curiously, net cash flow to invested capital appears on no financial statements, and private company owners almost never see it,” Mellen adds. “But it represents the critical cash that can be taken from the business by debt and equity capital providers after all of the company’s needs have been met. It is the capital providers’ true return.” 

  • Rate of return. Every investment carries a different level of risk. Proper investment choices must consider the risk or likelihood that the investment’s future return will be achieved. This required rate of return (i.e., discount rate) is used to quantify the likelihood that future returns will be achieved.

“Fundamental investment theory states that investors will accept higher risk in investments only if they have an opportunity to earn a higher return,” he says. “Therefore, the higher the perceived risk in an investment, the higher the rate of return must be on that investment. Mathematically, higher rates of return cause greater discounting of anticipated future returns, which reduces their value. Thus the greater the risk, the greater the discount rate and the lower the value. Conversely, lower risk would carry a lower discount rate and a higher value. The required rate of return is different from the actual rate of return, which reflects a company’s historical performance and is used to compare the company’s actual return on investment.”

While considering the issues that build value, it’s also important to identify your value drivers and risk drivers. “Risk drivers cause uncertainty for the company,” Mellen says. “Value drivers reflect the company’s strengths that enable it to both minimize risk and maximize net cash flow returns. Cumulatively, identifying the risk and value drivers establishes the company’s strategic advantages and disadvantages. They are ultimately quantified in the discount rate that reflects the company’s overall level of risk and in the forecast of expected net cash flows, considering the company’s competitive position.” Some of the more common risk factors include:

  • Company’s market share and market structure of the industry
  • Depth and breadth of management 
  • Heavy reliance on individuals with key knowledge, skills, or contacts 
  • Marketing and advertising capacity 
  • Breadth of products and/or services 
  • Purchasing power and related economies of scale 
  • Customer concentration 
  • Vendor and supplier relations and reliance 
  • Distribution capability
  • Depth, accuracy, and timeliness of accounting information and internal control
  • Condition of facility and upcoming capital expenditure needs
  • Ability to keep pace with technological changes
  • Ability to protect intellectual property
  • Increasing threat of foreign competition
  • Litigation, environmental, and adverse regulatory issues

The most critical factor in building value? “Timing is everything,” advises Mellen. “The business owner who was forced to sell his or her company in 2008 vs. 2006 was at a great disadvantage given that the value of many companies had declined in that two-year period. Opportunities to realize much higher values today are far greater than four to six years ago.”

Making the most of that opportunity means advance planning. Business owners are well-advised to include exit planning as part of their ongoing management responsibilities, Mellen says. “While five or 10 years is a long period to plan most activities, it is the advisable time frame for effective planning to exit a private company. The complexities of the process, the reality that needs and goals change over time, continually changing business conditions and the varying circumstances that multiple owners bring to an investment create a compelling case to plan well in advance.”

Value as a Function of Success

Building value can be critical to the success of any business. When you’re in a niche business, it’s especially key. Kasalis, a Burlington, Massachusetts-based technology firm supporting the manufacture of micro cameras, uses a series of unique processes to embed value throughout the development continuum. Learn more about the ways in which Kasalis bakes value into its work, and how support from Salem Five has helped drive its success from the very beginning.