Equity Value Enhancement. Sheeler Carl L.

and creation. Such analyses can and should provide benchmarks including soft and hard measures (human and financial capital). An example of a soft measure would be employee morale. A hard measure might be annual staff turnover. Common performance metrics are:

      • Linked to strategy

      • Clearly defined

      • Understandable

      • Easily measured

      • Few in number

      • Reported regularly

      • Consistent follow-through

      • Openly shared

      • Predictive in nature

      • Developed by everyone

      • Team or unit based

      • Tested against behavioral outcomes

      • Assessed and modified regularly

      • Linked to compensation

      So, a value is determined by establishing economic benefit, such as profit, net income, EBITDA, or cash flow. That's the numerator. Let's say it's $10 million. The remaining variables are growth and risk or the denominator stated as a percentage.

      If the risk measurement was opined to be 25 percent (expected investor return), then the equation would be $10 million/.25 or $40 million in value. The lower the risk, the higher the value.

      So, let's apply 20 percent instead of 25 percent to prove this point, of lower risk. The value would be $50 million or $10 million/.20. Stated another way, using 25 percent is the same thing as applying a price multiple of 4× or four times. Using 20 percent is the same as applying 5×.

      So, while seemingly straightforward, the tough part is “What is the risk (multiple)?” This issue is at the heart of what drives investor expectations and the difference between skilled research and analytics versus an otherwise expensive, unsupported result. Thus, the lower fee for services does not matter if the value is incorrect or unsupported.

      Behavioral finance does play a role in the valuation process. It's more difficult to discern value in private companies, where data is not as easy to come by compared to their public company counterparts. At the center of it all, does the company's upside investment potential outweigh its perceived level of risk?

      Therein lies the Achilles' heel of valuation: making assumptions of risk and future economic benefit. It behooves anyone with a stake to ensure adequate empirical factors are considered. This means that while legal and financial issues are relevant, operational and human capital issues are often overlooked and inadequately portrayed – and that omission can significantly impact value.

      Keep in mind there are assets that are seen and reported. These are tangible assets. What a business appraiser is most often retained to opine is the unseen or intangible asset values. A successful business has an ever increasing part of its value associated with intangible assets, such as, but not limited to, goodwill.

      A simple illustration is the comparison of public companies Wells Fargo Bank and Bank of America six-plus years after the Great Recession of 2009. The reported price to book value (P/BV) of Wells Fargo and Bank of America was 1.69× and .82×, respectively. This means the former's price multiple is more than twice the latter's.

      More importantly, Wells Fargo enjoys intangible value (as an operational primarily asset-based holding company that exceeds 100 % of its book value). That additional value is all intangible. This is likely associated with solid client relationships and reputation. Meanwhile, Bank of America's value is actually below its book value as of this book's writing.

      This is not good as is suggested by Wall Street analysts who recommend a “Buy” for Wells Fargo and a “Sell/Hold” for Bank of America. Also, the companies' measured volatility compared to the industry/sector, with a 1.0 being the median and over 1.0 being more volatile (risky) and below 1.0 being more stable, further proves the point. Bank of America's volatility (beta) was 1.59 as compared to Wells Fargo's 0.86.

      Capital and Risk

      Company size can be a significant consideration when it comes to risk, especially with regard to securing capital. As you might expect, larger companies usually have more options and better access to the capital markets as well as better rates and terms. A $1 billion company may have funding sources bending over backwards to provide financial support while a $25 million company may need its owner to make a personal guarantee to be considered for a loan/credit facility.

      The less risk perceived, the better rates and terms offered. That can pay huge dividends for larger companies, with which capital sources, such as banks, are more likely to share risk. However, size is not an absolute because growth and niche market dominance are examples of factors that could suggest a smaller company may have the potential of less risk and higher value. Sharp company owners have an idea what their company-specific risk rate is and how to spread risk by having debt allowing the lender to share the risk.

      Let's use for illustrative purposes only the previous example of the $50 million company with the $10 million net cash flow and an assumed 20 percent risk rate. Let's assume our research of comparable companies indicates the optimal level of debt to equity is 50/50. So, we determined that 50 percent has a 20 percent rate for equity. This would be shown by (1 – .50).20 = .10 or 10 percent allocated to equity.

      Let's then say that interest rate from the lending source is 5 percent and since interest expenses are tax deductible, that the combined state and federal tax rate is 40 percent. That means that the true cost of capital is (1 – .40).05 or 3.0 percent. Since debt represents half, we now have our new rate of (1 – .50).03 or 1.5 percent. The 1.5 percent debt rate is combined with the 10 percent equity rate for the weighted average cost of capital (WACC) of 10 percent + 1.5 percent = 11.5 percent. This is 42.5 percent lower than the 20 percent rate or risk for equity alone without debt. This improves the market value of invested capital by sharing risk with the note holder.

      Remember, the lower the risk, the lower the rate. The lower the rate, the higher the pricing multiple and value.

      Finally, assume the $25 million debt allows the company to produce twice the widgets in half the time, reducing labor expenses. So, despite the new interest expense and repayment of principal, the increased profits are $15 million versus the $10 million.

      This means the value of the company is $15 million/11.5 percent or $130.5 million (rounded) less $25 million in debt or $105.5 million in value. This is more than twice the $50 million value even prior to finding other areas where risk may be mitigated and/or minimized. This is why as a strategic value architect, it is possible to claim that in as brief as 24 months a company can feasibly increase its value by 100 percent and often more. Obviously, there are myriad other ways to accomplish this either by organic growth or through acquisition as long as synergies are achieved.

      Needless to say, overleveraging may result in high sensitivity to declines in growth and inadequate cash flow to service debt. Most seasoned CFOs know leverage is a single arrow in the business's quiver to shift or reduce risk.

      Yet, knowing how to get there – to create value – still is not common knowledge. Keep in mind the founder/owner is a rare breed. She or he is thinking “what if” through the opportunity-lens; whereas, advisors often think “what if” through the risk lens. Therefore, the goals of trusted advisors should include helping clients build and create value by ensuring they're aware of how to enhance their intangible assets' value and the options to do so. Advisors must also recognize that owners have limited time to shepherd growth, so having a plan is insufficient. Having resources to execute the plan is what's needed. Successful business owners and their advisors already know it's not simply selling more services and products profitably.

      Here's the more surprising issue to make the point. Let's say it takes $500,000 in advisory expenses to achieve this feat of an extra $50 million in value. Who would say “no” to the proposition of for every dollar paid $100 is returned? If a prospect or a client or an advisor says “not interested,” then they may not be ready to invest in themselves.

      The point here (as will be explored further in