The Value Equation. Christopher H. Volk

a role in our customers' achievements.

      As a finance professional, I do not think personally about borrowings when considering how a business should be capitalized. That is too simplistic. Instead, I think about “other people's money” (OPM). For instance, STORE Capital is in the business of owning the profit-center real estate of companies and then leasing it to them on a long-term basis. There are numerous companies that use a lot of real estate in their business (think restaurants, fitness clubs, retailers, and many more) and they have a problem to solve. They could own the real estate and seek bank financing, or they could instead lease the real estate from a company like STORE.

      Real estate ownership requires an equity investment that can typically range as high as 40%, paired with borrowings for the remaining 60% plus. The alternative is to have a company like STORE put up all the money for the real estate, buy it, and then lease it back to you on a long-term lease. The amount of OPM entailed is different. A real estate lease offers far more OPM than does the choice of real estate ownership. Yet both are viable choices when it comes to creating a corporate capital stack.

As a self-described “finance guy,” I could care less about the accounting treatment of my capital stack. My attention tends to turn in the direction of equity returns, corporate flexibility, liquidity, and margins for error, which are important keys to value and wealth creation. I find that most corporate CEOs feel likewise. Hence, some will choose to own equipment or real estate, while others will elect to lease equipment and real estate. Either way, these decisions impact the corporate OPM and equity mix. They impact the capital stack.

      Accountants like to include within company liabilities non-interest-costing obligations, such as trade payables, deposits (deferred income), and accrued liabilities. As a finance guy, I ignore such liabilities within the corporate capital stack. Since they cost nothing to me, I subtract them from the amount I would otherwise have to make to determine business investment, the first of the Six Variables, which was discussed in the preceding chapter.

      Borrowings at cost are generally visible on a corporate financial statement, while the cost of leased assets is nowhere to be seen. Accountants have always been obsessed with lease accounting, which embodies why accounting is always going to be an imperfect reflection of financial reality. For most of my career, real estate leases were not included on a balance sheet at all. They just showed up in the form of rent expense, and required a detailed financial statement footnote disclosure explaining how much in lease payments the company was obligated to pay over time. All of this changed with new accounting rules imposed in 2019.

       GAAP Lease Accounting

	Old Rules	2019 Rules
Show an Asset?	No	Yes
Show a Liability?	No	Yes
Show OPM Proceeds?	No	No

In 2019, new lease accounting standards set by the Financial Accounting Standards Board (FASB) were enacted, resulting in the creation of non-cash “right to use” assets and liabilities, representing the estimated present values of lease payment obligations.¹ Since a lease is generally not a debt substitute, but instead a debt and equity substitute, the amount of the “right to use” liability and asset created will typically not approximate the actual amount of the OPM represented by your decision to lease.

Variables #2 and #3: Amount and Cost of OPM

      A company's capital stack provides numbers two and three of the Six Variables at the hands of corporate leadership to deliver investor returns.

       The second of the Six Variables is the OPM/equity mix.

       The third variable is the cost of OPM.

      In starting a company, business owners understand fully the cost of assets they choose to rent instead of buy. Business owners also understand the amount of money they borrow from banks and other sources. Add the two together and you get the second variable, the amount of OPM used in a business.

      In determining current investor returns, the cost of OPM is paired with the amount of OPM used to arrive at the third equation variable. The simple formula is as follows:

If you were computing the cost of OPM for a year, you would take the total amount of interest and lease payments shown above and then divide them into the average of the loan principal outstanding and the cost of the leased assets deployed. When it comes to determining the cost of OPM, my treatment of leases can seem simplistic, because leases often have escalators built into them and sometimes allow for an accumulation of equity with a future known purchase option. But, as you will see as we go on, I am most interested in computing a current investor rate of return, and not a theoretical total rate of return. To do this requires that I simply compute a current cost of OPM.

Cost of Capital vs. Cost of Equity

      A corporate capital stack is comprised solely of interest-costing OPM, together with equity that is likewise demanding of a return. If you can take the total annual OPM interest and lease cost, together with the desired current annual rate of return for equity investors, and then divide that cost by the amount of your capital stack, you can determine your current annual corporate cost of capital. Then, if you can realize current corporate returns that exceed that cost of capital, you have market value added (MVA), creating a business worth more than its cost. The whole is now worth more than the sum of the cost of its parts.

      In golfing terms, you have broken par, which is a feat few can accomplish.

      Corporate cost of capital is a frequent topic of conversation in business schools. However, I decided some time ago that the only thing that really mattered from a mathematical point of view was the cost of equity. After all, entrepreneurs are not trying to make their lenders, equipment owners, or landlords rich. They are trying to make their equity owners rich.

      So, to keep it simple, the important metric to know is not corporate market value added. It's equity market value added, which is the amount by which the value of corporate equity exceeds its historic cost.

When it comes to your capital stack, you want to strike a balance between OPM and equity having the potential to deliver the highest equity rate of return. Hence, in the order of operations to determining a capital stack, you start with the amount of OPM you can attain and then back into the amount of equity you require. When it comes to equity, less tends to be more.

Capital Stack Assembly

      During my business career, I gained something of a reputation for creating financial models. Not to be outdone, Mort Fleischer—my mentor and business partner for most of those years—created “Mort's Model,” which he had framed, and then freely passed around, and which I will immortalize here. Mort's Model embodies the notion of less equity is more, and goes like this:

      “Yenem's Gelt” is Yiddish for OPM, and “∞,” otherwise called a “lazy eight,”