What you can’t see can do the most damage

Weren’t you heartbroken over the death of John F. Kennedy Jr.?

We recently finished a three-day soiree with our long time friends from Boston, who we have visited frequently on Martha’s Vineyard where their family has had a home for more than 100 years.

As usual, the conversation turned to island lore, Fall from Grace, the mystery novel from Richard North Patterson, which takes place on the island (andwhich I highly recommend), … and inevitably to the Kennedy folklore and the tragic death of JFK Jr.

Is it hubris that drives us into the storm clouds?

[pullquote]“Vision is the art of seeing the invisible.” ~ Jonathan Swift[/pullquote]

My wife has had a lifelong interest in the family side of the Kennedy dynasty, so she was enthralled by a factoid we hadn’t heard before … that as a poignant denouement to that fateful airplane crash, JFK Jr.’s suitcase happened to wash up on the shore of none other than his mother’s home on the island.

During our conversation, my mind drifted to wonder again why JFK Jr. was overreaching his capability as a private pilot.

He had a basic pilot’s license, which permitted him to fly under VFR (“Visual Flight Rules”), which basically means navigating around only the things you can see.

Yet he was flying into weather conditions that required IFR (“Instrument Flight Rules”) for which he was not qualified.

What’s visible is only a small part of the story

Flights operating under VFR are flown solely by reference to what is visible.

What you can see serves as your cue for navigation, orientation, and separation from terrain and other traffic for safe operations during all phases of flight.

[pullquote]Remember … you won’t become a better LEADER until you become a better READER. You can start by making sure you’re not creating your own distractions and you know where you’re pointing that finger … and don’t forget that it’s impossible to fake authenticity.[/pullquote]

Essentially, it means navigating around only the things you can see, while IFR requires instruments to see the things you can’t see.

“I’ll believe it when I see it” … but if you don’t?

Most of us are pretty good at dealing with what’s in front of us where we’re much more comfortable, aren’t we?

Don’t we often find ourselves saying something like, “I’ll believe it when I see it”, or “seeing is believing”?

Even utilizing all of our five senses, we are primarily attuned to only what is in our current space.

We’re convinced that if we can have full command of what’s in our field of perception, our powerful senses can guide us with great precision and understanding.

We’re good at that, so if we see it, we can handle it.

Does your business have a Certified Instrument Rating?

So, why do we continue to make so many decisions while flying VFR when the conditions demand an IFR instrument rating?

While we might hear or see or smell distant objects, our perception is severely limited by focusing only on what is within our “field of vision”, and hardly substitutes for other tools with more far reaching capability.

Why do we ignore the metrics we can’t see?

Maybe it’s hubris or arrogance that makes us think we can conquer anything regardless of our visibility, but that’s not very realistic, is it?

We really need to devote some quality time to advancing our skills to understand and refine the tools that do belong on our IFR dashboard.

These metrics can range from simple sales reports to more sophisticated business intelligence that captures and tracks information from multiple sources to help us understand what’s happening outside our field of vision.

What kind of aircraft are you flying? Solo? Passengers?

As your business grows, even finely tuned IFR skills will need to be revised and upgraded depending on the type of aircraft you’re flying.

Are you piloting a blimp or a helicopter? Is it a singe engine plane or a multi-engine aircraft?

[pullquote]Every week, we’re sharing valuable and practical leadership tips and tools to help you BECOME a better leader. Why not get these valuable tips and techniques sent directly to your inbox every week so you don’t miss them?[/pullquote]

You’ll need to be clear about that, as well, to make sure you’re collecting the right intelligence and developing the appropriate metrics.

As your team grows, you may even need a further upgrade to an Airline Transport Pilot certificate that allows you to bring other people along with you.

What are you doing to develop your IFR skills?

If you’re a solopreneur, VFR skills may take you a long way.

But if you’re building an organization, you’ll need to develop IFR capability.

So, if you find yourself airborne with only a VFR license, start working on the IFR upgrade that will allow you to navigate safely through those clouds.

Make sure you’re gathering information to measure and monitor what you can’t see.

Our upcoming series will teach you the IFR tools & metrics you need

I’m going to help you with this, too.

In the coming weeks, I will be rolling out a free video program describing some IFR tools and metrics that you can apply to your business.

You can visit the Exkalibur website or our new Facebook page, BuildYourBiz, to make sure you don’t miss this program.

Remember one more thing as you create and build your business:

Takeoffs are optional; landings are mandatory.

What about you?

Have you got your metrics in order … and are you paying attention to every one of them?

Every Tuesday, we’re sharing valuable and practical leadership tips and tools to help you BE a better leader so you can BECOME a better leader. Remember … you won’t BECOME a better leader until you start BEING a better leader … implementing NOW the changes necessary to adopt the proven strategies of successful leaders. You might start by building on the communication matrix and making sure you’re defending the castle to get done what only you can do. Make sure to take some time so you’re thinking past today. Don’t forget our 12 part Leadership series.

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We’re human, we make mistakes, we miscalculate …

I continue to examine some of the first 100 newspaper columns I’ve written … and continue to be struck by the timeless issues that we face as we build our businesses.
We’re human, we make mistakes, we don’t always get done what we intend, we miscalculate, things don’t turn out as planned.
Stuff happens.
We know we’re on a journey and not just seeking a destination, but that doesn’t diminish our struggle to overcome many of the same forces that have plagued progress throughout civilization.
(We’ll explore some of those forces, and how to overcome them, in an upcoming column.)

“The importance of knowing accounting can not be underestimated, it’s the language of business. If you don’t know it, it’s like being in a foreign country without knowing the language.”  ~ Warren E. Buffett, CEO, Berkshire Hathaway, Inc.

This famous quote from the Sage of Omaha kicked off the 13-part Big River series, a narrative journey examining the value and dangers of accelerated growth and illuminating many of the business finance issues that affect our businesses.

Dilution.

Leverage.

Financing.

Valuation.

Liquidity … and more.

It illustrates the balance that your business requires between the growth that nourishes the organization and the strains it imposes as the body grows. That series is now being published in book form, so stay tuned for that announcement very soon. 

“I don’t make jokes. I just watch the government and report the facts.” ~Will Rogers

Few would disagree about the timeless value of this statement. It appeared in a column in November 2008 as the wheels of American commerce were grinding to a halt. I used this “Double V” image to signify the High degree of Volatility and the Low degree of Visibility that branded the horizon, and I’m not sure those characteristics haven’t returned … if they ever left.
At the time, I suggested attacking the nefarious “V” words with a few “F” words of our own to communicate with your teams during hard times.

• Face time by spending more time with your employees.
• Be Forthcoming and tell it to your team as straight as you understand it.
• Use “Facts” not Fiction; your employees can take it and will appreciate knowing that you don’t have all the answers either.
• Frequency reminds us that we can’t over-communicate during these periods. Keep talking; update everyone on what you’re learning as well as what you still don’t know.

As I emphasized then: “Don’t wait to get this done. Your employees are walking on eggshells every day. Pick up the shucks and create a positive environment where employees know the rules and trust that you’ll keep them in the loop at all times.”

“Lewis & Clark didn’t load the canoe with Mojitos!”

I love this tagline from Jim Beam.
It says that we know who we are … and who we’re not … we’re proud of it … and if you don’t like it ….
When we recall the “sustainable competitive advantage” that should earmark our Strategy, it’s critical to stake out “who we are”, a subject we have covered in several previous columns.
Know your core market and “stand for something” is always better than trying to be all things to all people.
Try it sometime.
Your real customers like to hear that you understand the core values they’ve come to respect in your products and services … and you’ll be able to extend your appeal to people who want to buy from someone who knows who they are will make them part of something greater.
We’re got a few tours left through the museum of previous columns before we begin to tackle why these lessons are so hard for us to adopt and put to work.
In the meantime, take stock of these principles.

• Manage growth so it doesn’t consume your resources instead of adding to them.
• Continue to communicate with your employees in this stalled economy so they don’t have to be looking over their shoulder and can focus on what’s important to make the company more successful.

While you’re at it? Make sure everyone knows what you stand for.

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This article was published in the October 31, 2011 edition of the North Bay Business Journal, a publication of the New York Times, and a weekly business newspaper which I have served as a regular columnist for over three years. The Business Journal covers the North Bay area of San Francisco – from the Golden Gate bridge north, including the Wine Country of Sonoma and Napa counties. The electronic version of this article, as published by the North Bay Business Journal, may be found here.

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Lary Kirchenbauer is the president of Exkalibur Advisors, providing practical business strategies for family and other privately owned businesses in the middle market. Exkalibur works closely with senior executives and their businesses in the wine and other industries, and hosts the Exkalibur Leadership Forum for leaders of middle market companies in the North Bay. Please visit Exkalibur.com for a library of valuable resources, articles and insights or connect on Twitter, LinkedIN or the Exkalibur fan page on Facebook.

Every Tuesday, we’re sharing valuable and practical leadership tips and tools to help you BE a better leader so you can BECOME a better leader. Remember … you won’t BECOME a better leader until you start BEING a better leader … implementing NOW the changes necessary to adopt the proven strategies of successful leaders. You might start by building on the communication matrix and making sure you’re defending the castle to get done what only you can do. Make sure to take some time so you’re thinking past today. Don’t forget our 12 part Leadership series and #100 of my newspaper columns.

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Every Tuesday, we’re sharing valuable and practical leadership tips and tools to help you BE a better leader so you can BECOME a better leader. Remember … you won’t BECOME a better leader until you start BEING a better leader … implementing NOW the changes necessary to adopt the proven strategies of successful leaders. You might start by building on the communication matrix and making sure you’re defending the castle to get done what only you can do. Make sure to take some time so you’re thinking past today. Don’t forget our 12 part Leadership series.

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Finally, Column No. 100?

If I haven’t put you to sleep yet, you’re not reading every one of my columns published in the local New York Times affiliate … and guess what? By my count, this column is a milestone as column #100. Has anyone else written that many … other than the Editor in Chief, of course?

Have I been listening in on your conversations?

This journey began in the Fall, 2007 and for the most part, bi-weekly since then. The only exception is the most recent L.E.A.D.E.R.S.H.I.P. series that was published over 12 consecutive weeks. Most of the columns have climbed around the monkey bars at the intersection of Strategy, Finance & Leadership, but according to several keen observers, I’ve also listened in on their boardroom conversations. Others have said they recognized themselves in my examples … I’ll never tell … and some have even said, “stop writing about me”. We’ll never know if it was intentional or accidental, will we?

What are some of the most important concepts in Building a Business?

So, from that platform, I’ve decided to re-examine some of the concepts I’ve discussed over the last several years … and since so many of you have remarked about how much you love the quotes that have accompanied each column  … and have liberally “borrowed” them … I’ve used some of them again to re-introduce those concepts (and give you collective access to a bunch of them at once.)

Go ahead and borrow some of your favorite quotes

In most cases, time has only strengthened my conviction about the importance of these concepts. Most of them deserve to be regularly refreshed and repeated as the touchstones of successful businesses.

“There is nothing more exhilarating than to be shot at without result.”

This is one of my favorite quotes about entrepreneurship, capturing the risk and danger while highlighting the invigorating feeling it creates. Thanks, Sir Winston, for succinctly pinpointing the essence of what it means to pursue our entrepreneurial passions.

“If you don’t know where you’re going, any road will do.”  ~ Socrates

“In preparing for battle I have always found that plans are useless, but planning is indispensable.”    ~ Dwight D. Eisenhower

There are plenty more where these come from … and each of them is a powerful reminder of the need for strategic thinking. I’ve frequently touched on strategy and planning as cornerstones of successful businesses. Yes, it’s a time-consuming process and requires sharpshooter focus and relentless diligence … but the rewards for companies who pursue it with a passion are unarguable.
I said then and reiterate now: “Countless business studies have shown that businesses with a disciplined and consistent process for formulating AND implementing their strategy have out-performed their industry peers by a significant margin.

“In business, the competition will bite you if you keep running; if you stand still, they will swallow you.”   ~William Knudsen Jr., Former Chairman, Ford Motor Company

This quote accompanied an article about competitive intelligence. I used a football analogy because football teams, and professional sports in general, invest heavily to assess the competition. While you may be unable to obtain videotape for every play your competition has made, don’t let that stop you from evaluating the competition with as much vigor and rigor as you can muster.
“Some regard private enterprise as if it were a predatory tiger to be shot. Others look upon it as a cow that they can milk. Only a handful see it for what it really is – the strong horse that pulls the whole cart.”   ~Winston Churchill
In my column entitled, “Put the business back in the family business!” I reflected on the strong predisposition to focus on the “family” part of the “family business” at the exclusion of an equally important discussion about the “business” of the family. I watch companies struggle with these issues every day, and urge them to remember that the strength of the “mother ship” is the fountainhead of family stability and harmony. Without it, squabbling crescendos and family dynamics tend to disintegrate.
“Success is not the key to happiness. Happiness is the key to success. If you love what you are doing, you will be successful.”   ~ Albert Schweitzer
“Begin doing what you want to do now. We are not living in eternity. We have only this moment, sparkling like a star in our hand – and melting like a snowflake.” ~ Sir Francis Bacon
Are we having fun yet? This is one of several columns in which I emphasized the power of passion and commitment … as well as having fun. Others have said “if you love what you’re doing, you’ll never work a day in your life”, so make sure you’re committed to something you love and have fun along the way.

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This article will be published in the September 26, 2011 edition of the North Bay Business Journal, a publication of the New York Times, and a weekly business newspaper which I have served as a regular columnist for over three years. The Business Journal covers the North Bay area of San Francisco – from the Golden Gate bridge north, including the Wine Country of Sonoma and Napa counties. The electronic version of this article, as published by the North Bay Business Journal, may be found here.

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Lary Kirchenbauer is the president of Exkalibur Advisors, providing practical business strategies for family and other privately owned businesses in the middle market. Exkalibur works closely with senior executives and their businesses in the wine and other industries, and hosts the Exkalibur Leadership Forum for leaders of middle market companies in the North Bay. Please visit Exkalibur.com for a library of valuable resources, articles and insights or connect on Twitter, LinkedIN or the Exkalibur fan page on Facebook.

In the tumult surrounding the 3D maelstrom (Debt Ceiling, Downgrading and Deficit) of several weeks ago, you may have missed another chilling corporate finance update on the relentless pursuit of performance metrics that extol the sunshine while you’re in the heart of darkness. Yes, there may be some economic value for certain of these metrics, but they’re dangerous barometers of realizable value and highly misleading as to future achievements of tangible operating profits and free cash flow.

Another Sign of the Apocalypse?

Most of us recall the “eyeball counting” that preceded the Dot-Com-Bomb and those certain “Signs of the Apocalypse”, as when your cab driver is telling you what stocks you should buy.

So, in case you missed the New York Times article describing the latest incarnation of these prayerful metrics, “ACSOI” is one the latest inventions. Pronounced as either “ack-soy” or “ask-saw” depending on the source, it stands for “adjusted consolidated segment operating income.”

It may be one of those metrics that falls into the bucket that Lynn E. Turner, a former chief accountant for the Securities and Exchange Commission, once called E.B.B.S., or “earnings before bad stuff.” Sweet, huh?

Let’s leave out some of them stinkin’ marketing expenses

ACSOI is one of three yardsticks that Groupon invites investors to consider and refers to operating profit minus the company’s large online marketing and acquisition expenses. Groupon wants to emphasize that it’s important to segregate the extraordinary cost of obtaining new subscribers vs. the cost of sustaining existing subscribers, which are much less expensive. Interesting information … but similar to a reporting strategy used by Pets.com before they hit the wall at Mach 10 during the dot.com bust.

Does Internet content have a 5 year life?

With similar objectives, the article reports that Demand Media stretches its payments to content contributors over 5 years to emphasize the long life of the content on their site. While Google searches might turn up some of these older articles, there is so much new content that the old adage about “today’s newspaper is tomorrow’s fish wrap” may likewise apply to digital content. (As a result of this treatment, Demand Media turned net income from a -$5M number to a +$5M number. Hmmm ….)

Pay attention, kids. Momma ain’t no pushover.

So, heads-up investors. It may be a different world than the dot.bomb era, and there may be more substance to some of the new technology ventures, but if you’re going to drink the Koolaid … remember that drinking it too fast will make you lose your cookies!

Caveat Emptor!

Does this bother you? Am I making a mountain out of a mole hill? What do you think?

Follow us on Facebook and share your comments there.

“Financial Adrenaline” is a term we love around here because it reflects our commitment to help you turbocharge your business with practical tips and techniques to improve free cash flow, the lifeblood of business. As a further extension of our Financial Adrenaline program, we’re going to share a new Business Finance Tip every Wednesday specifically for those business executives who don’t have a finance background. Our current Big River series started with We’re Making Money. Why are we broke? … then No Cash? Can we borrow what we need?, What if our loan collateral doesn’t cut it? and the need for outside investors.

Last week, we began our conversation about business valuation. We continue that discussion today with a valuable chart that will help you understand some of the key valuation principles.

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“Can anybody remember when the times were not hard and money not scarce?”

~ Ralph Waldo Emerson

What’s the difference between a Strategic & Financial Buyer

John Wilson, CEO of Ace Business Stuff, has been working diligently with his controller, Tom Sampson, to assess his financing needs. They may require an equity investor as he suspects that his controller’s right that bank financing may be insufficient.

“Hi Lary,” John said when he got Lary Blogger on the phone again.

“We’re almost finished with our forecast, but it still looks like we’ll need some equity. I’d like to explore what you said about strategic buyers and financial buyers and see the diagram you mentioned.”

Different Buyers have Different Perspectives

“John, this diagram is only meant as a general overview of some key valuation concepts,” I said when I visited with John at his office a few days later. “It should help you better understand certain key concepts which underlie the valuation of an ownership interest in your company.

The Strategic Buyer will pay the highest premium

“At the top is the Strategic Buyer. In short, he’s looking for more than a simple financial return. He or she is looking to share a distribution network, like Google’s acquisition of YouTube, for example, or to expand an existing product line, like Mars buying Wrigley’s. These acquisitions are often about the “white space”, filling in gaps in the acquirer’s product line as we’ve seen happening in the wine industry, say with the sale several years ago of Rosenblum Cellars to Diageo. The expectation is that the Strategic Buyer will pay a “Special Premium” to obtain some of these strategic advantages.

The Financial Buyer has a different perspective

“Contrarily, the financial buyer is looking solely for a return on investment. That buyer is usually unwilling to pay a premium beyond his target rate of return. In the second horizontal bar, you’ll note the term “Control Value”. Keep in mind that when most people talk about “valuation”, they’re talking about value for the whole company, or at least a controlling interest of 51%.”

“But that’s not what I’m looking for,” John said. “I have no intention of selling my company. I’m just looking for a minority investor.”

What if you need a minority investor rather than a buyer?

“I understand, John, and that’s why I want to make sure you understand these concepts and how buyers and investors alike may look at your company. Since you’re considering a sale of a [kastooltip msg=”minority interest” tooltip=”A significant but non-controlling ownership of less than 50% of a company’s voting shares by either an investor or another company.”] in your company, the valuation is not the same as if you were selling a controlling interest.”

“I don’t see why not? They’re getting a piece of the same company I own and it should be worth to them what it’s worth to me.”

What kind of a discount is there for minority ownership?

“From a valuation perspective, John, it’s going to be worth more to you because you have a controlling interest. You’re the boss, you can elect a majority of your Board of Directors and you call the shots. Your potential partner has limited courses of action if he doesn’t like the direction in which the company is going.”

“Then he shouldn’t invest, Lary. It’s really that simple, isn’t it?”

“Absolutely, he must believe in the company as well as your leadership, but that doesn’t mean he has much influence over things if they don’t go well. So, let’s review the two primary discounts that occur from the valuation of a controlling interest in a company.

What is a Minority Discount?

“First, there is a [kastooltip msg=”control premium” tooltip=”An amount paid to gain enough ownership to set policies, direct operations, and make decisions for a business. Contrast with Minority Discount.”], or a [kastooltip msg=”minority discount” tooltip=”A reduction from the Market Value of an asset because the Minority Interest owner(s) cannot direct the business operations. Contrast with Control Premium.”] because, as I’ve said, the minority shareholders must depend on the majority shareholders to make wise decisions. Since they don’t control the company, their ownership piece is worth less, and therefore, they’ll expect to pay less to buy it.”

How is the Minority Discount applied?

“What you’re saying, Lary, is that if my company is worth, say $2 million, and I need to raise $400,000, I’m going to have to give up more than the 20% that I would get by multiplying $2 million by 20%. Is that right?”

“Generally speaking, that’s right, John. But in a negotiated situation like you’re thinking about, it might play out differently. If an investor agrees that the company is worth $2 million, he might conclude that it’s a fair proposition and pay $400K for a 20% interest.”

“What kind of discount are we talking about, Lary? How big is that so-called “minority discount?”

“I know you’ll love this answer, John … but it depends . . . on a number of factors that a qualified valuation specialist will assess. Why don’t we get into
those details another time?”

“Okay, but I don’t like the direction this is going, Lary. The value of the minority interest I’m selling keeps going lower.”

The value of a minority interest can get reduced even further

“I understand your point, John, but there is yet another, bigger factor to consider – a [kastooltip msg=”lack of marketability discount” tooltip=”A method used to help calculate the value of closely held and restricted shares. The theory is that a discount exists between the value of a company’s stock that is and is not marketable. Various methods have been used to quantify the discount that can be applied. The consensus of some studies suggests that this lack of marketability discount can range from 30-50%.”]. A minority investment in a private company is also an illiquid investment, and the lack of liquidity makes it less desirable, say, than a comparable investment in a public company. The minority investor in a private company is not usually able to ‘cash out’ until you do.”

“So, Lary, what are we up to, in total discounts I mean? Is there anything left for me?”

What do all these discounts amount to?

“First, John, these discounts don’t get added together. The ‘Marketable Minority Interest Value’ you see on the diagram gets calculated first by applying the minority discount. That term is roughly equivalent to share of stock of a publicly traded company; you’ve probably noted in your own experience that public company shareholders almost always receive a “control premium” when the entire company is purchased.

“At the same time, it’s quite different to own a share of publicly traded company that you can sell any time you’d like and a share in a privately help company where there is no ready market to sell it.”

What is the Lack of Marketability Discount?

“Sure, I guess so, Lary. That is an advantage with a public company, but I didn’t think about the fact that a share in our company isn’t very liquid. I can’t even sell my own shares back to the company with any expectation that they could afford to buy them from me.”

“That’s right, John. So lets look at how this “lack of marketability discount” works. It’s actually applied to the remaining net number, which is the “Marketable Minority Interest Value” to arrive at the Non-Marketable Minority Interest Value, which is at the bottom of the diagram. This generally represents the minority investment in a private company. All in? It wouldn’t be unusual for those discounts to equal a 30-45% discount from the value of a controlling interest in the same corporation.”

“So, in my little $2 million example, the value of my company to a minority investor might be more like $1.1 – $1.4 million or so. That’s a big difference.”

A Minority Investor has a unique perspective

“Yes it is, John. Remember, though, that in your case, this is a negotiated process and the potential investor won’t know all of this. I want you to be aware of these concepts, though, because minority investors are not easy to find for these two key reasons – they don’t have much control and they can’t get their money back easily.

“John, this is all the more reason you need to carefully prepare your forecast and be certain you’ve captured all of the unique attributes and capabilities of your company so you can justify a fulsome value and only raise the equity capital that you absolutely need.

“Let’s get together again next week when you have the forecast finished and we’ll talk further about this process.”

Nothing in life travels in a neat formation accompanied by bugles and cavalry. A lot of it shows up filthy and unkempt, prominent in the mess we’ve made around our foxhole. These lessons are typically the offspring of hubris, naivete and ignorance … or from overlooking the land mines hidden beneath our feet.

Every Tuesday, we’ll share valuable and practical leadership tips and tools to help you BE a better leader so you can BECOME a better leader. Remember … you won’t BECOME a better leader until you start BEING a better leader  … implementing NOW the changes necessary to adopt the proven strategies of successful leaders. You might start by building on the communication matrix and making sure you’re defending the castle to get done what only you can do. Make some time so you’re thinking past today.

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It’s Almost Midnight. Do you know where your cash is?

Okay, I admit it, I’m cheating a little this week … but I’ve got a few good reasons. Well, I’m calling them reasons anyway.

For one, I’m working hard to get ready for our Cash Flow Workshop, “It’s Almost Midnight. Do You Know Where Your Cash Is?” scheduled for May 25th. If you live in the San Francisco bay area, are not a financial executive and want to advance your business finance knowledge, our workshop is tailored for you.

Every successful business executive needs a solid grounding in the principles of cash flow … not artificial placeholders like EBITDA, but the hard, cold cash that Warren Buffett calls the “lifeblood of business”. This is an Extended Learning Workshop that is different than anything you’ve ever attended. There are special conference calls before and after the workshop, a financial literacy test, an E-book … and a private 1/1 consultation with a senior member of Moss Adams LLP, a senior banker from Exchange Bank and me. We’d love to see you there.

Alright, so maybe that sounded a little self-serving but it really isn’t. We’ve got a great group of North Bay sponsors who share my belief that helping small and middle market business owners and executives become better equipped to measure, manage and increase cash flow is the greatest service we can provide to that community.

Join us and we’ll teach you how to increase cash flow. It’s that simple.

New L.E.A.D.E.R.S.H.I.P. Series

I’ve also been planning a new program, the Top Ten Attributes of L.E.A.D.E.R.S.H.I.P., which is directly related to our weekly Leadership Series. Next Tuesday, and for the following 11 weeks, we’ll tackle this fascinating subject and get a dialogue started about the most important attributes of great leaders. The North Bay Business Journal, a San Francisco affiliate of the New York Times, will also be carrying these articles every week during the 12 week series.

What does it take to be a good leader? How much is inherited, and is that all we’re going to get? Where can we get what’s missing? What if we apply the best practices that others have learned and shared? Does that get us there?

Yes, it’s possible that we’re not quite the leaders we think we are. How do we measure our capability and success as leaders? If our company is making money, does that cover it? If our company is growing, have we arrived? Do we just need to look around to see if anyone is following us?

Join the Conversation

Please join us as we engage in a vibrant conversation about L.E.A.D.E.R.S.H.I.P. Maybe there are attributes you think I overlooked, or maybe you disagree with my choices, so feel free to share your thoughts along the way.

What do you think are the most important characteristics of leadership? Which ones do you cherish as critical to your success? Are there some that you think are overrated?

“Financial Adrenaline” is a term we love around here because it reflects our commitment to help you turbocharge your business with practical tips and techniques to improve free cash flow, the lifeblood of business. As a further extension of our Financial Adrenaline program, we’re going to share a new Business Finance Tidbit every Wednesday specifically for those business executives who don’t have a finance background. Our current Big River series started with We’re Making Money. Why are we broke? … then No Cash? Can we borrow what we need? and What if our loan collateral doesn’t cut it? Last week, we talked about the need for outside investors.

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“All intelligent investing is value investing — acquiring more than you are paying for. You must value the business in order to value the stock.”

~ Charlie Munger

How important is valuation?

John Wilson, CEO of Ace Business Stuff, spent the last few weeks preparing for his meeting with Lary Blogger. He called a few days ago to follow up on his recent conversation with his attorney, Frank Lee Documents, when they spoke about investors, [kastooltip msg=”Dilution” tooltip=”A reduction in earning per share of common stock that occurs through the issuance of additional shares or the conversion of convertible securities”] and [kastooltip msg=”Valuation” tooltip=”The process of determining the current worth of a company. An analyst valuing a company may look at the company’s management, the composition of its capital structure, prospect of future earnings, and market value of assets. Judging the contributions of a company’s management would be more subjective, while calculating intrinsic value based on future earnings would be an objective technique.”].

Valuation is the bedrock for investors

“Hi, Lary. I appreciate your coming by to meet in person to talk further about some of the issues we discussed a few weeks ago. Can we talk about valuation first, since that seems to be the foundation for conversations with prospective investors?

“Sure, John. I think you’ll find from our conversation that while valuation is one of the cornerstones for such discussions, your company’s performance, as well as its promise, is what really underlies any discussion about valuation.”

What you WILL do may be more important that what you’ve DONE

“I’m not sure I follow you, Lary. I understand the performance part – what we’ve done historically will have a lot to do with what the company’s worth, but what does the future have to do with our valuation now?”

“John, let me give you a brief overview of the valuation process, which I hope will make it clearer. As you’ve already figured out, valuation is as much an art as a science, and there are many subjective factors to consider. Certain judgments about future conditions in your industry, for example, and in the economy, can be thought of as ‘subjective’ information since nothing in the future is really ‘objective’.

There are also other factors relevant to the final valuation outcome like the purpose of the valuation, the calculation of “invested capital” and the various discounts that often apply. If we don’t get to those today, we’ll talk about them another time.

How is a company valued?

“In the meantime, let’s cover the two most prominent approaches to value a company’s shares. For each approach, a certified appraiser will select the appropriate method to apply based on the company’s characteristics. Once their work is complete, all of the findings will be taken into account to come up with a fair market value for the company.

The Market Approach looks at sales of comparable companies

“The ‘market approach’ looks for relevant information among public companies, or about the sale of comparable private companies. As you know, there is a gold mine of information available about public companies, but it is more limited for private companies. Appraisers are looking for public companies in your industry with characteristics similar to your company. They will then consider those stock prices and the relevant metrics that may apply to your business.”

“But there aren’t any public companies like ours, at least none we know about. So how is that going to help?”

“That’s only one method, John. An appraiser will also want to look at the sale of comparable private companies from the growing variety of databases available for this data.”

“Can you give me an example, Lary, to illustrate what you mean?”

Study the sale of comparable companies

“Sure. Let’s say that we find a few companies that were sold in the last 12 months or so, with about $20 million annual sales volume. Let’s further assume that they prices at which they were sold translate to something like 1.2 X revenues or 4.5 X EBITDA. We would then try to determine the comparability of your company to those examples.

• Do you use a similar distribution channel to sell comparable products?
• Are the general levels of profitability similar?
• Are the growth rates in the same ballpark?
• Etc.

Then you could apply similar metrics to get one estimate of value for your company.

The Income Method is another valuation approach

“The second approach is the “income approach”, which is usually the most important for private companies. That approach typically looks at the cash flow from future revenues and expenses based on a forecast that you provide, to arrive at a future value.

Then, that stream of cash flows is discounted at a rate that reflects the risk associated with achieving those cash flows. That’s why your company’s future ‘promise’ is so important.”

The importance of forecasting can’t be overlooked

“I see what you mean, now. I don’t think we’ve ever put together a real forecast, I mean we do some budgeting each year, but usually only to get some idea of our expenses. Is a complete forecast that essential?”

“In my experience, it is, John. For one thing, an investor is likely to ask ‘what are your plans for the future’ since they are rightfully looking at how their investment is going to be repaid … sometime in the future … with an appropriate rate of return. Responding ‘I don’t know’ isn’t going to work.”

“I see your point, Lary. Even though we can tell our story, without anything written that illust
rates the revenue growth and profitability, it will seem like we haven’t done a very thorough job in evaluating our own future. I’ll sit down with Tom Sampson and hammer something out this afternoon.”

Where does the forecasting process begin?

“John, this is not something you’ll be able to cobble together in a few hours. You need to think carefully about your underlying assumptions for revenue and expenses, and make sure they’re well documented. You’ll also want to get some input from your leadership team about your plans, as well as the related cost structures and investments that might be required to support those plans.

The future investments that may be required to realize your plans will be critical to investors. Access to that funding will be important to the company’s future success and the likelihood that an investor will recoup her investment with an acceptable rate of return.

If you haven’t done it before, you’ll need to set aside some quality time to prepare a thoughtful and thorough forecast.”

Make sure you’re well prepared if you’re courting outside investors

“Getting investors isn’t as simple as I thought, Lary, but I think I understand why it’s important to get it right. I don’t want to give up more equity than absolutely necessary, but I see that the better job we do up front, the better result we’ll get. By the way, does all of this have anything to do with what my attorney mentioned about financial buyers vs. strategic buyers?”

“It all ties together, John. The next time we get together to review your forecast, I’ll show you a useful diagram to explain those principles. In the meantime, you’ve some work to do.”

____________________________________________

TO BE CONTINUED …

This is Part 5 of a 12 part series called the “Big River“. The Big River signifies the growth path that so many companies follow, or are seeking, and the dangers that lurk along the shoreline as the Big River races forward trying to consume everything in its path. Next week, an important valuation framework is included to help you understand the most important concepts that effect company valuation. Make sure you sign up now so you receive every update in this practical series.

John Wilson, CEO of Ace Business Stuff, was thinking about several of the issues that he discussed earlier that day with his controller, Tom Sampson, and what Tom told him:

“Giving our customers an additional 30 days to pay, relaxing collections and neglecting the sale of inventory already on hand, isn’t a very sound strategy.”

Instinctively, he knew that Tom was right and that whatever bank loan they could obtain, it wouldn’t be enough.

What if bank financing isn’t enough?

Ted Deepockets, his long-time friend, had periodically needled John about the pros and cons of outside investors. He always seemed like he’d be interested in investing if the opportunity was presented.

[pullquote]“The worst mistake is to have the best ladder and the wrong wall.”~ Donald Rumsfeld[/pullquote]

They had never discussed price, terms or amount, but Ted’s name kept coming to mind over the last several days. John decided to call his attorney first.

“Hi, Frank. What’s new in the legal world these days?” Frank Lee Documents was John’s long-time friend and the company attorney.

“Same-o, John. The legal work keeps piling up so I guess that’s good. How about with you?”

“Frank Lee,” John drew out the syllables to emphasize the double entendre, “business is great, if that’s what you mean. Too good, in fact, but a few sloppy decisions on my part has us with booming sales and no cash.

“I’m actually thinking about taking on an investor.”

“That’s quite a change, John. You’ve never been inclined to consider that in the past.”

The “Big River” is a 12 part series that begins with We’re Making Money. Why Are We Broke? It is delivered as a conversation among a company’s CEO, CFO and other advisors as the story unfolds. Join us on this journey to learn how to deal with some of the most important business finance issues facing companies today.

Is it possible to run out of cash while sales are still growing?

“I know, Frank, and I’m still very skeptical about taking on a partner, but we’re really growing. I don’t think we can borrow enough to fund our growth.

“Even if we tighten up a few things, we’re going to run out of cash before we run out of sales.”

“So, how can I help, John? Do have any kind of proposal or plan in front of you yet?”

“No, but I’m thinking of calling Ted to talk about it.”

“Deepockets might be a good place to start. He always speaks highly of you and what you’re doing, and after that windfall sale of his Saratoga property, he can probably spare a few bucks.”

Equity Investors raise a lot of new issues

[pullquote]Please note that if you hover your mouse over a defined term that is underlined with a dotted line, the definition will appear alongside. A complete Glossary is also available.[/pullquote]
“Probably so, Frank. But I’m not sure how to approach him. We’re still figuring out how much money we’ll need and even then, I’m not sure how this works.

“You and I have chatted before about Dilution … Leverage … Valuation … a lot of concepts that remain pretty unfamiliar to me. I need to understand this stuff – and sooner than later.”

John could hear Frank’s stubby pencil scribbling across the page of the dog-eared notebook he always had at hand.

Make sure you’re getting the right kind of advice

“Here’s what I think, John. Of course, we can help you with the documentation, and you certainly better make sure any transaction like this is well documented.

“But I think there is someone else who is better prepared to guide you from a business perspective.

“He’s had a lot of experience with middle market companies, and has helped companies raise capital during some difficult times. Let’s try to get him on the phone.”

What is dilution … exactly”

After a brief introduction and a few pleasant exchanges, John briefly described his issue to Lary Blogger.”

“So, Lary, can you help me understand what this term “dilution” is all about?”

“Don’t be put off by the fancy term, John. In this context, it simply means that by issuing additional stock to a new partner, you’ll own a lesser share of the company than you own now.

“You’ll be ‘diluted’. The subject can get pretty complex because there are a lot of ways that dilution occurs, but we can deal with those issues if and when they come up.”

How much money do you need?

“So, Lary, how much dilution are we talking about? How can I make that as small as possible?

“The key question is how much money do you need, John, and what will it cost, which quickly gets around to ’what’s the value of the company’ today?

“Here’s a simple example to make the point. Don’t get hung up on the math, though, because we can go back over it later.

Consider this dilution illustration

“For now, let’s assume your company is worth $1 million and you own 100% of the stock.

“The $1 million is known as the “pre-money valuation”, meaning that it’s the valuation before any investment is made.

“In our example, let’s assume there are 10,000 shares such that each share is worth $100/share ($1,000,000 value divided by 10,000 shares).

“Just to make the math easy, let’s say you need to raise $300,000 to meet your capital needs. To do that, you will have to issue 3,000 new shares (the $300,000 investment divided by $100/share price).

“After the investment, the share price won’t change – it will still be $100/share but there will now be 13,000 shares (the original 10,000 shares plus the 3,000 newly-issued shares). Are you with me, John?”

“Yes, Lary. I think I understand. We’re issuing new shares based on the current value and based on how much money we raise, that’s how many new shares will need to be issued.”

“You’ve got it, John … so, let’s go on.

“The value of the Company will also increase by the amount of the investment so that the total “post-money valuation” will be equal to $1.3 million (the original pre-money valuation of $1 million plus the $300,000 investment).

What does dilution do to my ownership?

“From this, you can see two things.

“First, as I said earlier, the share price doesn’t change.

“Secondly, although you still have the 10,000 shares you started with, the Company now has 13,000 shares outstanding, so your percentage ownership goes from 100%, when you owned all of the 10,000 shares, to around 77% (your 10,000 shares divided by the total number of outstanding shares of 13,000).”
“So, Lary, if I understand you correctly, the valuation of my company is pretty critical to this process. The higher it is, the less dilution I’ll experience. Is that right?”

What can I do to minimize dilution?

“That’s absolutely right. Let’s take our previous example and assume that the company is actually worth more, say $2 million is the pre-money valuation where each share is worth $200, using the same 10,000 outstanding shares.

“In this case, with a new investor putting up $300K, they would only get 1,500 shares.

“Now, there would be only 11,500 shares outstanding (the original 10,000 shares plus the newly-issued 1,500 shares),
and you would own about 87% of the company, a full 10% more than the 77% in our earlier example.

Is Valuation an Art or a Science?

“I understand, but valuation is pretty subjective, isn’t it?”

“Yes, John, it is as much art as it is science.”

“Thanks, Lary. Could we get together in person next week to talk more about some of this stuff? That would really help me and by that time, I’ll know more about our company situation.”

“Anytime will be fine, John. Just give me a call when you’re ready.”

Continue reading … Chapter 5: “What’s the value of my Company?”

Tom Sampson, the controller for Ace Business Stuff, was in his office considering how to explain to John Wilson, the Company’s CEO, the issues related to the Company’s borrowing capacity and the weaknesses in the Company’s Balance Sheet.

Tom pulled together several schedules for his meeting with his CEO that afternoon, but was still struggling with how to get across some of the subtleties that he knew John would want to understand.

Tom knew that his CEO was absolutely committed to the Company’s success, although he became very frustrated when his convictions about future performance collided with the bank’s concerns about current performance.

What factors will the bank consider?

Tom knew that the bank considered many factors when judging an asset-based loan.

Having enough collateral to support the Company’s borrowing request was only part of it.

How do they measure the strength of the collateral?

One key ingredient is the quality of the collateral. Tom had often expressed concerns about the Company’s liberal return policy, as well as its lenient collection policy.

He knew the bank would examine the Company’s historical product return rate and its collection policies and they might fall a little short.

The “Big River” is a 12 part series that begins with We’re Making Money. Why Are We Broke? It is delivered as a conversation among a company’s CEO, CFO and other advisors as the story unfolds. Join us on this journey to learn how to deal with some of the most important business finance issues facing companies today.

What is the quality of our receivables?

It was likely that the generally-accepted 80% advance rate against receivables would be reduced by the bank given the Company’s product return rate of around 7%, meaning that the Company only netted about 93% out of every sales dollar.

Tom knew that the return rate was unacceptably high and while they were working to improve it, they hadn’t made much progress.

Is there any bad debt expense?

[pullquote]“Anyone who lives within their means suffers from a lack of imagination.” ~ Oscar Wilde[/pullquote]

Also, their bad debt expense was 5% last year because they failed to uncover a large but struggling customer before they went out of business.

The bank would calculate that the 100% value of every sale is really more like 93% minus the 5% bad debt, which brings the realizable value from each dollar of sales to something closer to 88% … and that’s in a perfect world with no other hiccups.

Tom was pretty sure that the 8% margin over the target 80% advance rate would not give the bank a sufficient cushion.

Most likely, the company would be unable to borrow at an 80% rate … more likely, something like 70%, which would make things even tighter.

What about our inventory value?

“Hi Frank,” Tom said when he reached the Company’s warehouse manager.

“John and I will be visiting with our bank next week and I wanted to get an update from you on some of the older inventory we still have on hand. Any movement on any of that?”

“Not really, Tom,” Frank replied. “I’ve reminded the sales guys every time they wander through here, and I know John has talked to David about it.”

David is the company’s sales manager, a capable executive but one who, in Tom’s opinion, always looked forward to next season’s products without much accountability for inventory that remained unsold for the past season.

“Tom, you know John. Like the rest of us, he hates writing stuff off but some of this stuff, well, I don’t think the customers really want it anymore.”

What are you doing about slow-moving inventory?

“Thanks, Frank. I know I need to talk to John further about it. I’ll get back to you with whatever I learn.”

This is why their inventory turnover is declining, Tom thought. He knew that the sales department, with John’s tacit support, was unwilling to reduce prices on products that an objective observer might consider obsolete, believing that they could be sold “if they could just find the right customer”.

They rarely did, so the inventory just sat there.

Once the “salable inventory” was identified and examined by the bank, the traditional 50% advance rate for inventory might also be under attack.

Are you paying enough attention to your balance sheet?

Tom considered various ways to overcome these issues but also realized that the Company’s Balance Sheet was also working against him.

He didn’t have a current schedule handy, but he knew he needed to update their various ratios so he could show John, in black and white, exactly what was going on.

What are some of the ratios the bank cares about?

[pullquote]Please note that if you hover your mouse over a defined term that is underlined with a dotted line, the definition will appear alongside. A complete Glossary is also available.[/pullquote]

Tom knew that their Current Ratio was tolerable but not great.

He also realized that a greater concern would be the Quick Ratio, which was not very strong, barely half the size of the current ratio.

To be forewarned is to be forearmed

A lot was on the line. They weren’t just asking for a collateral loan.

It was a balance sheet loan, too, and Tom hadn’t even dealt with those issues yet.

“John,” Tom said when he called his CEO and got a voicemail recording.

“I’ve got a few more things I’d like to prepare for our meeting, a few more schedules I’d like to put together. I’d like to push our meeting out by 24 hours so I can be better prepared and show you a more comprehensive picture.

“I’ll give you a call in the morning to reschedule our meeting.”

Do your homework

Question: Have you carefully prepared for your meeting with the top executives in your company? Will you “bring it” when you meet with your bank or will they find you stumbling around for answers that you should know cold?

Continue reading … Chapter 4: “What’s’ our borrowing capacity?”