Build Value in a Small Business

Transform a job into an investment

2002 Volume 5 Issue 4

It is possible to transform a small business from simply being a job to being an investment to be managed. This increases the possibility that one can move from financial dependence to financial independence.

The goal of this article is to radically change the behavior of most small business owners. This all-important behavioral change, which many call a shift to a “superior venture thinker,” can be accomplished by redirecting the entrepreneur toward the key focus of business finance: Maximizing Shareholder Wealth. This transformation, simply stated, requires changing the perspective of the capable and willing small business owner from perceiving the business as only a job to one that recognizes the company as a viable and profitable financial investment.[1][2]

How, then, can you as an entrepreneur become a “superior venture thinker?” You start by spending time identifying and evaluating the basic ways to create, grow, stabilize, and possibly sell, go public or otherwise harvest a venture. Such thinking then goes one step further: it converts these options into financial scenarios.[3]

The Orientation

The initial entrepreneurial creation of the small business (500 or fewer employees) focuses on three concepts:

  • the idea
  • the capital
  • the owner’s active participation.

When all three steps come together, the small business creates an income stream allowing the business to proceed. It is at this point that most small business owners stop strategic thinking. They typically become captive of operations without knowing there is a more viable path.

This alternative path turns what is merely a financially-rewarding job into a successful investment. If this path is not taken, the small business continues to be dependent on the owner. This path is normally chosen because most owners delude themselves into believing that they are the sole capable decision-maker in the business. What is needed is superior venture thinking—the second path.

The second path suggests that it is the role of the owner to develop and encourage effective decision-making by others. This normally requires a signal behavioral modification of the small business owner. However, the small business owner needs to understand that in order to transform the business from a personal income stream to an investment, a change in mind-set is normally required.

This mind-set change is the linking pin necessary to transform the small business into an investment. Only as an investment can the business be sold at the highest possible value. If the business still requires the owner’s operational involvement, this value is compromised as the small business is then sold simply as a job.

The main theme of this article is that it is possible to transform the small business from simply being a job to being an investment to be managed. This increases the possibility that one can move from financial dependence to financial independence. It allows the small business owner true freedom.

The process by which one is able to accomplish this theme requires small business owners to change their job descriptions three times in the course of changing the business enterprise into a managed business investment. These three job descriptions are as follows:

  1. Creating the Job. This entrepreneurial role involves combining the business idea with capital. This and the small business owner’s own work ethic create a job that can be sustained by a profitable business.
  2. Creating the Investment. The entrepreneurial role gives way to a managerial role. The task is to create an investment by building an organization that can effectively run and grow the business in a productive manner independent of the owner.
  3. Managing the Investment. The managerial role gives way to a strategic role that sets goals and targets for both growth and profitability to maximize the owner’s discretionary income that includes salary, perks, pre-tax business income, and depreciation.

Creating the Investment

For purposes here, we are assuming that the entrepreneur has created the business. The focus here is on the transition from job (or the first role) to an investment that occurs when the small business owner decides to change that role. This change requires him or her to move away from operational duties (the job) and begin to work in three new areas. These three areas are

  • Developing an operational decision-making team process
  • Developing a marketing process
  • Developing a productivity process.

The goal of the operational process is to run the business profitably on a day-to-day basis without the small business owner’s involvement. The goal of the marketing process is to create a sustainable growing revenue stream without the small business owner’s involvement. The goal of the productivity process is to benchmark a basic profit margin and its sustainable growth without the small business owner’s involvement.[4][5]

The above can only be accomplished if the small business owner creates a personal agenda based on these new roles. This agenda loads his or her daily calendar with action items aimed only at achieving these new
goals. If a small business owner focuses on this agenda, he or she will find, at the end of the transition period, a business that is operationally independent with a professional management orientation. It is at this point that the business will have become an investment. It is the observation of the authors that the valuation multiple against owner’s discretionary income increases dramatically upon the achievement of this investment status.

Managing the Investment

The third role for small business owners is that of investment manager. This requires owners to move to a new, more focused, level of involvement. This new involvement encompasses investment monitoring and value enhancement functions. The focus is to continually measure operational and financial performance. This allows owners to manage the investment by exception. Enhancement of the business suggests that owners spend their time looking for new income streams or improving productivity. Since owners are no longer needed to produce the product or service, they can focus on these strategic issues.

Consider American Dixie Group, Inc., founded by Lay Cooper in 1989 in Albany, New York, to build the industrial machines used in food processing, packaging, and plastic making. The business became successful, was praised for its problem-solving wizardry, and served customers like Nestle and Campbell Soup. As long as the business remained small, with no more than two dozen employees in the shop and a half dozen or so projects in the pipeline, it apparently performed quite well. As it expanded, however, it ran into problems. Suppliers began griping about late payments, and customers became unhappy because of delayed deliveries and shoddy workmanship. In September 1998, American Dixie Group filed for bankruptcy; it failed because it lacked professional management. Managerial weaknesses of the type just described are all too typical of small firms. The good news, however, is that poor management is neither universal nor inevitable.[6]

The authors strongly believe that a radical change in the mind-set is also required for the budgeting process involved with managing the investment. This is due to the fact that the typical budget does not give the small business owner a tool for creating and enhancing the investment value of the business. The typical budget is not a plan for investment value building, but only a vision of sales potential (Revenues) and cost expectations (Expenses). This is the normal top-down approach. In large organizations with extensive time and resources, this top-down approach is worked and reworked into a feasible plan properly monitored. Our experience indicates that the small business owner has neither the time nor the resources to accomplish this lengthy budgeting process. The small business owner consequently must develop a profit vision and work-up.

It is our contention therefore that most small business owners should build a budget from the bottom-up. This radical shift puts the emphasis on the end goal of creating and enhancing the investment value of the business. Further, it can be accomplished with the limited time and resources of the small business owner. The proper budget should also be strictly established on the basis of percentages. There are five specific steps in this process.

  1. Create a Pro-Forma Budget with percentages based on the owner’s profit vision.
  2. Establish the gap between the vision budget and the current budget.
  3. Establish a gap closing strategy –Downsize or Grow into the budget or a combination.
  4. Write Action Plans to implement the gap closing strategies.
  5. Develop a reporting system on key performance indicators as well as their value building impact.

The small business owner must first determine the required rate of equity return demanded for the type of business and risk. This is the most appropriate, but least asked, question. This percentage should be based on what an outside stand-alone investment buyer would demand. Far too often, the percentage is established at the owner’s personal lower-end comfort zone. The numbers used should be based on the behavioral components of return on investment (ROE), also called the Du Pont System of Financial Control.[7] We will illustrate the concept using only two items: Profit before Tax (PBT) and Pre-tax Return on Equity (PTROE).

Once these two key percentages are established, the small business owner will create the other percentages for all other items. A simple example illustrates this thinking. You have reviewed peer group performance noting that PBT is between 14-16% of sales and pre-tax return on equity (ROE) is between 22-26%. The current income statement is shown below in percentages. It falls below the peer group composite with PBT at 10%, and the pre-tax ROE on $700,000 equity is 14.29%. Budget A is the new initial forecasted income statement for the next period in percentages with the new required PBT percentage in mind to enhance and create investment value. Unfortunately, Budget A fails to achieve these desired percentages with $1,000,000 in revenues. You could not reduce costs sufficiently to achieve the desired PBT or PTROE. Budget B is the final attempted pro-forma income statement to achieve the 15%. To achieve the desired investment value return, management must not only reduce cost of goods sold (CGS) as a percent but operating expenses (OE) as a percent as well. Further, to pragmatically achieve these percentages, actual dollar revenues must increase $200,000. All this implies that the small business owner has a common sense understanding of cost-volume-profit impacts. Any managerial accounting text would aid in this understanding.

CURRENT INCOME STATEMENT BUDGET A BUDGET B
Sales: $1,000,000 Sales: $1,000,000 Sales: $1,200,000
Revenues: 100% Revenuees: 100% Revenues: 100%
CGS: 40.00 % CGS: 39.00 % CGS 38.00 %
OE: 50.00 % OE: 48.00 % OE: 47.00 %
PBT: 10.00 % PBT: 13.00 % PBT: 15.00 %
PBROE: 14.29 % PBROE: 18.57% PBROE: 25.71 %

To achieve this goal, action plans must be developed to get these percentages in line in order to reduce the gap between actual PBT (Current) and desired PBT (Budget B). The small business owner must create a two-part action matrix. The first part is a priority list of actions based on value impact (from the most to least). The second part is a list based on ease of accomplishment (from the easiest to the most difficult). The small business owner must then delineate a master list of action plans that will move the business most quickly toward the desired outcome which is Budget B. Even if he or she runs out of time and/or energy for a specific budget year, the master action plan, none-the-less, will have improved PBT above 10.00% and PTROE above 14.29%. Finally, a Summary of Performance tied to the valuation parameters is needed on an ongoing quarterly basis to monitor the budget. This compares planned performance to actual performance. Any managerial accounting text details this statement’s construction.

Conclusion

The new millenium is here. It has brought a new requirement of financial performance. We are suggesting that to effectively compete in today’s complex environment an owner must think in financial terms dominated by enhancing the firm’s value. To accomplish this goal, the small business owner must change his or her mind-set more than ever before. We suggest that the failure to do so will result in a lower standard of living and a lower end net worth for the small business owner. We recognize that a good number of small business owners are unable to make this transition due to their inability to behaviorally change, because they simply want a job, or they do not have the understanding and/or dedication to carry out the tasks necessary. The small business owner must carefully reflect on what is suggested by this article. If one is capable of making the transition to a “superior venture thinker,” one is foolish not to change.

The number one challenge in business today is profitability. The question becomes: How can you make a profit in your industry? Where is the profit zone today? Where will it be tomorrow? (The profit zone is the area of your economic neighborhood in which you are allowed to earn a profit.) To reach and operate in the profit zone is the goal of every viable company.[8]


[1] Richard Rondstadt, Entrepreneurial Finance: Taking Control of Your Financial Decision Making, (South Natick, MA: Lord Publishing, Inc., 1989). Rondstadt’s book is very good book on the topic of taking control of your financial decision making.

[2] Justin G. Longenecker, Carlos W. Moore, and J. William Petty, Small Business Management: An Entrepreneurial Emphasis, (Mason, OH: South-Western, a division of Thomson Learning, 2003). Chapter 14, “Exit Strategy,” is an excellent extended discussion of this topic.

[3] Rondstadt, p. xvii

[4] Longenecker et al. Chapter 18, “Professional Management,” is a good discussion of this topic.

[5] See also J. D. Ryan and Gail P. Hiduke, Chapter 11, “Build a Working Team,” Small Business: An Entrepreneur’s Business Plan, (Cincinnati, OH: South-Western, a division of Thomson Learning, 2003).

[6] Longenecker et al, p. 448-449.

[7] Krishna G. Palepu, Paul M. Healy, and Victor L. Bernard, Business Analysis & Valuation, (Cincinnati, OH: Wouth-Western College Publishing, a divsion of Thomson Learning, 2000). See Chapters 9 and 10.

[8] Adrian J. Slywotzky and David J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, 1997), p. 3. We strongly recommend that this book be read regardless of the industry or size of your business. The Profit Zone is a solid attempt to help businesses to strategically design a financial plan that will lead a business to tomorrow’s profits.

Reference List

(The books noted in the endnotes are listed below in a more easily-read fashion.)

Longenecker, Justin C., Carlos W. Moore, and J. William Petty, Small Business Management: An Entrepreneurial Emphasis, (Mason, OH: South-Western, a division of Thomson Learning, 2003).

Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard, Business Analysis & Valuation, (Cincinnati, OH: Wouth-Western College Publishing, a divsion of Thomson Learning, 2000).

Rondstadt, Richard, Entrepreneurial Finance: Taking Control of Your Financial Decision Making, (South Natick, MA: Lord Publishing, Inc., 1989).

Ryan, J. D. and Gail P. Hiduke, Small Business: An Entrepreneur’s Business Plan, (Cincinnati, OH: South-Western, a division of Thomson Learning, 2003).

Slywotzky, Adrian J. and David J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, 1997).

About the Author(s)

Darrol J. Stanley, DBA, is a professor of finance at the Graziadio School of Business and Management. He is well-known as a financial consultant with special emphasis on valuing corporations for a variety of purposes. He has also rendered fairness opinions on many financial transactions, and he has been engaged by corporations to develop strategies to enhance their value. He has served as head of corporate finance, research, and trading of four NYSE member firms. He likewise has been the principal of an SEC-registered investment advisor. He has completed global assignments as well as having served as Chief Appraiser of International Valuations/Standard & Poor's in Europe, Central Europe, and Russia.

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