Value Architecture: A Fresh Perspective On Risk / Reward And Business Value
Like so many other local business owners, today’s challenging business environment has kept me and perhaps you awake on more than a few nights. Confidence in both the local and global economy has been shaken in the general population. The skies truly appear dark and stormy - yet a select few companies, business owners, shareholders are not just surviving but thriving! What are they doing differently? What can we learn from them?
“It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.” – Charles Darwin
WHAT IS VALUE ARCHITECTURE
Value Architecture is a framework for assessing and influencing business value on a risk-adjusted basis. This framework gives us perspective that moves beyond accounting and the basic reporting of past economic activity, financial ratios etc. It provides easy to understand transparency around the actual economic value effect of the business decisions that we make. It is invaluable whether looking through the eyes of an owner-operator, a member of management, a director, non-active shareholder or professional advisor.
BASIC TENETS OF VALUE ARCHITECTURE
1. As the perceived risk of an investment (business) increases, a 'rational' investor will require an increased reward (return)
2. To create value in an investment (business), its returns must exceed its cost of capital. In other words, the reward must exceed the risk.
3. Business value can be increased through 3 fundamental activities
3.1. Increase available free cash flow
3.2. Lower cost of capital by lowering perceived risk to debt and equity in the business
3.3. Increase growth rate of available free cash flow
4. There are four broad areas of business activity that can most effectively be adjusted to create value
4.1. Strategy –Value is created not just by what a business does, but what it doesn’t do. We find that most owners / managers benefit significantly from assessing the business’ value proposition from a holistic perspective rather than focusing simply on day-to-day tactical activities
4.2. Governance – Improving general transparency for shareholders, ensuring general compliance with regulatory bodies, documentation of procedures and transactions etc. reduce the perceived ownership risk (cost of equity) and often the perceived risk to lenders (cost of debt) as well.
4.3. Finance – Improving financial transparency, communicating key financial metrics throughout the organization and understanding of the long-term financial impact of seemingly innocuous decisions is critical to developing a well managed business and long-term success.
4.4. Operations – Increased transparency provides the opportunity to identify ways in which your business’ resources could be better used. This may mean opportunities to outsource, to reduce waste, to invest more resources etc. all with the ultimate intent of maximizing business value.
VALUE ARCHITECTURE EQUATION / PROCESS
The value architecture perspective on business value can be distilled to the following equation:
Value = Income / (Risk – Growth) = Free Cash Flow / (Cost of Capital – Growth in Free Cash Flow)
The process consists of an initial diagnostic phase, where your business’ key metrics are identified for the entire business and for separate business units / segments of your business as appropriate. These metrics include cost of capital, cost of debt (including hidden costs), cost of equity, returns, contribution margin, breakeven units required etc. Subsequent phases include identification of activities required to preserve / add business value, implementation, measurement and adjustment etc…
BENEFITS OF VALUE ARCHITECTURE
Insights from the value architecture process help us make better business value decisions including:
1. Appropriate human resources decisions. How to develop appropriate compensation package structures, determine how much individuals are actually contributing to business value and managing expectations.
2. Pricing Strategy. How to price products and services more effectively
3. Managing Long Term Expenses. Deciding whether to lease or buy premises and under what terms
4. Determining the most appropriate financing decisions. Whether to reinvest retained earnings (and how much), borrow from a traditional lender or a source of private capital. Determining the appropriate level of financing and optimal capital structure.
5. Strategic Outlook. Whether to grow the business, change direction or convert it into a cash cow. Determining what the most appropriate growth strategy may be – buying a competitor, growing organically etc.
“You can either take action, or you can hang back and hope for a miracle. Miracles are great, but they are so unpredictable.” – Peter Drucker
Kumi Bradshaw is President of Firm Advisory Ltd.
T: +441 295 3301 E: firstname.lastname@example.org
Firm Advisory Ltd. helps “business owners measure, grow and harvest the value in their companies”
For a more in-depth look at value architecture, with actual case studies, download a free copy of the ebook ‘Value Architecture: A Guide To Making Better Business Value Decisions’ at http://bit.ly/TEuYH1 or email us for a free copy.