Blog Archives

To Build Value

10/26/2013

"Try not to become a man of success, but rather try to become a man of value" - Albert Einstein

To build value into the business should be the FIRST objective of an entrepreneur. The entrepreneur needs to build value so that he or she can eventually sell the business in a planned succession. If the value is maximized, the entrepreneur maximizes his return on the risks he or she takes.

The first step in building value is to maximize the net income of the business.

A business can accomplish an incredible amount of good in a society. The money that flows into the community from the sales provides commerce, jobs, pays taxes, funds charities, and indirectly funds all sorts of other businesses. But it can do so only if it makes a profit. If it does not make a profit, it begins the slow spiral downward into oblivion. If it turns a profit, though, then it can remain operating and accomplish all of the good things a business can accomplish.

From an entrepreneur's perspective, the goal to build a profit is a subset to the overarching goal of building value into the business. And simply put, building value is the process of taking steps to increase the market value of the business.

Step one: Create a product that has a market. This is trickier than you think. In doing this, you have to ask yourself whether your product is unique in the marketplace, or whether your product is a better version of an existing product. If it is not unique, there has to be a reason customers will choose your product. Better quality? Cheaper? More features? What makes it a better choice over the competition?

Step two: Create a production process. Do you produce it yourself? Do you contract out the production? What is your quality control process? How do you design the production facility? What effect do your decisions in this step have on the core value of the business?

Step three: Create a system that distributes the product. Who do you distribute to? Wholesalers? Retailers? The end-user? Do you sell via the internet? Or a combination of all?

Step four: Implement a plan to market the product. Find a way to target your ideal customer as directly as possible. Ask yourself - Am I like the hunter who carefully surveys the land, choosing the most likely place for his prey, quietly tracking and then setting himself up for the shot? Or, am I like the hunter who was driving by the forest shooting into the bushes hoping to hit something he could eat for dinner (hint: one of them will go hungry)?

Step five: create a system to collect the money from the sales. Cash and cash equivalents are king. My father-in-law used to say "receivables don't feed the pit-bull. And nobody wants a hungry pit-bull in their house."

Step six: Create a system to pay the business' bills - i.e. Feed the pit-bull. A business that can't pay it's bills has no value.

Step seven: Implement a system to account for each of the business' activities. If you have a clean accounting system, you are more likely to survive an audit by any of the various taxing authorities that could come knocking at your door, you will have better information to run your business with, and your accountant will be very happy. Not to mention that the money you spend with your accountant will go toward things like business planning, tax planning and asset-protection planning, as opposed to cleaning up your books.

Step eight: Through a thoughtful and complete cash-flow budgeting process, make a determination of how much of the excess cash-flow can be distributed to the entrepreneur and how much has to remain in the business. I see his as the biggest stumbling block to a huge number of entrepreneurs. Not knowing how much of their income should remain in the business can cause them to artificially inflate their lifestyle and inhibit the ability of the business to grow. Planning is the key. Decide ahead of time how much you can take as opposed to how much you want.

Step nine: Allocate enough time to each system to minimize failures. See my previous blog. Monitoring and regularly adjusting all of your systems will help you to make sure everything remains working and viable.

Step 10: Do it all again. This is a cycle that will repeat until you sell your business. Each area is necessary and each area is important.

Combined together, the cycle represents a spiral upward toward maximizing the value of the business. Each should be consciously created, faithfully monitored and regularly adjusted.

0 Comments

Building It Up...Tearing It Down

10/8/2013

0 Comments

"When virtue is lost, benevolence appears, when benevolence is lost right conduct appears, when right conduct is lost, expedience appears. Expediency is the mere shadow of right and truth; it is the beginning of disorder." Lao Tsu

In a random, quantum universe, there are variables that creep into every seemingly perfect system, causing disorder. In physics this is called entropy - the systematic destruction of a system, or the movement from order to disorder.

Also, it seems that every orbital body (such as Earth's moon) undergoes the process of entropy - a deterioration in its orbit that is similar to an object caught in a whirlpool. Also called "Orbital Decay", every revolution around the Earth, the moon gets slightly closer. And it will continue to do so until it is inevitably trapped beyond a point of no return where it will crash violently through our atmosphere and become one with our planet. Lucky for us, it will be eons before that happens.

If left to progress too far, this inexorable march downward can only be stopped by the application of a massive external force in a manner that will correct the orbit, yet not destroy both the moon and the Earth simultaneously. However, if nothing is done, the results are as inevitable as death or taxes. The system fails.

But there is another choice. We can stop this creeping disorder. If precise corrections are made along the way, an orbit does not have to decay, and a much smaller level of force is required. In the case of the moon, mankind does not have the ability as of yet to make the small adjustments necessary to keep the moon stable for all of eternity, but we can stabilize smaller objects, like satellites, throughout their useful lives. NASA does this by efficiently correcting the orbits of the satellites on a daily, if not hourly, basis.

In another application, a good friend of mine is a bodybuilder. He monitors his intake of fats, carbohydrates, protein and fluids religiously every day. And each day he makes small adjustments based on the results of the previous day. He also combines weight training with cardiovascular training so as to make sure he is in peak health all of the time. These are the daily adjustments required for him to avoid or postpone the process of entropy that his body would experience if he were to stop. If he were to stop for too long, then a massive corrective force would need to be applied to get himself back into shape.

As business leaders, we must recognize the concept of entropy and realize that ignoring any part of our business could lead to a downward spiral that could destroy the business. Most entrepreneurs are great at marketing their products and ideas. They spend their waking time promoting and building a business, but have little interest in the underlying systems that make the business possible. This entrepreneurial myopia, however, is dangerous. Just as our bodies include subsystems like our heart, brain, organs, skin and musculoskeletal tissue, our business systems are made up of subsystems like marketing, operations, accounting and human resources. Each of these areas require attention on a regular basis in order to recognize the ongoing corrective forces that are required to keep the whole system running smoothly.

Here is how we use entropy as a model for business:

In the beginning, Enron started out pretty well. It was created by the merger between Northern Natural Gas and InterNorth, two relatively solid companies. Over the next 10-15 years, though, Enron dedicated most of their time and energy to creating new ways to account for their revenues, regardless of the lack of cash-flow to support them. This allowed them to take on larger and larger quantities of debt. The accumulation of debt was never supported by the cash flows, so they had to continue to manufacture phantom earnings in order to justify more debt, which would then be used to pay the debt service of the previous debt. This cycle kept going until somebody decided not to loan them any more money. At that time, the whole house of cards came tumbling down and the shareholders were left to pick up the pieces. Let's examine this from an entropic basis.

It began with a stable system,
Management began focusing on one aspect of the system,
In order to support that aspect the rest of the system began compensating,
The system began to be artificially supported,
When the artificial supports were removed, the system failed. Spectacularly.

When basic pieces of the system are ignored, the small adjustments that need to be made on a regular basis are forgotten. When this happens, the system begins to decay. Stopgap measures can sometimes give a business the time it needs to fix itself, but more often they just prolong the death.

I know I pick on Enron a lot, but they are such a textbook account of massive system failure in a business. It is not just Enron that we can use as an example - unfortunately there are plenty of others like WorldCom and Tyco, where the systems either collapsed from an insidious failure or a massive correction was required in order to right the ship.

When you are looking at your business, realize it is an organic, living system that needs constant attention in all aspects. Here is a blueprint for avoiding an entropic decay:

If you are an entrepreneur, you need to recognize your weaknesses and compensate for them,
If you do not have enough expertise in a particular subsystem, hire those who do,
Create an outline of all of the subsystems in your business,
Create a regular review schedule that is designed to identify weaknesses in each subsystem,
Make the ongoing corrections necessary to keep the subsystem performing.

Avoid: non-organic fixes such as additional debt, artificially low sales prices, taking on the actual work of the subsystem yourself, etc. - short-term fixes often create an imbalance in the system that end up hastening the collapse. In general, if the fix to one subsystem negatively impacts another subsystem, you are beginning to create an imbalance that will lead to the deterioration we are trying to avoid.

Finally, avoid the easy fix. Be prepared to roll up your sleeves every day in every aspect of your business. Know what is going on in the subsystems and be prepared to fix them.

0 Comments

To Build Value

Building It Up...Tearing It Down

Archives

David A. Pope, CPA CGMA

Categories