Value Creation - Part II

Part I appeared earlier this week. The full article can be found here. If you would like to read more about business transformation, restructuring, turnaround and value creation from a middle market perspective, visit and subscribe to Base of the Pyramid.

Business Transformation

Business transformation is the practice of driving lasting strategic change in an organization, and when this is done successfully, value creation is the logical result.

The various ways in which companies are valued may seem esoteric to those being exposed to the M&A process for the first time, but the mechanics of valuation are relatively simple, particularly intrinsic valuation (i.e. a discounted cash flow analysis, or DCF). Similarly, once the mechanics of valuation are understood, it becomes clear that business transformation can be an extremely effective driver of value creation.

Consider a few key elements driving an intrinsic valuation:

• Sales. Expectations for sales growth can be reset through a year or two of improvement (a more robust pricing policy, improved market intelligence, etc.) coupled with the identification, in granular, executable detail, of the levers which will allow the acceleration of revenue, both organic and inorganic (i.e. through acquisitions).  
• Profitability. A deep investigation of cost structure will inevitably result in cost savings opportunities being uncovered. More importantly, ensuring that a business has operating leverage (i.e. costs increase at a lower aggregate rate than revenue, resulting in profit rising at a faster rate than revenue increases) is crucial.
• Working Capital. Accounts Receivable (DSO) levels can be optimized by negotiating better payment terms with customers. Inventory (DIO) levels can be optimized through improved supply chain systems and processes. And Accounts Payable (DPO) levels can be optimized through vendor negotiations (I prefer to rank my suppliers A, B, or C, and invite vendors to give me their best terms in order to justify a higher level of spend with them).

In addition to those intrinsic valuation drivers, miscellaneous items such as strength of (leadership) team, a current and executable strategic plan, existence of SOPs with appropriate documentation, etc. are all elements that give prospective buyers comfort, and these elements will tend to maximize valuation in a competitive process.

Consider a hypothetical example, Nonesuch Chocolates. Please note, this example is entirely fictitious, but the scope of the improvement in this scenario is very much in line with my own results in successful business transformation situations as well as those of other practitioners with whose work I am deeply familiar.

Exhibit B: Nonesuch Chocolate Forecast – Baseline and Optimized

The optimized Nonesuch is recognizable, but much improved:

• Sales growth is supported through a higher level of capital expenditures as well as a commitment to acquisitions. As a result, terminal year (year 5) sales are 28.5% higher in the Optimized scenario vs. Baseline.
• Profitability at the gross profit level is 43.8% higher in the Optimized scenario vs. Baseline, and at the EBITDA level is 145.4% higher in the Optimized scenario vs. Baseline.
• Net Working Capital is 10.5% lower in the Optimized scenario vs. Baseline, driven by a Cash Conversion Cycle that is 30.4% lower in the Optimized scenario vs. Baseline.

The bottom line is that an aggressive but achievable business transformation, focused on increasing revenue, right sizing the cost structure, and optimizing working capital (see Exhibit B), would yield the owner(s) of Nonesuch Chocolates an approximate 70% increase in equity value (see Exhibit C).

 Exhibit C: Nonesuch Value Creation

Conclusion

Whereas valuation remains a significant hurdle for the owners of small and midsized businesses who need to sell, and as such it represents the greatest potential barrier to the anticipated ownership transitions driven by the Silver Tsunami, value creation through business transformation just may be the solution that business owners are seeking. Investment bankers or business brokers, the key company advisors in an M&A process, specialize in helping companies transact at full value. These advisors do not create value, they help a company realize its full value through a well-run auction process. But for those owners who are both fortunate enough to recognize a valuation gap and also possess the luxury to defer a sale by an additional year or so, an investment of time and effort into a formal program of value creation, in many cases spearheaded by a leader with a business transformation background, can result in noteworthy value creation, potentially significantly more than originally needed to plug any valuation gap.

About the Author

David Johnson is the founder and managing partner of Abraxas Group, a boutique advisory firm focused on providing leadership and support services to companies in need of transformational change. He is an accomplished thought leader with multiple articles and speaking engagements on the topics of business transformation, change management, performance improvement, restructuring, turnaround, and value creation to his credit. David can be reached at: david@abraxasgp.com.

Part I appeared earlier this week. The full article can be found here. If you would like to read more about business transformation, restructuring, turnaround and value creation from a middle market perspective, visit and subscribe to Base of the Pyramid.