Valuation vs. Value Creation
Value creation is the strategy business owners put in place to get to the valuation result that satisfies their wants and needs.
We had the good fortune of speaking with Dr. Carl Sheeler, managing director at Berkeley Research Group and author of "Equity Value Enhancement: A Tool to Leverage Human and Financial Capital While Managing Risk," on our weekly podcast, "The Second Stage." During our conversation, Mr. Sheeler addressed the difference between a business valuation and value creation. While these are two very distinct processes, as a small business private equity firm, Evolution Capital Partners believe that these are crucial concepts for business owners to understand, and not only in definition, but in relation to the effect they have on one another.
Let’s begin our discussion with third party definitions of each. Valuation, as defined by Divestopedia.com, is the process of determining the fair market value of a company in a notional context meaning that the valuation is a) time specific, b) there is no negotiation, c) there is no exposure to the open market. Valuations are highly subjective calculations that aim to determine the fair market value of a company. There are many common situations when valuations are required including business reorganizations, expropriations, employee share/stock option plans (ESOPs), mergers and acquisitions (M&As), and shareholder disputes.
Value Creation Defined
Value creation, as defined by BusinessDictionary.com, is the performance of actions that increase the worth of goods, services or even a business. Many business operators now focus on value creation both in the context of creating better value for customers purchasing its products and services, as well as for shareholders in the business who want to see their stake appreciate in value.
With these definitions as reference points, Dr. Sheeler describes valuation as an assessment of risk associated with an asset’s ability to generate free cash flow. However, there is some gray area. Who is assessing the risk? What period of time are they looking at? With a valuation in writing (whether you agree or not), you have a “baseline” as to where you are today and a decision to make. Are you satisfied with this valuation of your business? Does it meet your goals? If it falls short, you have the opportunity to put a strategy in place to get you to the valuation that satisfies your wants and needs. This is value creation!
Company Assets Identified
During our discussion, Dr. Sheeler puts a unique framework around value creation, which he calls “GRRK” or Governance, Relationships, Risk and Knowledge. He describes governance, relationships and knowledge as assets of the company, which all impact the risk or the value of the business.
Important takeaways for business owners include:
- Both tangible and intangible assets affect value creation.
- You have the opportunity to create value in your business by establishing AND executing a strategy or vision for your business with very specific, measurable goals.
The 5 Pillars of Business Freedom
At Evolution Capital Partners, we support small growing businesses in the value creation process by building a foundation for sustained growth through the implementation of The 5 Pillars of Business Freedom(SM), which consist of:
- Great financials – Accurate and timely financial reporting (current and backward looking)
- A shared plan – Achievable and measurable strategic plan (forward looking)
- The attraction and retention of the right people – Aligned and experienced team
- A culture of transparency – Teaching employees to think and act like owners
- A culture of accountability – Holding peers accountable
THIS CHECKLIST WILL HELP YOU ACHIEVE BUSINESS FREEDOM
While a business owner may not have as much control over the variables calculated by the time a valuation is performed, he/she does have the power to positively increase their numbers with the insight gained from a valuation and using this to come up with a game plan, or value creation plan. Therefore, while a valuation is a more passive event, value creation requires the same type of entrepreneurial innovation that perhaps got you into business in the first place and what you'll need to perform a successful exit.
Written by Jeffrey Kadlic
Jeffrey Kadlic is the Co-founder and Managing Partner of Evolution Capital Partners. He is a private equity professional with broad experience in all aspects of the private investment life cycle with a particular interest in supporting the development of “gazelles”, second stage growth companies and other entrepreneurial businesses in the micro market.