What is the most important type of value creation for your business? It is increasing your company’s equity value. At the end of the day, the most consequential measure of the success of a business from the perspective of the owner(s) is the value of the company’s equity. There are many different ways to increase your company’s equity value, and this article is dedicated to outlining five prevalent alternatives. Each of these approaches is dedicated to either achieving greater revenues or lowering costs because ultimately equity value creation is primarily about increasing earnings, and improving the quality and prospect of earnings. As a prefacing remark, it should be noted all of your company’s operating, financial and strategic objectives should be assessed in regard to validating a direct relationship between each objective, and its impact on the company’s equity value. If this linkage is identified and understood, any business plan or strategic agenda will, by definition, be of a confirmed high quality. Too many companies do not focus on this critical relationship! The most prevalent form of equity value creation is the “incremental approach.” This approach is predominantly employed by the over-whelming majority of companies since it entails the utilization of only a company’s existing and unaltered capacities to grow and realize profit. It is an alternative affording a company with the seeming benefit and certainty of remaining within its comfort zone in relation to engaging its business practice in the same manner year after year. Most companies implement this approach by default, i.e., “if it’s not broken, why fix it,” although this alternative unfortunately possesses the most limited prospect of equity value creation. This modality may be entirely satisfactory given the objectives and risk profile of ownership and management. However, I would only add the opportunity cost of this approach is usually very high given the extraordinary opportunities to create new equity value. The second most common approach to equity value creation is the “accelerated approach.” This alternative is an iteration of the incremental approach save one significant exception, which is the raising of external capital to accelerate and/or expand ability to achieve increased revenues or lower costs in conjunction with the existing nature and content of a business practice. In effect, this approach affords a company with the ability to do more of the same with greater resources, which is a very appealing and desirable result. The key prerequisite to this approach is the existence of a bona-fide opportunity to realize a return greater than the cost of capital. If a company decides to raise only senior or subordinated debt financing the cost-benefit calculation is self-evident. If a company decides to raise equity capital, the expected return should be around 30% as this is the return generally being sought by private equity firms. Aside from many other issues, the accelerated approach affords the prospect of creating new equity value commensurate with the return of the opportunity. While the previous two approaches did not encompass any alteration to a company’s business practice or model, the remaining three alternatives require significant modifications to the structure or strategic engagement of a company, in order to realize different forms of synergy. Synergy is the most fertile source of equity value creation. The below referenced alternatives are the favorite mechanisms of professional corporate developers seeking to engineer new equity value creation, and remain the core apparatus of platform development activities. The “market-share approach” entails the least amount of change. It is based on the proposition of acquiring market share through the purchase of competitors through which the same products or services are sold to an expanded customer base. While there may be some realized pricing advantages, its primary impetus is to enhance the franchise value of the business. Franchise value pertains to the non-financial aspects of a business that are recognized and indirectly quantified within most valuation methods. Other benefits of this approach include the increase to revenues as larger companies are usually valued higher than smaller companies when holding other factors constant, and the ability to enhance earnings through both the elimination of cost redundancies associated with the acquired company and overall the more efficient absorption of overhead. While this approach can produce significant increases in equity value, it does require the execution and integration of add-on acquisitions, and most smaller companies are not oriented toward making acquisitions. The “higher-content approach” encompasses the synergistic expansion of the service or production capability of a company through its horizontal integration. Its essence is the increase to the value-added component of a service or production-related capability through the acquisition or development of complementary capability, thereby producing increases to the gross margin. In effect, higher-content, or more value added is being offered to the same customer base. While this alternative is a highly efficacious means to create new equity value under any conditions, it is usually the first structural response to pricing pressure and the decline of margins. It represents the best prescription for insulating, if not expanding margins. Many industries, such as the aerospace and automotive industries, have undergone substantial change based on this approach. Again, this approach usually requires the pursuit and execution of add-on acquisitions. The last of the fundamental paradigms related to increasing equity value is the “turnkey approach.” This alternative entails the acquisition of the capabilities either preceding, or subsequent to a company’s existing service or production contribution thereby, in effect, “turnkeying” all, of part of the service or production cycle within which the company participates. The approach affords equity value creation based on earnings and franchise value increases. This is a vertical integration alternative, and as such, encompasses the most risk given the requirement of integrating a typically completely foreign service or production process. The economic basis of pursuing this alternative is the efficiencies to be gained and returns to be earned by controlling the service or production cycle. Acquisitions are a necessity for this alternative given the distinction between the existing and added capabilities. While the above only introduces the prominent approaches to the creation of equity value, there are many issues associated with each alternative. Moreover, although the overwhelming majority of companies utilize the incremental approach to building value, the opportunities to create equity value are tremendous for EVERY COMPANY. It is a matter of understanding that such alternatives exist, and then, evaluating each proposition. Jeffrey R. Knakal is the managing partner of Growth Partners, which is a private investment banking firm specializing in value-creation and value-realization activities and transactions, base on M & A;, valuation, capital formation and platform development competencies. He can be reached at 818-713-8000.
Five Options for Increasing Your Firm’s Equity Value