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Value Based Management for Small to Medium Sized Enterprises


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This whitepaper addresses why and how small and medium size businesses can significantly improve the market value of their organizations using the same methods that public companies utilize year after year.

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Value Based Management for Small to Medium Sized Enterprises

  1. 1. 24400 N. Alma School Rd, #21 Scottsdale, AZ 85255 602-633-5353 Beyer Management Consulting, Inc. Strategy, Business Modeling & Tactics The Case for Value Based Management for Small to Medium Sized Enterprises By Thomas M. Beyer (This whitepaper addresses why and how small and medium size businesses can significantly improve the market value of their organizations using the same methods that public companies utilize year after year.) Why are valuations higher for Large Companies (LC’s) versus small and medium size companies (SME)? Why do LC’s seemingly have access to unlimited amounts of liquidity that give rise to new and powerful opportunities? Is it even possible for owners/managers of SME’s able to significantly improve the value of their enterprises while effectively competing with the big boys? The answer to these questions may be found in the valuation based focus of the management to of LC’s versus the cash flow focus and profits focus of most SME’s. 2 Guiding Principles VBM 1.) Investments must yield a higher return than the cost of capital (and cost of equity- CAPM) 2.) All management decisions have to lead to higher returns than the cost of capital considering the lifecycle of the decision VBM leads to enhanced allocation of capital, long-term strategically focused management and decision making processes consistent with the economic goals of the company. Internal Results Application of VBM results in performance measurement and incentive systems that determine the responsibilities within the organization structure and defining the reporting processes.
  2. 2. 24400 N. Alma School Rd, #21 Scottsdale, AZ 85255 602-633-5353 External Results All enterprises regardless of size compete for the scarce resources of capital. Most SMEs do not have access to organized capital markets as they do not fulfill the requirements Of modern capital market instruments concerning profitability. The ability to raise external equity usually depends on the expected value gain of the external investors. Owner-managers of SMEs also have other objectives besides economic growth and profitability (such as self-actualization or social commitment), which often discourages external investors. SMEs often exemplify an extreme degree of control aversion to the sale of equity to outsiders. For most SMEs retained earnings are the main source for new equity. The equity-deficit of many SMEs results in an increased demand for debt. SME financing thereby is substantially affected by the relationship banking, which is primarily based on a traditionally grown long-term relationship with the respective house bank. Equity Ratio The importance of the equity ratio as an indicator for the security of a credit is easily comprehensible by keeping in mind the fact, that many SMEs are short of assets, which can be used as collateral. Therefore, it seems to be more than plausible that SMEs should focus their corporate management on strengthening the long-term equity base and thus should implement value based instruments. Annual Cash Flow This ratio is one of the central determinants of the shareholder value, which is traditionally calculated as the sum of the discounted free cash flows and determines the amount which could be distributed to the shareholders. The cash flow also shows a company’s ability to meet its payment obligations (and thus its credit obligations) in future. For this reason an increasing cash flow leads to a better rating grade and thus has a direct and an indirect effect on the shareholder value calculated by the Capital value method. The shareholder value is on the one hand directly influenced by the ascended cash flow, which is the denominator of the calculation formula of the shareholder value. It is on the other hand indirectly influenced by the shrinking discount rate caused by the reduced costs of capital as a result of the improved rating grade. Result The increased cash flow and the decreased cost of debt will result in an increasing shareholder value, because of the reduced capital cost rates used in profit concepts in the capital value-method.
  3. 3. 24400 N. Alma School Rd, #21 Scottsdale, AZ 85255 602-633-5353 Direct and Indirect Effects of Value Based Management Value Based Management Implementing value based principles helps meeting the rating requirements and therefore getting a better rating grade (e.g. increased equity ratios and cash flows and improved decisionmaking.) Direct Effect- Increasing cash flow leads to ascending shareholder value Indirect Effects- A better rating grade leads to reduced costs of capital and therefore to an increased shareholder value.
  4. 4. 24400 N. Alma School Rd, #21 Scottsdale, AZ 85255 602-633-5353 Globalization- the accelerated case for SME’s to apply VBM Globalization, internationalization, and widespread structural changes across economies are aspects that affect more and more SMEs. These developments cause enormous challenges for SMEs in order to survive or even develop their business. Integrating value based principles in their corporate management generally helps to identify the chances but also the risks resulting from the increasing dynamic environment and helps to stay competitive in the long run in global markets. It’s in Every Owner’s Best Interest to Implement VBM 1.) Owner-Managers- Important to closely monitor and manage economic risk of the business as this effects them personally. a. VBM- eliminates and/or minimizes solvency risk associated with the owner’s personal financial profile. 2.) Long-term Existence of the Enterprise- Manager in public companies views the entity in perpetuity and makes decisions accordingly. a. Owners- after reaching a personal income/success level tend to focus on self-actualization. The less importance place on the longevity of the enterprise (succession planning). b. This makes the company less competitive over time (Life Style Companies) c. 3 Options for the company i. Intra-Family Succession ii. External succession (MBO/MBI) iii. Separate possession and management (All/Majority Sale) 3.) Improved competitiveness and advantage over larger/public competition. a. E.g. - the never ending debate between the need for job security versus customer service. 4.) VBM is the basis for analyzing strategic options and help assess the profits and return associated with each strategy. Why have SME’s traditionally not focused on VBM? 1.) Cost of Valuation Services 2.) Lack of academic background 3.) The short-term maximization of stock price (value) is not compatible to the personal aspiration of the owner-manager. This includes social relationships within the business community, suppliers, vendors, clients, etc. 4.) Limited reporting resources and technical skills 5.) Lack of internal objections to decision making (self-fulfilling circle)
  5. 5. 24400 N. Alma School Rd, #21 Scottsdale, AZ 85255 602-633-5353 VBM evaluation instruments SME’s Absent public markets a regular independent valuation is required. 1.) Valuations- regular intervals 2.) Focus on Bank based/capital providers orientation (ratios that effect the cost of capital) 3.) Focus on financial reporting Conclusions Large public and Venture Funded enterprises compete at a higher level because the cultures of these entities are continuously focused on VBM. In the past the SME has been limited by time, capital, and human resource to effectively apply the principles of VBM thus relegating the SME to a lower tier of competitive evolution leaving technology gains as the primary source of value improvement. This is further exacerbated by the owner-manager’s tendency to focus on personal growth and self actualization after attain a personally preferred level of economic freedom. However with availability of reasonable priced valuation services, streamlined and expert accounting and financial reporting systems, and marketing technology- owner-managers of SME’s can now enjoy the financial and competitive benefits of driving a value based culture that will deliver unparallel long term value.