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Copyright REI Commercial Capital 2018

Business Succession

It Better Be More Than a Paycheck

When you start a business, when you buy a business, as you run a business – and when you sell that business or pass it on to your successors – the difference between a cash flow and a business is key. In the days when railroads and steel mills and factories and assembly plants were at the center of our economy, those huge capital assets made the difference pretty obvious. Today, when the backbone of the economy is based on “small business,” and the future is vectored from service and knowledge-based businesses, the difference between a business and a paycheck is not always visible.

In fact, it takes financial expertise, and ongoing attention, to be sure that this important difference is being built. Seasoned pros ask, “Are you working in your business, or working ON your business?” The unfortunate answer in far too many cases is that entrepreneurs have merely “bought themselves a job.”

The Fatal Assumption

The passions and skills that drive people to start a business are usually not the same as what it takes to run that business successfully. And when people buy a business, the product or expertise at the core of that business is rarely related to the know-how and discipline that it takes to keep the business right-side-up. Making it something someone else wants to buy when you are ready to be done with it takes a different kind of know-how, and it’s a job that begins, ideally, as soon as you open the door.

It’s been called “the E-Myth.” That’s short for “the entrepreneurial myth. Fully a quarter-century ago, author Michael Gerber wrote a book on it, and the subtitle spells out the scope pretty well: “Why most businesses don’t work, and what to do about it.” The E-Myth, quite simply, is the assumption that people who start a business have business skills. In fact, most businesses today are started by people who have technical or creative skills. The disciplines and practices and perspectives of real business management might appear to be “just common sense and arithmetic,” but in fact they are as foreign to most entrepreneurs as baking skills would be to a shirt maker.

Those skills involve an everyday perspective, not just some attention every month when invoices go out and bills are paid. Every transaction changes the status and composition of your business. There’s more to effective business finance than staying in the black and avoiding red ink. Some of the benefits of building a solid capital stack into your balance sheet are surprisingly subjective, yet no less real. Attention and energy are sapped by financial concerns when credit and capital decisions are haphazard, and it’s hard to devote enough attention to clients and customers when you’re worried about making payroll.

Wealth: a Day-One Vision

Never is it more important to “start with the end in mind.” When you start or buy a business, it is vital to realize that it is more that starting a job. If all you’re looking for is a paycheck, then it would be better to stay employed than to become an owner. A true business owner aims beyond the money it takes to get along. From the beginning, he or she takes steps to create a dependable paycheck, plus a profit, plus a growing equity that results in wealth.

Wealth results when a business owner realizes and creates the value that the business represents, over and above the money that is coming in. That value is in fact measured in multiples of the cash flow. Typically, in a publicly-traded company, that value is expressed in a price/earnings ratio. If the business is earning $10 per share, and investors are willing to pay $100 for a share, then the business is said to have a P/E ratio of 10. The lesson for privately-owned companies can be seen through this lens, because the value of their business at the time they choose to sell it can be some multiple of the Seller’s Discretionary Cash Flow (SDC). This has been called “the mother of all bottom lines.” If so, then it is also the father of wealth.

What determines the value created in the business, and the wealth that could be derived from it? The potential earning power of the business, balanced with the risk perceived in owning it. The balance of those perceptions can sometimes result in a kind of electro-magnet for money. Grubhub, for example, is projected to finish this year with a price/earnings ratio of 84.3 – exponentially greater than its already-impressive 2018 P/E ratio of 45.24. That’s what the power of a proposition can do.

But not every band is the Beatles. What creates wealth in most businesses is a combination of factors that includes a solid “capital stack” as an essential component.

Make Your Capital Stack a Pillar of Strength

The story of that value – risk versus reward – is spelled out in the capital stack on the balance sheet. That’s where a savvy buyer will look when it is time for sale. Or in a family business, that’s where the generations can point, at succession time, to discuss the value and considerations intelligently. There are fewer fault lines in the inevitably emotional topic of handing down one’s life’s work, when the capital stack is in order, keeping family controversy to a minimum. The strength of that capital stack is something to be envisioned specifically and worked toward continually, from the earliest days. When sale or succession appears on the horizon, it is often too late to fix a capital stack that has been neglected. How can you avoid this, and what makes a solid capital stack?

Return on equity is one of the pictures projected from this part of the balance sheet. The way to paint that picture can be summarized pretty simply. Pay down debt. Choose wisely among the sources of finance. “Match maturities,” i.e., pay off equipment and resources at the same rate that you use them. Since most businesses start with considerable debt, return on equity is a goal to be envisioned clearly and worked toward every day.

Terms are almost as important as the cost of money. In a way, if you get the terms right, the cost will take care of itself to a great extent. In an era when most startups include credit-card debt, there can be a lot to overcome in getting the terms of payment back into reasonable range. Staying on that initial path can be a treadmill, with terms and interest rates that sap the earning power of the company and its people. Choosing from among the better options for sources of funding – debt and equity – takes experience and training – and the contacts that result from them.

Continuous attention and action are called for to solidify the capital stack. One result of this kind of attention is a continually improving credit score, which brings down the cost of money. Even when credit is aligned, maturities are matched, and terms are reasonable, there are ongoing operational decisions – such as whether to buy or lease necessary equipment – that should be viewed from the perspective of their impact on the balance sheet. The tax implications of those decisions, too, can play a big part in arriving at profit rather than loss. This calls for regular checkups from a financial expert, the kind of advantage with which Fortune 500 companies have populated whole floors.

Beyond the Black and Red

The multiples that mean wealth when your business is valued, at sale or succession time, have a subjective quotient too. Awareness, good will, reputation, and brand equity have everything to do with a buyer’s perception of potential. Minimizing risk in the capital stack has the dual benefit of freeing the business leadership to focus on these external values and perceptions. Now that digital reviews shape commercial reputations – and negative experiences are six times as likely to appear in reviews as positive ones – the power of freeing the leadership to put the customer first is not to be underestimated.

Consider the advantages of having your own on-demand CFO. Clients have depended on REI Commercial Capital for our portfolio of skills and resources so broadly that we call it the 21st Floor, a nickname from our Fortune 500 executive suite days. Call us and see how to put that big-company power in your own hands now.

 

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