This article is part of a comprehensive series exploring value creation in anticipation of a downstream transaction and as a foundational business strategy. You can download the complete guide here.
As growth and sell-side advisors, we work closely with business owners to help increase the value of their organization and guide them through the sale process.
Business owners are often initially skeptical of how impactful the value creation process can be. However, doubters turn to believers as they witness tangible evidence of improved performance and find themselves optimally positioned for a downstream monetization event.
What is Value Creation and Why Does it Matter?
Simply stated, value creation is the process of building both tangible and intangible value into the business. It can be measured in real dollars – that is, what is my business worth?
The most widely used measure of value is Enterprise Value (“EV”). EV is the value of the entire company – the amount of consideration that a third party would pay to buy the company. EV includes not only the equity value of the company, but its term debt and cash reserves as well. It is calculated as follows:
EV = Equity Value + Debt – Cash
In an M&A transaction, the buyer is most often purchasing the equity value of the Company. Rather than assuming the debt and cash on the balance sheet, the deal is structured so that the debt and cash remain with the seller who has the responsibility for satisfying the debt upon close of the transaction. This is referred to as a cash-free-debt-free transaction. Formulaically, it can be expressed as follows:
EV – Debt + Cash = Equity Value
Now that we have started to lay the foundation, there is one more formula to discuss: the EBITDA multiple. Multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization) are derived across industry or market segments to approximate the EV of similar companies within that segment. The basic formula for EV using a multiple of EBITDA is:
EV = EBITDA x Market Multiple
This is the key equation underlying value creation. Market multiples are quoted as a range of value – for example, the range of value for companies in the IT services space may be 7 to 10 times EBITDA. So, an IT services company with an EBITDA of $2 million could have an EV range of $14 million (7 multiple) to $20 million (10 multiple).
The goal behind value creation is to improve a company’s relative position along the range of value. For instance, in the example above, the IT services company would aim to move the multiple from a 7 to an 8 or 9. As improvements drive the multiple upward, invariably EBITDA (or profitability) is also positively impacted. Thus, value creation can positively impact both factors that drive Enterprise Value and create the basis for an exponential increase in value over time.
Adopting a Value Creation Mindset
Value creation is not a one-time exercise, but an ongoing business mindset or strategy. It is complimentary to the mission, as a well-run company can provide increased value or upside to all stakeholders, including customers, employees, and the business owners themselves. Improved performance and profitability, for example, can drive more opportunities for employees to advance as the company grows over time. And customers are positively impacted when companies realize efficiencies in delivery or invest more dollars in R&D.
The value creation mindset is fundamentally a paradigm shift that entails focusing more acutely on those specific activities that add value to the organization and baking that mindset into the company’s tactical and strategic orientation.
Many middle market companies lack a clearly defined strategy. While owners may have a vision of the future, they lack the ability to clearly define the steps and process to achieve that vision. Frequently, when owners have multiple initiatives in process, none of them seem aligned to a clearly defined strategy. With so many projects in play, very little—besides excess cost and frustration—gets accomplished. Establishing a firm strategic direction with an execution framework based on value creation can help define which projects to pursue and prioritize. Defining and pursuing the top 2-3 initiatives at any given time will help create focus within the organization, drive measurable progress and value and allow the company to celebrate success as it goes.
Whether an owner is seeking monetization or wants to develop a solid lifestyle business, adopting a value creation mindset can provide benefits, including creating a solid foundation to achieve a vision, create and enhance growth opportunities and drive improved decision-making and financial results.
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About SD Capital
SD Capital is a premier, full-service, value advisory and investment banking practice that assists middle-market companies in creating and maximizing business value. We provide strategic evaluation and execution of various downstream sales and monetization pathways. With decades of combined executive experience running, owning and advising private companies our team is uniquely positioned to guide owners through the complex process of growing and selling their companies.
Learn more at www.sdcapital.com or contact the team directly at [email protected].
Schneider Downs Capital LLC is a subsidiary of Schneider Downs & Co., Inc.
