Businesses create revenue and income relative to how they utilize assets. When a business owner goes into the marketplace to try to raise money, the bigger the business’s asset base, the better its position to do so — whether it needs to buy things to sell or make things to sell, says Michael Denning, Ph.D., professor of practice, marketing, at the W. P. Carey School of Business at Arizona State University.
Assets, he notes, include people to create the value that goes into the product or service the business sells. Business owners may need to step back from the narrow focus on day-to-day survival to consider, “How can I create the greatest leverage, so that, with least amount of investment, I get greatest amount of return?”
And the answer to that may be vastly different for someone who went into business to be his own boss — which impelled many in the recent economic downturn that pushed unemployment rates to new heights — from someone who went into business to make money.
“Usually, when we talk about creating value in a business, we talk about trying to increase liquidation value,” Dr. Denning says, explaining this may be from the owner cashing out, in some way, the equity he has built up in the business, such as from someone buying it or going public. Building value means making it worth more than it is today, but Dr. Denning notes it is the buyer who establishes the value of something that is going to be marketed; “If there is no buyer, it has no value except for the owner himself.”
There are strategies that businesses can use to marshal their internal resources rather than looking to outside funding. But Rick Murray, CEO of the Arizona Small Business Association, advises small-business owners to be sure they are looking at growing for the sake of increasing revenues, not for sake of adding personnel and just being larger. “They must have a return on investment,” he says, noting that if the result does not increase the business’s EBITA (earnings before interest, taxes and amortization), the business owner should think twice about taking steps to grow it. “It doesn’t make sense to grow if you have same profitability; you’re just working harder for the same amount of money,” he says.
However, business owners may be driven by any of a variety of motivations, and Bob Wilson, co-principal of Stoney-Wilson Business Consulting, notes, “Everything you do leads down that path to get to that objective.” Growing big is one motivation Wilson has seen, but others are name recognition, wanting the cash, pride, wanting to leave solid assets for one’s family, and wanting simply to do good and create products that help other people. “We see a lot of this,” he says. And some people “just like doing what they do,” and want just to have enough to have a comfortable life while doing it.
Whatever the motivation, it’s important to establish long-term goals and objectives. Says Wilson, “A lot of businesses don’t do this; they live for today.”
But there’s a step even before that. Observes Dr. Denning, “No plan is worth anything unless you’re clear about what you’re trying to do.”
Cultivate an Investment Mentality
The entrepreneur trying to create wealth — whether for self, heirs or another beneficiary — needs to have an investment mentality in the business. “They have to reinvest the proceeds they would normally take out of the business back into the business,” Dr. Denning explains. This is at the heart of using the business’s internal resources to grow as opposed to seeking outside investors.
This can be directed to diversification to offer more variety to existing customers, acquiring a complementary business, or organic growth — expanding outside the existing market area or increasing the volume of sales of the product or service to the existing customer base. “Expanding inventory to be able to sell additional items, including bringing on new product, is easier and more realistic today than it was two years ago,” Murray says, observing that we are now out of the recession.
Making the Most of Internal Resources … Now
There are a variety of options businesses can use to leverage non-external resources, including, says Mike Patterson, a shareholder with the Phoenix office of Polsinelli, “unusual hybrid-type of financing for people who don’t want the traditional external equity of venture capital financing.”
One of these that Patterson has begun to see recently in the Phoenix market is royalty-based financing. Basically, it is lending, with payments based on the company’s cash flow and ability to pay, and a balloon payment at the end of a couple of years. “It doesn’t give away equity,” Patterson explains. “It allows people who are ramping up, who aren’t revenue-positive, to reinvest into their company.” There are underwriting considerations as to whether this is suitable for a business. “It’s not for startups; the business must have a proven track record of moving toward its goal,” says Patterson. A suitable business may be one with intellectual property assets, and a good management team is as important as with traditional lending.
Another option is receivable financing, or factoring of receivables. A business may have made a lot of sales but have receivables that may be 30 or 60 or 90 days out, or may be looking to break into a market and, in order to compete with established companies, need to offer preferential payment terms. Factoring can help meet immediate cash need — for instance, payroll and manufacturing costs.
“Employees may have an interest in investing in the company, through employee-based equity plans that are qualified under federal and state tax laws,” Patterson continues. An employee stock ownership plan (ESOP) is one of a plethora of alternatives whereby employees can buy into a company. “This is a real benefit if you’re looking for money that’s not outside the company,” Patterson says, observing it builds loyalty and increases the employee’s motivation to do well and help make the company stock worth more; fostering an owner mentality. “There are tax implications, but no cash outlay.”
Businesses may also find they qualify for a grant. There are grant programs from federal, state and city governments as well as private foundations for, among others, women-owned businesses, veteran-owned businesses, minority-owned businesses and businesses that target depressed areas to create jobs. AguaSAC founder Liesl Harder Kielp, in this issue’s “Feedback” feature, shares that her company was helped tremendously by a grant from the Arizona Commerce Authority. And JPMorganChase announced last month that it was putting $100,000 seed money into the Metro Phoenix Export Alliance for imports and exports. “So if you’re not currently exporting, you may want to consider doing that,” Patterson says.
… and Later
Companies that work in technology may have ideas that are patentable, and each patent is an asset that increases the worth of the company. “A patent can be licensed, and a lender can lend against it,” Patterson explains. Some businesses his firm works with, he shares, train their employees to come up with patentable ideas, which can include improving on products or processes that already exist.
There may be opportunities for a business to partner with another that is in a complementary industry. An example Patterson offers is a company that provides a technology which could be applied to, for instance, the banking and credit union market, but the company has never broken into that market. “They might find someone who serves that market in another way, and use its relationships.” It could be a joint venture, for a company to expand what it’s been doing with another company that will share the benefit, but there is no cash outlay.
“You can create new relationships [with someone] to be the front person for you, almost like a salesman,” Wilson suggests for a business looking to expand into other markets. “They can add your product to what they are already selling.” This strategy may be especially well-suited to breaking into a new market internationally, with the business offering the representative a percentage of the sales.
Discussing the potential of strategic acquisitions to help a company grow, Chuck McLane, lead managing director of Operations with CBIZ, observes, “There are synergies to generate revenues through involvement of other lines of business that tie to yours,” including buying an existing business. He also suggests a business look at the supply chain of where its goods or supplies are coming from.
The nonprofit community may offer opportunities for for-profit businesses through public-private partnerships (PPPs). There may be opportunity to create an internship program that would benefit both parties, or they may work together to create specialized technology. Notes Patterson, “ASU was just awarded ‘most innovative university in the nation’ partly because it does so many PPPs as well as working with entrepreneurs.”
Developing intellectual property with future value in a larger scale is another way a business could develop value into the future. To this end, businesses might tap into the younger workforce coming out of college, McLane observes, and perhaps promise them equity in the future company. “They’ll work harder and with greater purpose to produce intellectual property utilized for the future.” It could be creating a product to sell to others or be something that benefits the company internally by creating new processes.
Also touching on processes, automation and improving on what was previously done manually can also boost future value.
Social media provides a means to create value, McLane points out. “It creates volume and attention for the company, which leads to greater value in the long run.” The volume itself, not just the connecting to potential customers, adds greater value to the organization.
Strategies, of course, are based on the resources a business has available, and the more resources it has, the more its alternatives. “It takes more sweat equity to build when it’s a small business,” McLane observes. But the size of the marketplace impacts as well. “Have a business plan that identifies that the market is large enough that a small penetration will produce enough cash flow for your need,” he says, explaining businesses must confront both a time gap and a money gap — to show they can achieve the target penetration within a reasonable time in order to convince people to put in the effort.
Using Outside Resources
Business owners may find options with resources outside of their business, such as drawing on equity in real estate or taking out a second mortgage on their home. “They get financing on existing assets because the business, itself, does not support financing from a bank,” McLane says. “We see this most often with small businesses just starting out — they have an idea but no revenue yet, so use the personal finances of the ownership group.” This includes using their salaries from their current employment, credit cards, and resources from family and friends.
“For any small business, the opportunity to grow without giving up equity is the preferred way,” says ASBA’s Murray. Giving up equity, he notes, creates expectations from the investors and adds responsibilities on the business owner — including communication with the investors and managing their expectations.
Pay Attention to Cash Flow
“Cash is king in a small business, but it’s also the rest of the deck as well,” Dr. Denning puts it neatly. He notes that most small businesses fail, mostly, because of bad management, and “management of cash is right up there near the top.”
Business owners should consider how to maximize their cash flow, including minimizing the outflow. This can be accomplished by stretching trade payables. “Get the best terms on when you pay people, and the most aggressive terms on when you collect,” Dr. Denning explains.
It may seem attractive to buy a building for the business rather than paying rent, but Wilson notes that, too, comes back to cash flow. Among other considerations about buying a building are: Where is the value? Is the deal on the mortgage better than the cost of rent?
Decisions on major purchases, whether of equipment or real estate, depend on access to liquidity — what kind of financial condition the business is in and what is the most prudent use of the capital it has. And analyze the effect in both the short term and the long term. Notes Dr. Denning, “You may use up assets and not have the liquidity to take advantage of an opportunity that comes along, such as the purchase of a competitor.”
It may be feasible to cut existing expenses, such as renegotiating rent, Wilson suggests. Or even identify unnecessary assets that can be sold to generate cash.
Plan to Grow
Murray notes the value of a measured approach to growth. “Small businesses need to plan to grow at a reasonable rate, so that if they have to expand or buy equipment it can be done in increments — so it’s achievable,” he explains.
But one of the first things to do, Dr. Denning believes, is invest in people, “so you have the human resources and intellectual capital” to sustain the business. Small businesses are typically understaffed, he observes. “They don’t have ‘A’ players in every position, nor bench strength.”
While business owners focus on being successful enough to survive to achieve their goals, the larger community benefits as well. Points out Patterson, not only do businesses pay taxes, but “as a business grows, it creates jobs. And those families pay taxes and consume within the state — which also creates tax revenue.” Furthermore, as businesses grow, there may be a snowball effect as they create clusters and synergies that attract other jobs.
A business owner may be focused on building a company to hand down to his or her children, building the company’s value in the marketplace, or creating value to him- or herself — self-actualization, pride of ownership or sense of accomplishment. “Start with the objective of the particular owner,” Dr. Denning says. “They have to be clear in their own mind of what they’re doing and why they’re doing it.” But he notes reinvesting in the business must be part of the plan for value creation for small and medium-sized businesses. “Make sure heirs — or whoever takes over the company — will have a sufficient asset base to survive the ups and down that normally occur in business cycles.”