Value Creation…The ONLY Thing That Matters

The news is full of doom and gloom about the economy. Politicians from all quarters are promising that they can turn things around. Talking-head economists on the TV try to explain why spending more money that doesn’t even exist right now will make everything better. And the hardworking people who either own or are employed by a small business shake their heads and get back to work.

Small business gets it. They see what Fortune 500 companies routinely miss. They live in reality while ivory-tower academics pontificate about a theoretical world that doesn’t actually exist anywhere.

So what do small businesses get? SUCCESS IN BUSINESS IS THE RESULT OF VALUE CREATION…PERIOD!

I admit that “success” is defined differently by different people. So, let’s talk about three common definitions.

Profits

The most basic and universally held definition of “success” in business is profit. For any business to continue existing, it must take in more revenue than it pays in expenses. The margin doesn’t have to be huge, but there has to be a margin.

This is true, oddly enough, with all organizations. Non-profits have to take in more receipts than they pay out in expenses. The basic family unit must take in more income than it pays out in expenses. And, for those entities that fail to make more than they spend, someone else in society has to chip in to make up the loss…out of their profits!

So how does a business generate profits? How does a non-profit keep receipts larger than expenses? How does a family keep income larger than expenses? Of course, it is always a good idea to minimize expense as much as practicable, but at some point you hit the minimum load and you have to focus on gross income.

The simple answer to the profits question is VALUE CREATION. A business (or other entity) must do something with its available resources that make the resulting product or service more valuable as a unit than the sum of the components. For a retail business, the sum of purchasing power, access to wholesale pricing, cost of facility, benefit of convenience to customer, etc., must be less than the customers’ are willing to pay for the purchase experience as a whole. For a manufacturer, the sum of production capability, cost of materials, cost of labor, etc., must be less than the customers’ are willing to pay for the finished goods. You get the picture.

Peter Drucker has written that the goal of every business is to create a customer. He also points out that profits are a success metric that helps measure the health of the business. Lurking behind this practical explanation is the necessity for the business to create value. Customers will not buy and profits will not exist if your business is not creating more value than it is consuming.

Employment

Everyone seems fixated on employment in the current political cycle. The politicians are all explaining how they will wave their magic wand and create jobs (if elected). Mitt Romney surely understands that this is all rhetoric. As a private equity fund manager, he most certainly knows that businesses create jobs…not government. In fact, the small business sector makes up about 75% of the US economy, making them the most important players in the employment game.

So how does a small business “create jobs”? Simple answer: increase the amount of value created so that demand requires more labor to keep up.

Let’s say that Joe wants to be a good citizen and help out the economy. So Joe hires 5 people that he doesn’t really need. Over the course of a couple of years, this increased burden causes Joe (for any number of possible reasons) to either downsize his business by more than 4 employees or to go out of business altogether causing everyone to lose a job.

But what if Joe does some market research, invests in some new technology, and then offers new or improved products or services to the community? Existing customers continue to buy (possibly at a higher amount than before). New customers start begin to buy. Before long, Joe has to hire 4 new employees just to keep up.

If Joe isn’t offering something to the public that is worth more to the customers than it costs Joe, then there is no point in even talking about Joe’s employment figures. Value creation is the real key to increasing employment.

Business Value

Another measure of success is the value of the business. We see this most often in publicly-traded companies with Wall Street’s fixation on share prices and a variety of ratios. For small business, the value of the business usually becomes imporant to the owner about the time the owner decides to retire or sell the business for some other reason. When it comes to business value as a success metric, the higher the better.

Unfortunately, business owners that finally start thinking about the value of their business a year or two before retirement are late to the party. The value of a business is synonymous to the value created by the business. Put another way, the value of a business will be evaluated by a potential buyer or investor in terms of how much value the business will create in order to return the initial capital required to buy the business and then to show profits on the investment. Small business owners should be thinking about the value of their business EVERY DAY!

For most small businesses, the source of value creation is in a handful of key assets. Either the business has a key piece of equipment or a key body of knowledge usually housed in the skull of a particular person. If the value creation of the business rests on an asset that is not properly maintained or may become obsolete, the value of the business is discounted. If the value creation of the business depends on the knowledge or skill of a very small group of people that may leave the business or be incapacitated in some way, then the value of the business is discounted. Business valuation is all about sustainable value creation.

No matter what measurement you use, your business is only as good as the value it creates. Your task as a business owner or manager is to constantly look for ways to increase the value created by your business. Thankfully, you are not alone. There are legal, financial and consulting professionals available to provide the value of their expertise to help you find ways to increase the value created by your business.

Anthony Wayne Business Exchange, a leader in the business intermediary profession, offers you expertise for your varied business needs. Formed in 1987 with a vision of providing unparalleled business services to owners and entrepreneurs, AWBE provides professional assistance to business leaders in the areas of succession planning, funding growth, selling a going concern or accomplishing a merger or acquisition.

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About Jim Hanson

I am a sinner saved by God's grace who is learning day-by-day how to die to self so that I can live in Christ.
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