Every company must serve at least two purposes; to provide a needed set of products and/or services and to create corporate value. What a company does matters to its customers, leadership, team, investors, and community. Building and delivering a product or service that makes a difference to a group of people is the essence of value, and the way in which it is done can add or detract additional value. The more clearly that is understood, the easier it will be to attract talent, customers, and build a great company. That is, however, only part of the challenge. Doing that while also making the economics work is the difference between having a company and not. Doing that in a way where the leadership partners with investors to create corporate value that returns a sufficient return for the investors and their investors as well as the internal stakeholders is a further requirement for institutional investment. Given this purpose, it is relevant to have a deep understanding of what corporate value is and how it is created.
Financially, corporate value is the value of the equity of the company; typically reflected in a share price. Corporate value is the residual value of the equity of the company at time of exit. First, the value of a company, like anything else, is what someone else will pay for it. There are three common methods of estimating the value of the company and its equity: asset, market, and income. The first two methods provide useful insights into debt and assets impact as well as market perceptions. The last approach, by income, is simply that the value of the enterprise is the expected value of the future discounted free cash flows, adjusted for cash, tangible assets, and debt. Free cash flows are the surplus cash generated by the business after accounting for all operational funding needs including those required for investments in new capital and growth.
It’s important to separate these factors into what is controllable and what isn’t controllable. Current market conditions and the discounting factors are out of your control; except insofar as you choose your exit timing. What is in your control is the amount of free cash flow the company produces, the debt burden it carries, the capital it raises and uses, and the assets it holds. A key job of the CEO, board, and the executive team is to leverage that control to maximize the value of the company.
Free Cash Flow refers to the amount of cash a company’s operations throws off after accounting for the costs of running the day to day operations and setting sufficient reserves aside to fuel growth. One of the best proxies for free cash flow is EBITDA or Earnings Before Interest, Tax, Depreciation, and Amortization. Why before? Because each of these items reflect financial engineering rather than the core profitability of the company. So, at its core, creating corporate value is about driving the current and expected EBITDA, while also making prudent decisions about assets and liabilities. Yes, there are many who say EBITDA is imperfect for certain situations; keep in mind EBITDA is a guide rather than the valuation basis in a transaction and the conclusions in this blog are not altered in those situations (high capital intensity, high leverage, etc.).
It is important to keep in mind that profitability is the key to financial corporate value. In venture capital, revenue is commonly used as an early stage proxy for corporate value and in times of capital abundance, it may be used as a proxy for corporate value of extreme high-growth companies. While extremely useful in assessing the traction of the company through the early stages of corporate development, revenue can held too long as the sole key results indicator. In private equity, EBITDA growth is a key objective. However, under both investment models, capital efficiency in driving EBITDA (or with unicorns, its revenue proxy) is the critical end-objective.
Intrinsically, corporate value is the value of the impact of the products and services on the company’s customers, the value of growth and prosperity for employees and contractors and other stakeholders, and finally the transformative value of the impact of the way the company’s leaders and employees conduct themselves to change marketplaces, lives, and perceptions. The rulebook and metrics for this side of corporate value are more subjective but no less important.
Leadership is a responsibility, not a perk. Strong leaders seek ways to build corporate value financially as well as intrinsically; recognizing the interdependency of the two driven by our common humanity. The tools, methods, and approaches to doing that require experience, creativity, and a deep understanding of the tradeoffs in each decision. For that reason, experience and depth of understanding have always been and will always be key to successfully building a great company; whether inherent to the team or brought in as needed.
At Maroon Creek Operating Partners, our purpose is helping executives, boards, and investors build great companies and the corporate value, both financially and intrinsically, of those companies. We work with executive teams, boards, and investors to find the right answers, supplement the experience and knowledge base as well as bandwidth. Our passion is your success.
This is a slightly modified reposting of a blog post from April of 2018. In future blog posts, I will continue explore some of the models for corporate development and value creation, the investment models that drive them, and the levers that can be used to drive corporate growth as well as a myriad of topics that I hope you will find useful in reaching in your goals.