Emerge Dynamics Podcast

Today we discuss working with equity investors.

Small business owners can be hesitant to bring in equity investors, but there can be good reasons to consider this path.

Equity capital is almost always more expensive than debt capital, but it can enable you to grow much faster than you otherwise would have.

Join us as we discuss how to talk with potential equity investors, the importance of having our pro forma in order, and how if you are a business owner you are already an equity investor. If you are a business owner or manager, you need to understand how to view a business through the lens of an equity investor.

Be sure the term IRR is in your vocabulary.   https://www.investopedia.com/articles/investing/102715/calculating-internal-rate-return-using-excel.asp

In this episode, David and Eric link the discussion of financial analysis to making banks want you. There can be good cases for using other people’s money to help accelerate your growth. There is so much confusion with businesses about what banks’ objectives and restrictions are. We clarify this before diving into financial analysis.

If you have three income statement balance sheet and cash flow financials historically linked to a forward-looking forecast with all the same line items then you are likely in at least the 90th percentile of applicants your banker is talking to. We also discuss how metrics banks often look at such as Debt Service Coverage Ratio and Debt to EBITDA should be added to your analysis to articulate to a banker in their terms how you will be able to pay them back.

Listen to this episode to be way ahead the next time you talk with a banker.

In last week’s episode, David and Eric talked about ROA and ROA and why it’s important to grow your margin, but not at the expense of ROA. In today’s episode David and Eric discuss Financial Forecasting. While many seek a tool to help them see into the future, we believe this is a tool that should help you create the future. Let’s go into the future proactively and purposefully.

The first priority is discussing why Financial Forecasting is important. We can’t get stuck on the past and then assume that the past will be the predictor of the future. While it is certainly a good indicator- looking in the rear view mirror all the time is not the best way to run your business. You must think forward. If you’re planning to scale, your financial forecast does not guarantee that you will get there, but it does show that there is a way to get there. At least half of the value that comes from a financial forecast is created as the forecast is built. The disciplined process of maturing and being able to articulate every area of the business model often creates more value than the end product itself.

No matter how far out you make projections for the future, nothing ever happens the way we anticipate it. Being able to build scenarios and make adjustments is very important as the world changes.

There are three major components to the financial forecast for identifying all the key variables that drive changes in the business model: the income statement, the balance sheet and, the cash flow statement of the company. Without these – you’re missing many components that reveal the real value of this process in the model. You are going to need to understand and articulate not only the future profitability of the business, but its future cash flows and returns to investors.

To summarize these key components: when talking about the impact on the income statement, you start with revenue and breaking that down to units, pricing, and the sensitivities. At this point you’ll really start to generate amazing value beyond probably 90% of the financial models out there. Listen to this episode to get all of this in detail and more.

In this episode David and Eric return to unpacking the importance of Financial Analysis for a business. Today’s discussion will revolves around Return on Assets and Return on Equity – which involve numbers from both the Income statement and balance sheet. These two together are used in a powerful way to analyze business performance.

Linking back to a previous episode on valuation: If Company A has a higher ROA, then it will likely sell for more than an otherwise identical Company B, even if they both have the same EBITDA.

While you don’t need to understand ROA and ROE as well as maybe a financial analyst working in your company, you do need to know what these concepts are and understand that the more efficient you are with your assets the better everything is within your company.

While margin is important, don’t chase margin at the expense of the ROA. So many business owners do this to their detriment.

ROA is a good metric for evaluating the performance of management as management is tasked with putting the assets to work that they are stewards of.

ROE is a better metric for evaluating returns to the equity holders. One of the primary reasons that ROA and ROE differ is debt. When properly measured ROE can also be used as a measuring stick for comparing investments in your company with external investment options.

Don’t go through your whole career blind – thinking you’re creating amazing wealth when you aren’t. You don’t go through your whole career making 5% when you could have been making 10% for 20 years somewhere else. The main message for the audience is that these calculations exist. They provide additional insights into the efficiency and the level of profitability of the business, and it helps you make better decisions with things like: How efficient are we being? How can we be more efficient with our or utilization of assets? If you want to reinvest in the business – do you put more into this business or less into this business?

But be careful, ROA and, to a greater extent, ROE can be very distorted when taken directly from the financials statements of most private companies. We also discuss why and what to do about.

Additional resources on why profit isn’t everything and why you should pay attention to these metrics: https://www.emergedynamics.com/post/its-all-about-profit

And here is the math example we reference: https://www.emergedynamics.com/margin-vs-roa

On this episode we’re joined by Amy Bakay, founder of HR NOLA. HR NOLA is a human resources consulting business that offers both onsite and remote HR services. Diving right into the topic of HR is the perfect opportunity to circle back on and unpack an important component of strategic planning: the people on your team.

Amy identified a need among startups as well as small and mid-size businesses to have access to experienced HR professionals on whatever basis meets their needs, and this is how HR NOLA came to be. Their primary goal is to provide strategic HR consulting as well as outsourcing solutions.

Establishing a healthy, brand-aligned company culture is important for success. It’s the character and personality of your business, and it goes a long way in dictating the behaviors and attitudes of your team. As they say at HR NOLA, compliance in culture starts with the first hire.

It’s the whole person who shows up at work—their mind, their heart, and whatever is in their briefcase. If you know precisely who you’re looking for, you will choose people who are a great influence on your business (and vice-versa). Your HR decisions are going to be as unique as your business. Your policies and programs should be created for how they work in your environment.

Candid feedback on your company culture is crucial. You have to know where your people are at so you can meet them there. Creating a sense of belonging and a place where people feel safe is of the utmost importance in today’s workplace cultures. Employees prioritize working in a place where they can belong and be themselves.

In this week’s episode, David and Eric discuss Financial Analysis. We had more to day on this topic than we realized – it may be the new series!

Before diving into any specifics – How well do business owners or managers need to know their numbers? How well do they need to be able to analyze their number?

You don’t need to know your numbers as well as your CPA or CFO, but you do need to know your numbers when someone speaks to you about the topic. For example: say it’s a banker and you’re trying to raise money right now or investor and when they ask you questions like what your gross margin is, why is it trending this way or that way – you say I don’t know, let me call my finance person. That answer can take away your credibility. When it comes to the key components of your numbers like revenue, cash flow, or operating margin…. These are the basic fundamental accounting aspects of your business.

First, start with the historic financials. You can lineup the columns by months (at least the last 12 months- powerful with the last 24 months) of income statements and balance sheets. You’ve just finished step one and are now looking at a time series. When you look at the periods side-by-side you start seeing things move across them. Ultimately what a financial analysis is doing – is it’s telling the story.

If you’re a business owner you don’t need to know how to build a cashflow statement from an income statement and balance sheet, but you do need to understand there is a thing called a cash flow statement and it’s very critical. One of the first places to look at is operating cash flow. A business can last a long time with negative profit but cannot last very long with negative operating cash flow. We have a guest next week who we think you are going to love. Then we’ll resume this them with some more advanced metrics and how to look into the future.

In this episode: David and Eric discuss EBITDA’s limitations and adjustments and why they are so important to understanding your business’ value.

We also discuss some critiques of using EBITDA including the famous one from one from Charlie Munger, Warren Buffett’s longtime business partner who boldly stated: “I think that every time you see the word EBITDA, you should substitute the word ‘bull#%$#’ earnings.”

While we aren’t as critical as Mr. Munger of EBITDA and do think it has valid uses, a clue as to why he might say such a thing comes from his partner, Warren Buffet, in his 2000 shareholder letter, “does management think the tooth fairy pays for capital expenditures?”

You can read a more expanded view of the benefits and shortcomings of EBITDA here:

https://www.emergedynamics.com/post/your-ebitda-multiple-is-misleading-you

Even though it has limitations, it is the most prevalent metric in valuation and business valuation and for good reason. We will discuss its capabilities and limitations. EBITDA is often touted as a proxy for cash flow but it really isn’t. One of its biggest limitations is that it doesn’t capture needed capital expenditure.  For businesses that are capital intensive – there’s a huge impact on cash flows and business value that EBITDA will never pick up.

EBITDA almost always needs to be adjusted after it is properly calculated from the income statement.  There are numerous things that could be adjusted.  Anything that a business is paying for that is above or below market needs to be adjusted. The most common example of this owner compensation.  Some owners don’t pay themselves at all while others may themselves enormous amounts.  This will have a large impact on perceived business value. 

Another example of something that needs to be adjusted is unusual or one-time expenses.

We discuss several examples and the importance of working with a seasoned M&A advisor, investment banker, or business advisor to go through each one.

On this episode of Emerge Dynamics we’re joined by guest Ladi Franklin. Not only is this woman doing amazing things for the businesses she works with, but she has also been working on the value-builder drivers in a culturally different space. She’s proving these principles are globally applicable.

Originally from Nigeria, Ladi has been living in Trinidad and Tobago since 2000. She’s currently working with the Network of Christians in Business (NCB) (https://ncbtt.org/) as their Executive Director and Coordinator. This platform supports Christian entrepreneurs across industries. She’s well-versed in working with small to medium-sized businesses.

She’s been incorporating the value-builder drivers into her work with these businesses for over a year now, both inside and outside of the NCB platform. This has been most helpful for businesses who are in a growth phase. These are businesses who have developed a profitable structure, but they need a new strategy in order to reach new heights.

Some of these businesses are also dealing with high competition and aren’t equipped with the strategies to separate themselves apart. Ladi has been using specific principles, such as monopoly control, to build a significant competitive advantage. Hub and spoke has also been a powerful tool for clients to reinforce their business growth.

One distinct cultural difference is the approach of teaching these value-building strategies. In Trinidad and Tobago, business owners focus less on the end goal of selling their businesses because it’s not as common of a practice as it is in other places. It’s more about supporting growth in key areas to give these business owners more opportunities and creating awareness around their options.

In this episode, David and Eric wrap up their coverage of Value Builder (https://valuebuilder.com/for-business-owners/) drivers with Customer Satisfaction.

Do your customers promote your business on your behalf? A lot of business owners assume their customers are satisfied. We discuss some interesting dynamics that often make that not the case.

Created by Fred Reichheld and a team at Bain & Company, The Net Promoter Score (https://www.bain.com/insights/introducing-the-net-promoter-system-loyalty-insights/) is one of the most reliable customer assessments out there. It is simple so it is much more likely to be completed honestly, and gives actionable insight into customer satisfaction and likelihood of future growth of a company. Furthermore, it quantifies an often qualitative hunch into a score that can be bench-marked and acted upon.

We also discuss the importance of turning your customers into raving fans of your business as they will promote your business without you asking them to. This is the best kind of advertising you can get.

We tie this into business valuation as we discuss that more satisfied customers are a signal to a buyer of lower future cash flow risk and greater future cash flow growth. This increases the amount a buyer will pay.

You can also do a Net Promoter score assessment for your employees (eNPS) ( https://www.qualtrics.com/blog/employee-net-promoter-score-enps-good-measure-engagement/ ) It accurately measures how engaged your employees are and gives incredible insight into how you can improve it. Are people just showing up for work? Or are engaged fans who are promoting your company every chance they get?

We’re wrapping up a mini-series on Value Builder drivers within our series on Business Valuation  

In today’s episode, David and Eric discuss:  Financial performance, Growth potential and the Valuation “teeter totter”. 

In depth we discuss the three main moving components mathematically on the business valuation. These components are the inherent cash flows in the business, the growth rate (or projected growth rate) of the cash flows in the business, and then the discount rate (or the actual risk within those numbers).  

We discuss the importance of maintaining your books on an accrual basis. We also discuss why you might also want to consider having your financials reviewed or audited by a CPA firm and how all of this can increase what a buyer might pay for your business.

We conclude the conversation by talking about the valuation teeter totter value driver and how it is another name for working capital. We discuss practical action items to challenge the status quo of payments terms in your industry.

We reference this article written by David about his interaction with a friend who risked growing his business into bankruptcy by not understanding working capital: https://www.emergedynamics.com/post/growing-yourself-into-bankruptcy

We also mention advice from Professor Aswath Damodaran of NYU. You can listen to his lectures for free online here: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/home.htm