The CEO s End Game: Realizing Shareholder Value

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1 The CEO s End Game: Realizing Shareholder Value By George Isaac, Family Business & Management Consultant You re a busy executive. Are you spending your most valuable resource -- your senior executive team s time -- addressing issues that create realizable shareholder returns or are you consumed with addressing issues based upon internal or external noise levels or other short-term factors? A lack of understanding of the key levers that impact shareholder value in a privately held business typically results in an inappropriate prioritization of work assignments. The results are suboptimal financial returns and increased investment risk for your shareholders. Shareholder Value: Realized vs. Non-Realized The first step in creating shareholder value is to recognize that an investment is only as good as its ability to generate current and future cash. Until cash is distributed to your investors/shareholders, it is merely a potential increase in shareholder value (i.e., unrealized value). This unrealized increase in shareholder value does not impact an investor s ROI until the cash is actually distributed and becomes realized the earlier, the better -- due to the time value of money. Since shareholder value is driven by cash distributions, the CEO needs to manage how his company can generate cash. There are three primary ways a company distributes cash to its shareholders, as illustrated in the chart below: Chart 1 Realizing Shareholder Value 1. Regular distributions of cash - generated from operating profits. Operating profits typically receive a great deal of attention due to management s focus on a business income statement. 1

2 2. One-time or periodic distributions of cash - from improvements in working capital management or reconfiguration of capital structure. These are balance sheet items that often do not receive proper management attention (other than the management of outside debt). 3. Cash from sale of business based on the valuation of the business at a future end point. Realizing Shareholder Value from Regular Cash Distributions The primary generator for regular cash distributions is operating profits, or free cash flow from operations. Operating profits are generated by the following sub-elements: Revenues X Gross Margin % = Gross Profits Gross Profits S.G. & A. = Operating Profits Operating Profits + Depreciation/Amortization = EBITDA (Operating Cash Flow)* *EBITDA= Earnings before Interest, Taxes, Depreciation & Amortization The successful executive evaluates each of these sub-elements to identify significant opportunities where operating results can be improved, through increases in revenues, expansion of gross margins, and reduction in S.G.&A. expenses. This evaluation must address a multitude of factors, such as current and future business and marketing strategies, product line profitability, customer profitability, customer/product pricing, reduction in operating, materials and logistics costs, outsourcing opportunities, distribution channel alternatives, administrative efficiency, discretionary spending, value engineering, etc. For additional information on how to conduct an operational review of your business, go to to request a detailed review checklist for each functional area. Once this evaluation phase is completed, each opportunity area should be quantified and prioritized in terms of impact on operating cash flow, requirements for successful implementation, and probability of success. Realizing Shareholder Value by Creating Periodic Cash Distributions The two areas in a business that can generate one-time or periodic cash distributions to your shareholders/investors are through changes in working capital management and capital structures. 2

3 The goal for working capital management is to minimize the working capital required to support your business to free up cash consumed in working capital assets. The main levers to review are accounts receivables, inventories, and accounts payable. There are numerous ways to impact each of these areas. For example, In Accounts Receivables: Offering quick pay discounts to your customers; Requiring deposits for certain types of longer lead time/build product sales; Being more aggressive at collections; Changing terms of sale, etc. In Inventories: Selling off obsolete or slow moving products; Manufacturing smaller production run sizes; Re-evaluating inventory safety stock levels; Outsourcing part of your manufacturing process and requiring just-in-time delivery; Requiring your raw material vendors to deliver just-in-time or provide dated terms for payment; Having your customer retain ownership of the raw materials and charging a contract manufacturing/assembly fee, etc. In Account Payables; Slowing down your payments to vendors; Renegotiating better terms (this must be carefully reviewed so as to not disrupt your supply chain). By properly right-sizing (i.e., reducing) working capital, management can often generate excess cash that then could be distributed to your shareholders as a periodic cash distribution. In addition to working capital, revising capital structures can be a source for one-time distribution of cash. For example, adding debt to a company, sale of non-essential assets or sale/leaseback of real property can facilitate a one-time distribution of cash for your shareholders/investors Prior to revising your capital structure, there are many trades-offs to consider, such as: Debt levels and corresponding financial risk; Volatility of your earnings and ability to service debt; Current interest rates; Business opportunities for re-investment in your business to improve future revenue and earnings growth rates versus distributions to shareholders; Importance of generating realized returns to your equity investors; 3

4 Shareholder wealth investment diversification objectives, etc. Realizing Shareholder Value from Sale of the Business Creating long-term shareholder value from the sale of the business requires careful planning over at least a two- to three-year time horizon to maximize the company s valuation. In addition to operating profits, there are factors such as growth rates, operating margins, working capital consumption, capital structure, and general asset/liability management that impact a company s value. The basic formula for shareholder value is EBITDA multiplied by a Valuation Multiple less interest bearing debt/preferred stock, as depicted in Chart 2. Chart 2 Company Valuation Model The CEO s job is to analyze each attribute in the shareholder valuation model to determine the specific levers that can improve and then determine where the greatest opportunities exist. The first step after breaking down shareholder value into its elemental drivers is understanding the levers that impact each. The final step is assessing the opportunities for improvement for each elemental driver. Some of the factors are intrinsic to your industry or the story about the future of your company and are more difficult to impact. This article will focus on the controllable elements of your business. There are four elemental drivers that impact shareholder value: 1. Operating Profits, or more technically correct EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization) that increases your business enterprise value and ultimately shareholder value; 2. Operating Margins and its impact on valuation multiples; 3. Growth Rates and its impact on valuation multiples; 4. Working Capital Management & Capital Structure and its impact on cash. 4

5 We will discuss each. Summary Operating Profits & EBITDA. The main driver of EBITDA is operating profits. EBITDA is used to determine the value of a business ( Enterprise Value ). Enterprise value is computed by multiplying EBITDA by a valuation multiple. The valuation multiple is similar to a price/earnings (P/E) multiple used to value public company stocks but is based upon EBITDA (P/EBITDA). Once the enterprise value is determined, shareholder values can be computed by subtracting the business permanent debt and preferred stock from enterprise value. Operating Margins. Gross margins and operating margins impact shareholder valuations. A higher gross margin and operating margin business will benefit from a higher valuation multiple since these businesses are less risky than lower margin businesses. In addition, they provide greater leverage by generating greater operating profits for every incremental dollar of revenues. Growth Rates. Both top line (revenues) and bottom line (earnings) growth rates impact P/EBITDA ratios. A high growth company will benefit from a higher P/EBITDA multiple since earnings should be significantly increasing each year over the base year. Capital Structure. Capital structure impacts shareholder value since enterprise value is reduced by the amount of permanent debt or preferred stock a company has on its books to compute shareholder value. As a result, less debt and interest-bearing liabilities will increase shareholder value. By minimizing working capital requirements, the business will generate cash that can be used to pay down permanent debt (or be distributed to the shareholders). If done in advance of your company sale so the company has time to demonstrate it can operate with less working capital, it will increase shareholder value. Other opportunities include selling off non-productive or economically unattractive assets to generate cash. Sometimes, alternative financing arrangements such as sale and leaseback of facilities can increase shareholder value, particularly when considering the difference in valuation multiples between real estate and operating businesses. By carefully examining the levers that create shareholder value, the CEO can significantly increase realized shareholder returns without negatively impacting the long term prospects of the business. When the CEO is not focused on realizing shareholder returns, the riskiness of the shareholders investment increases dramatically since the shareholders return is solely based upon a future sale where many unexpected or non-controllable factors may negatively impact the future business value. 5

George Isaac has 30 years of family business experience as well as serving on 14 public and private corporate boards and consulting on over 100 client engagements.

6 George Isaac has 30 years of family business experience as well as serving on 14 public and private corporate boards and consulting on over 100 client engagements. His firm provides board and management consulting services to mid-market private and family owned businesses typically addressing issues associated with succession planning, corporate/family governance, realization of captive family business wealth, business strategy and operating performance improvement, and M&A transactions. See for details or contact Mr. Isaac at or 2013 George Isaac, GAI Capital Ltd.; PO Box 50009; Santa Barbara, CA 93150; Reproduction allowed with credits. 6

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Is your Private Company Really Managing For Shareholder Value? By George Isaac Insights is powered by ACE Portal The NYSE-backed Private Placement Marketplace (www.aceportal.com) Is your Private Company