Why is Private Company Governance Elusive?
The above question is a segment from Equity Value Enhancement ("EVE") - a Wiley Finance book ranked #1 by Amazon in its category that addresses the leveraging of both financial and human capital while managing risk. The first segments examined the differing optics of owners and trusted advisors.
Governance is the next segment and is the letter "G" from the acronym "GRRK". GRRK stands for Governance, Relationships, Risks and Knowledge. These four areas are interrelated and believed to create more value as a sum of the parts when a holistic and aligned approach is applied. EVE's premise is human capital is often overlooked by business owners and advisors as it takes a back seat to revenues and profits. Human capital is not formally found on any financial statement and developing metrics are more difficult. However, EVE shows, in fact, there are metrics and when well managed not only leads to increases in operating margins, but increases price multiples. In turn, value is enhanced. The following link explains why I wrote EVE. LINK
Most business owners first started with an idea and then executed with brute force, some cash and wishful thinking. By three to 12 months most of their dreams are nightmares. The next tier are those who created self-employment. If their compensation was applied to the salary of a manager, there is little to no profits remaining. Statistically most fail in a few years because profits are razor thin and there isn’t anything that differentiates from competitors. Yet, they work over 40 hours and often rely on other family. Mind you there is nothing wrong with a sole practitioner or a very small business.
The next tier is a high-five or lower six figure compensation ($75,000 - $125,000) founder with a solid reputation and/or a few key clients. Growth is based upon the belief of selling more… smarter. Many deem employees and advisors as necessary expenses. If owners as clients are sufficient in quantity, providers can make a living at or near the levels of the owners they serve.
The “cut above” are the owners who earn enough to “put something away” and may see the need for advice on an event driven basis, such as needing a lease agreement reviewed by an attorney or financial statements audited by a CPA for a loan originated from a banker. These professionals may have general legal, accounting and banking knowledge. This tier tends to earn $125,000 to $250,000 with businesses reporting $2.5 to $5 million in sales. About three of four will close their doors either because there is no interest in trying to sell or no interest by most buyers looking to buy.
The $5 to $15 million annual sales companies have built some infrastructure because the owner simply cannot perform all the needed functions of the business. The owner may earn from $250,000 to $1.5 million in compensation.
However, if asked, most founders will indicate they can perform most or all of these functions as well as or better than the person(s) they employ. Many owners try to do so. As such, an advisory board aside from friends and family may be worthwhile to consider.
Because equity values can be in the millions, this is where gift and estate tax planning should occur; especially, when the owner has children or is over age 40 (sense of mortality and concentrated risk). Yet, management turnover may be a challenge which can be based upon founder friction or compensation that may be noncompetitive. Outside advice is sometimes sought to assess, clarify, guide or mitigate decisions and outcomes.
These more complex advisory engagements are often 0.20% to 1.0% of company annual sales depending upon ability, complexity and/or scope. Again, like the companies themselves, advisors may find it difficult to express real differentiation. The involvement of allied professionals is often deemed on an “as needed basis” emphasizing cost versus benefit. While familiarity may grow with “key” advisors such as insurers, bankers, accountants and financial advisors, attorney and specialist retentions may be more situational dependent.
Arguably, it is this group, (depending upon sophistication, growth rate ad resources) and certainly $15 million and above, that would benefit from the “governance” discussion.
The next tier of $15 to $50 million in revenues tends to be about diversifying risk and seizing new opportunities either organically by new offerings and new markets or through acquisition. Few pursue the latter. Key here is the depth of the company’s “bench” (key staff and advisors). A common Achilles heel is back office weakness where the CFO/controller may be performing more reporting functions and may have nominal private capital markets background to examine any option other than cash flow performance improvement, minimization of tax liability and use of debt. They may not know any investment bankers.
While it would behoove ownership to expend 1% of sales annually to ensure a reduction of “trees versus forest” myopia by seeking professional perspectives of outsiders, this is uncommon. The great majority of companies plateau at this point because bureaucracy becomes time consuming and ownership has reached their capability and may think delegation as giving up control. There is seldom a strategic focus because that suggests a degree of precision, planning and metrics that requires a step-back from the “let’s try this” method of managing. As long as pre-tax income is $1 million and above, these companies are candidates for a sale, but seldom at the price multiples and values wished for by ownership.
So, what removes the plateau of $50 million (respectable for sure)? A shared vision that incorporates those from within and outside the firm. This is the company’s “ecosystem” and the army of knowledge and action who are “constituents”. Their engagement is not an after-thought. Therefore, a “process” must become inherent to the way the company approaches its marketplace. It is not only sales and profits driven, but offers a dynamic and differentiated approach to providing products and services. This requires a conscious and sustained effort to manage and maximize relationships, risks and knowledge.
So why is governance (strategy and vision development, communication and execution) so elusive? Only one out of 10 owners ever has had a business plan and fewer follow it. Mike Tyson wisely said “Everyone has a plan 'till they get punched in the mouth.” So, given that most advice is reactive, ad hoc, tactical, technical and transactional, what are the odds of adherence to governance?
Keep in mind for simplicity sake governance is how decisions are made and how stakeholders are represented. The word suggests constraint and financial transparency, which are what most business owners will push back against. So, we’ll use terms like a holistic approach, strategy, vision, culture and innovation.
What do all these and the acronym GRRK (Governance, Relationships, Risks and Knowledge) have in common? It’s the human capital within a company and between it and third parties (clients, vendors and advisors). Ask any Private Equity or Venture Capital Group what is among the first things they examine: Management strength, board capabilities and caliber of investors.
So Governance isn’t only about rules. It is how the founder/family’s/ management’s decisions get made and the vision gets executed. And the family business versus the business of family is a complex system. Key is a “charter” and a committee, council and/or board that agrees to immutable principles that steer the company towards opportunities and away from activities that dilute the company’s purpose or place it at risk. This allows the company to become more dynamic as well as develop, sense and seize new opportunities. These companies influence the marketplace versus the marketplace solely influencing them.
Critical to governance is to develop a strategic framework and have executives, staff and/or advisors whose primary purpose is to be strategy stewards accountable for long-term outcomes. This is the role of a truly independent board – guiding the vision pursuit. The CEO creates a culture that supports the vision and its strategy execution. This limits disputes as well as increases trust and communication.
Yet, the common failure to implement is the investment seldom has immediate results. Because strategy implementation can take six to 24 months depending upon resource gaps and commitment limitations, few will suggest and fewer will entertain the process unless they wish to buck Einstein’s sentiment on insanity (doing the same thing over and over again and expecting different results).
I have seen company values double by making the investment. Isn’t that reason enough? If the above is a compelling issue I invite you to consider requesting the first few chapters of EVE by visiting my website or Amazon.com to buy.
Carl Sheeler, PhD, ASA brings wisdom gained from his 25 years of strategic planning, governance, business
operations, finance and advanced analytics experiences to bring clarity to complex risk identification, measurement, management, and mitigation issues faced by family offices and businesses. He is the author of the John Wiley & Sons book titled Equity Valuation Enhancement, a treatise which addresses scaling 8- to 10-figure companies and has presented or published 200+ times for entities such as the American Institute of Certified Public Accountants, the American Bar Association, the Federal Bar Association and other organizations on value, strategy and governance. He can be reached at firstname.lastname@example.org or 424-253-0110