Value drivers are the different factors that increase the worth of a product or service to consumers.
Focusing on the entrepreneurial aspect of value drivers, and from perspectives such as that of a finance professional, we can think of value drivers as aspects of one’s business that provide value in relation to shareholder value specifically.
For the vast majority of businesses, especially those that operate with multiple stakeholders, value is primarily estimated in relation to its shareholder value. But what metrics and factors play a part in increasing this? The answer? Value Drivers.
Increasing shareholder value is of course one of the primary objectives for any entrepreneur; yet figuring out how you can maximise the value of your business is the key to understanding value drivers as a whole. Let us explore a little deeper as to what value drivers are, as well as how entrepreneurs can better take advantage of them.
Defining value drivers
There are micro and macro levels to value drivers. At the macro level, you are looking at the levers you can pull to achieve the increase in value of the business (getting the right team together, organising processes, and managing broad-picture cash flow). On a micro level, we are looking at the internal aspects of the business and the product itself – how you can differentiate it, how you can raise brand awareness, how you can be cost-efficient in both your operations and marketing.
The primary metric for a larger company that is listed on the stock market will be its share price and what people think the company is worth.
Looking through the lens of strategy and finance gives you a view of total company value. The challenge is understanding how that can be enhanced, and it is the job of CEOs and senior managers to garner this understanding.
Determining value: shifting through stages
The ‘idea’ stage
SMEs, startups, and entrepreneurs need to be thinking about how they can increase and optimise the value of their business, so a working knowledge of determining value is useful in this case.
It is common when one is starting out to have aspirations to raise money but often there is little knowledge of how to put a price on the company.
At the ‘idea stage’ of a new business, what investors are interested in is the calibre, experience, and record of the top-level management team.
For example, you can have an average idea and an excellent management team that makes it work. Or you can have a great idea and a mediocre team, but you might find the business fails to succeed.
It is important to be aware, then, of just how critical the management team is within a startup, and how much of a difference it makes in the eyes of potential investors.
Another factor to consider at this stage involves the board of a company. Having high-calibre, relevant individuals on your board of directors signals to investors and the marketplace that the prospects are potentially encouraging for this company.
The ‘evolution’ stage
Once you have a product or service, and you start to find customers – strengthened with recurring or contracted revenues – you enter the evolution stage where ‘de-risking’ is a huge priority.
If customers, for example, are well-established entities, the risk to revenue begins to be mitigated, because they are less likely to default on payment. Well-established entities are often more likely to have well-established revenues themselves, making your revenue stream less volatile in turn.
Shifting from a volatile revenue stream that could collapse at any minute to a stable one is crucial at this point and eventually when you want to sell up.
In preparation for a sale (which can take months or even years), you should consider the ways in which you can demonstrate how your revenues have evolved. Displaying a stable and increasing revenue stream operating with a ‘ratchet effect’ hikes up the valuation multiple.
With smaller businesses with revenues of a few hundred thousand pounds, value is not determined based on discounted cash flows – which is what finance professionals tend to do for bigger companies.
For most companies that are sub-10 million in value, this value is calculated based on earnings multiple. When looking at the operating profit pre- or post-tax and then applying a multiple, the number increases based on the size of the business.
If you can steer the business through those rocky first few years to a point where investors can see an increasingly stable performance, you are benefiting from higher earnings and also a higher multiple to get a good valuation.
A strategy for enhancing value drivers specific to your business and industry, therefore, makes a difference.
Utilising value drivers effectively – and what to avoid
Naturally, your tendency will be to get on with developing the product and making it the best-performing of its kind, being mindful of the cost of delivering that product and of its margins, and the competition. That is going to be your overall focus.
But when you start to move further up the ladder in terms of the growth of the business, you have to look at raising capital and what access to it means for the business.
Who you have on your team
At this point, it is important to assess how you can strengthen the management team and whether the team you had early on are still the best set of people to lead it forward. At the end of the day, growth is going to depend on this team and the perception that investors have of the quality of the management.
You may need to upgrade this team as you scale; strengthen the board and bring in the right people at the right time according to business growth and needs. That does not have to be the focus on day 1 but you should be aware of it from day 1.
Securing your revenues
The importance of securing your revenues – and having recurring ones – translates across all sizes of business.
If a business is preparing for sale and the founder is looking to exit in the next few years, one of the things they would be advised to do is assess which of the revenue splits can be contracted.
When looking at memorandums within businesses for sale, one of the things that are often highlighted is contracted revenue as a percentage of overall revenue. Investors analyse the split in terms of the customer base, ensuring you are not heavily dependent on one or two customers that make up 80% of your revenues. It begs the question: what happens if you lose those one or two customers?
Making sure that no particular customer is making up 10-20% of your revenue, diversifying your revenue mix, and being able to demonstrate your diverse clientele factors significantly into valuations.
For example, in healthcare business valuations, one of the things that really transforms the valuation is long-term contracts with the NHS – these contracts are unlikely to fail. Similarly, home-care businesses with services provided through local authorities and the NHS will be valued at a drastically different level to a similar company that provides the same service on a private basis. The latter is uncertain and has a higher risk involved.
In sum, if you are shifting with a view to selling, you need to be able to both strengthen your revenue stream while ensuring it is also diversified.
Cash flow as a value driver
Cash injections and cash gaps
You cannot overstate the importance of cash flow for small businesses.
In fact, when a finance professional looks at what value actually means, it translates to future cash flows from the business. You arrive at a value by trying to estimate the future cash flows that this business will be generating.
The main source of a business’s struggle in terms of cash flow would be working capital concerns.
Nowadays, a select few business models might be able to get up and running with little or no capital – for example, with online delivery, and no fixed or upfront costs.
But for the majority of businesses, there needs to be an upfront cash injection for buying equipment, manufacturing a prototype, etc.
Even if you manage to estimate that upfront and think there is enough available, once you start operations and want to scale up, it will become evident that you need more inputs.
Being short of cash injections at that point brings your business under stress and you might find yourself unable to pay out for your obligations and employees at this time, which can significantly drain morale from the company.
If you have not yet completed your operating cycle or finished the products and reached a place where customers are paying you, this cash ‘gap’ can be difficult to bridge.
Managing cash flow
Making sure you are on top of cash flow – when money comes in and is expected to go out – is key for entrepreneurs, and not just on an annual or bi-annual basis. You might find you need to keep an eye on this on a weekly basis or an even shorter period.
As well as this, predicting what you will do in the case of a delay and considering the knock-on effects is a good idea.
At this early stage, not being able to access alternative sources of capital, and not having relationships with banks or other means of finding capital quickly can create quite the conundrum.
This is precisely why managing and optimising cash flow and working capital is so vital for small businesses.
Avoid deprioritising cash flow
Cash flow can get neglected as managing teams become preoccupied with perfecting the product and start focusing less on cash positioning.
A related pitfall that we often see within startups – and namely within tech startups – results from the mantra “grow at all costs”. The desire here is to grow (leads, subscribers, customers) as quickly as possible. And yes, while the metrics are based on the number of subscribers, this can translate to high valuation.
But tunnel vision when looking to achieve that growth is where the pitfall lies: if you have not adequately addressed working capital, you could be in for some trouble.
Many traditional businesses with high fixed costs can succumb to that temptation to grow but should keep in mind that it can in fact have precisely the opposite result.
When considering value drivers, one should also be aware of value gaps. These relate to what the company is worth now and what the company would be worth if it were, for example, better run. This becomes a target for takeover and acquisition – for someone to step in and say “we can do a better job.”
To put it simply, if that gap is present, it indicates that something is not working well.
It might require shifting people and responsibilities around, and often, investors will come in and do this for you if you do not anticipate that need. It is in a founder’s best interest to do what they can to increase the business value – and sometimes this may mean handing over a portion of their duties to someone better-equipped. But there is often a reluctance to ‘let go’. Being prepared for this possibility is arguably vital.
Having the ability to narrow down and ultimately eliminate these value gaps should be a part of your strategy for maximising the value of the business.
In short, determining your value drivers early on enables you to harness and integrate them into your business growth strategy – and learning what does drive value to your specific business puts you a step ahead.
About Othman Cole
Othman Cole is a Senior Faculty in Management Practice (Finance) and deputy director of the Executive MBA programme at Cambridge Judge Business School.
Othman teaches Entrepreneurial Finance in the MSt in Entrepreneurship programme.
Othman’s previous experiences were in investment banking during his roles at Barclays Capital and DNA Project Finance. He has also consulted for a number of companies in risk management, real estate, and energy.