Simple Numbers™ PROFIT + PURPOSE = IMPACT Slides at: SimpleNumbers.me/wharton Greg Crabtree [email protected] 256-704-0620 Scaling Up Cash Applying the Cash Decision Questions to: • Scale Up Cash • Profitability • The Wealth BuilDing Capacity of your business PresenteD by: Greg Crabtree, CPA, Author of “Simple Numbers, Straight Talk, Big Profits” anD contributor to Scaling Up (Chapter 13) CASH ACTION #1 WHAT IS THE APPROPRIATE RETURN ON INVESTMENT FOR MY BUSINESS? UnDerstanDing ROIC for Private Companies • ROIC (Return on InvesteD Capital) – Annual Pre-tax Profit DiviDeD by your investment • Your Investment – Cash anD property you contribute – Sweat Equity • Does not include terminal value on a sale unless you are looking back after a sale Typical Self FunDeD Entrepreneur Startup The Power of CompounDing ROIC Takeaways • Economy is growing much faster than we think • Private Companies now dominate the economy • Cash is not the inhibitor to grow. The main inhibitors are: – Unable to build capacity – Not confiDent in growth – Desire to consume profits insteaD of growth The Conundrum of Growth vs Profits Company A & Company B are both at $5M in Revenue. • Company A decides to commit to 15% annual profit and grows at 10% for the next 7 years and sells for $9.7M • Company B decides to reinvest all profits, operate at zero net income anD grows at 19% for the the next 7 years and sells for $17M • Which company has the best total cash return to their owners after the sale? The Conundrum of Growth vs Profits Answer: The Same! Both companies haD a net return to owners of $14.2M. Let’s look at why….. Growth vs Profits - Organic Growth vs Profits - Organic • Company A • Company B – HaD Distributable – Since there were no earnings annually anD profits, they had to was able to grow with finance growth through their own cash debt or capital injections – Even though they solD – Even though the sales for a lower value (anD price was higher (harder more achievable), the to achieve), a significant net investment was the portion of the sales same (76% ROIC) proceeds was a return of capital (41% ROIC) Growth vs Profits with $1M Investment Outside Invested Capital Returns Let’s look at the same two plans again. This time, both have just sold 20% of their company to an outsiDe investor for $1M that is useD to capitalize the business for growth. Growth vs Profits with $1M Investment Growth vs Profits with $1M Investment • Company A • Company B – ROIC for Original Capital – ROIC for Original Capital Plus infusion Drops to plus infusion drops to 47% 30% Growth vs Profits Summary • Be clear on the math! A higher sales price might mean less money given the neeD for capital infusions along the way • Most Profitable companies can self fund growth at 20% per year • If management DeciDes to Diminish profits to grow, always moDel what profit woulD be without the experimental investment • Privately helD businesses can be great investments! Action Steps • Calculate ROIC for your company – If Company is unDercapitalizeD, calculate what ROIC woulD be given increaseD capital (retaineD through earnings or injecteD) – If ROIC is below 50%, challenge assumptions – IF ROIC is above 100%, is it sustainable? • Look at growth plans anD evaluate potential ROIC over a 5 to 10 year perioD CASH ACTION #2 THE BUSINESS IS STRUCTURED AND OPERATED TO OPTIMIZE MARKET VALUE. Running an “OptimizeD” Business • Effective Business Structure (legal anD tax) to either keep or sell • Operational excellence with documented processes that being followeD • Knowing anD monitoring what Drives market value for your business • Regularly scrub internal financials for “Deal adjustments” to reveal ”financial truth” 3 Essential Business Value Data Points • Economic Value – What is the business worth to you on a cash flow/ROE basis without selling • Current Market Value similar businesses in size anD inDustry are selling for • Replacement Return neeDeD if you solD at Market Value Economic Value • See Chapter 9 of “Simple Numbers, Straight Talk, Big Profits” by Greg Crabtree • Developed to manage shareholder or management buyout concepts baseD on after tax cash flow anD a reasonable time frame for purchase • 5 years to buyout a 50% owner, 10 to 14 years depending on interest rate for a 100% sale • Formula – 3 times Net Income Plus Equity Current Market Value • Can be a multiple of EBITDA (after deal adjustments) (5 is generally consiDereD neutral) • Can be a multiplier of Revenue, Gross Margin or Value per qualifieD customer • If you are carrying Debt, you generally have to payoff debt from proceeds or adjust price if they keep the Debt Replacement Return NeeDeD • Calculate “Net After Tax Proceeds” (use an average 25% tax rate for illustration) • Divide Net Income (after deal adjustments) by the Net After Tax proceeDs • If replacement return neeDeD is above 15%, reconsiDer whether selling is the best Decision or are you at a point in life where you will not need to consume more than the annual earnings of the replacement investment 3 Business Value “Plays” • Run to harvest – Profitable, cash flow generating – Only sell when you are reaDy to retire or start another more profitable business • Harvest until Premium Sale – Profitable, cash flow generating – Only sell if you can get a significant premium (usually 10x EbitDa) • BuilD to Sell – Cash flow neutral to negative – BuilDing a business of volume for a “strip sale” – Be certain of market DemanD anD valuation Action Steps • Calculate Economic Value for your company – Assess if there are any agreements for buy/sell or stock baseD compensation that use a value higher than this anD evaluate consequences if this agreement fails to cash flow. • Calculate estimated sale at current Market Value • Calculate the replacement return needed from proceeds if you sell CASH ACTION #3 PROFIT MODEL IN THE TOP 10% FOR YOUR INDUSTRY AND SIZE CATEGORY Profitability Keys • Have your P&L speak “truth” by eliminating distortions • Be careful comparing to “inDustry” data that has not been normalized for distortions • Create a simplified rolled up view like the Simple Numbers P&L moDel to look at first before looking at details • Think “moDel”, not “report” Profitability Keys - ContinueD • Compare your performance to businesses with similar moDels that may not be in the same inDustry (contracting, staffing, retail, manufacturing, etc) • Isolate expense spenDing that is for future years anD consiDer Displaying it below Net Operating Income to not distort current operational performance. 4 Primary Business MoDels • Services • ProDuct Sale • ProDuct Sale + Services • Manufacturing Action Steps • Create a rolleD up view of the business moDel for the Company • Focus on Isolation of Labor Categories • Remove Distortions if possible or at least move them below the Net Operating Income line CASH DECISION #4 WE HAVE A TARGET FOR NEXT LEVEL OF SIGNIFICANT ATTAINMENT AND … A ROLLING FORECAST LOOKING FORWARD 12 TO 18 MONTHS UPDATED AT LEAST MONTHLY. Art of Targeting & Forecasting Target – “a goal to be reacheD” (single point) Forecast – “to contrive or plan beforehanD; to prearrange; to make a prediction of” (journey) Art of Targeting • “A man who aims at nothing hits it with amazing accuracy” • Rolling 12 Data is usually able to preDict 3 to six months out just from trenD patterns • Labor ProDuctivity is the #1 Key to Profitability – OptimizeD Management Labor proDuctivity sets the stage for Direct Labor to be efficient. Larger companies can also isolate labor in more granular segments. Art of Targeting • TraDitional Targeting uses “Top Down methoD” – Determine expecteD revenue – PreDict costs neeDeD to support activity – Make unfounded assumptions about cost control to hit profit target Art of Targeting • Bottom Up MethoD is more reliable – Identify Management Labor – Multiply Management Labor by mLER target to get the Contribution Margin target – Identify dLER rate targeteD to calculate Direct Labor (CM / (DLER-1)) – Sum of Direct Labor anD Contribution Margin is Gross Margin Target – DiviDe Gross Margin by GM% to estimate Revenue Services Business Transformation Not Sustainable Management Labor What Does Management Need to Produce to Earn Comp? Management Labor Step 1 ??? Times Management LER Management Labor $3.50 Contribution Margin is Target for Management Labor Management Labor $433,300 Times Management LER Management Labor $3.50 Determining Direct Labor from Contribution Margin Target Contribution Margin Step 2 ??? DiviDeD by $3.00 (Direct LER minus 1) $433,300 Management Labor $3.50 Use DLER to Set Salary Cap Contribution Margin Step 2 ???$216,650 DiviDeD by $3.00 (Direct LER minus 1) $433,300/($3-$1) $433,300 Management Labor $3.50 Deriving GM Target Contribution Margin Step 3 ??? Plus Direct Labor $216,650 $3.00 $433,300 Management Labor $3.50 Plan for First Year of Transformation Contribution Margin $649,950 Plus Direct Labor $216,650 $3.00 $433,300 Management Labor $3.50 So How Did They Do? Management Labor Lather Rinse Repeat $3.00 Management Labor $3.50 Next Year Targets $1,088,640 $362,880 $3.00 $725,760 Management Labor $3.50 How Did They Do? Management Labor Lather Rinse Repeat $3.00 Management Labor $3.50 Next Year Targets $1,334,287 $444,762 $3.00 $889,525 Management Labor $3.50 How Did They Do? Management Labor Re-Targeting for Business Decision • Business Opportunities often arise after your plan has been set • Re-Target using the Bottom Up Approach – Most common issue is the Decision to hire a new key executive – UnDerstanD the builD up of Contribution