How to Boost Shareholder Value through Board Mix
Corporate selection of independent board directors has historically followed broad economic and social trends. First came the celebrity board director – CEOs, politicians, and even media stars – who helped increase brand awareness. Then, following Sarbanes-Oxley, came the rise of the audit focused board director who would protect investors from accounting shenanigans. Then, with the digital boom, came the board director with technology expertise who would advise companies on how best to fix and integrate all the IT systems. Most recently, the rise of social media has meant that a marketing and multi-media guru was needed to advise on how to integrate social media into business strategy. Boost Shareholder Value.
While it is important to keep up with economic and social trends, it is also important to ensure that the selection criteria for independent board directors matches the underlying goals of the company. We all have heard through the popular press that the primary goal of any corporation is to maximize shareholder wealth, but what is the fundamental responsibility of a board? Simply put, the board exists to protect the interests of the shareholders. The question then is, what is the best way to govern the management and decisions of a company so that shareholder wealth is maximized and protected?
While the component parts to governance (e.g., compensation, audit) are certainly required, effective board governance requires members who can assist management in navigating the maze of value creation strategies, knowing full well that human and financial resources are finite and dynamic. Adding a board member with deep expertise in financial economics and, more specifically, value creation can create a holistic framework from which all decisions can be informed and quantified. Any public or private board that is missing this expertise is likely not optimized, and Management and shareholders are probably not fully served.
So how does a board focused on value creation accomplish these goals? The answer is by concentrating on the variables that most directly impact shareholder wealth: next period cash flow (CF1) or profits, risk (as measured by the cost of capital (k)), and the growth rate of future cash flow (g).
Understanding this formula, we can break the value creation opportunity into its three underlying components.
Path 1 (CF1): Cash Flow / Profit Maximization: Most organizations are data rich, especially those with numerous transactions. Finding optimal price points and structuring pricing algorithms through elasticity and regression modeling can lead to immense value creation, as every dollar increase in price typically falls to the bottom line. Likewise, unit volume and sales close rates can be increased through similar modeling. This results in revenue and profit growth without significant risk or cost. The increase in profitability results in a substantial increase in value. For example, if you double the profit, you double the value. Optimizing cost structures, especially sales force and executive incentive compensation, can also lead to improved growth and profits.
Real example: I assisted an in-home flooring sales and installation company improve their product pricing and allocation of leads to salespeople by moving from ad hoc processes to algorithms. The company was pricing its product arbitrarily without consideration of all available information, resulting in the company not maximizing its profit. Similarly, leads were not being allocated to salespeople in a manner that optimized close rates and profit. I performed a detailed analysis of all historical transactions for a sample period by SKU to determine the relevant statistics and price variations across product lines. I determined the close rates by salesperson by SKU at varying prices so that we could develop a pricing algorithm that estimated the profit-maximizing price for each SKU based on key characteristics of the transaction. While the optimal stated price increase ranged from 3% to 8% depending on the SKU, the average effective price increase ranged from 1.3% to 4.0% after considering slightly lower close rates. This improved overall gross margin by about 2.5%, which translated to about a 50% increase in net profit and net margin (from about 5% to 7.5%).
Path 2 (k): Risk Mitigation and Capital Structure: The weighted average cost of capital is primarily influenced by the market risk, or “systematic” risk, of the firm. However, there are company-specific, or “unsystematic,” risks that influence cash flow and growth as well. Company and shareholder risk can take many forms: lawsuits, price and cost volatility, exogenous variables such as tax and regulation changes, succession, and keyman risk. Many of these shocks can be mitigated through planning and various strategies such as hedging with futures contracts and using long-term employment contracts. Likewise, diversification and counter-cyclical business units can lower both systematic and unsystematic risks. Most common, and often ignored, is succession risk that is both unsystematic and asymmetric (to the downside). Developing long-term incentive plans, carefully crafted employment agreements, and succession plans can greatly lower this risk.
Whatever the cause, meaningful reductions in systematic and/or unsystematic risk often lead to significant and immediate value creation, for both public and private companies. As a result, the overall cost of capital can be minimized, and shareholder value can be enhanced via a more optimal capitalization of the firm.
Real example: I assisted a $1 Billion biofuel production and distribution company with several risk mitigation projects including optimizing its capital structure and developing executive compensation and retention plans. At the time of my analysis, the asset-intensive company was underutilizing debt in its capital structure due to the board’s perceived risks of debt. Utilizing several methodologies, I was able to determine the wealth maximizing capital structure for the widely-held investor group and prove to them that a less conservative approach was more optimal. Furthermore, through cash flow simulation forecasting, I was able to demonstrate and quantify the potential cash flow risks related to taking on additional debt.
In addition to assisting the firm in resolving capital structure issues, I was able to develop an executive compensation program that aligned the interests of management with those of the owners. This plan helped reduce and eliminate the agency issues associated with the non-owner operators and help reduce the unsystematic risk of the firm.
Path 3A (g): Organic Growth: Everyone loves growth. Here’s some simple math about the effect of growth on value: double the expected long-term growth rate from, say, 5% to 10%, and you double the current value. Now, you can see why effectively modeling growth for scale or diversification opportunities, while minimizing execution risk, is vital for any expansion or strategic plan.
Real example: I assisted a fast-casual restaurant chain scale from six to thirty locations by developing an integrated model that allowed the company to project financials on a store-by-store basis, estimate capital expenditures and cash requirements, and project investor and company returns. The model was utilized by the company to develop their organic growth strategy and obtain the required growth capital. The flexibility of the model allowed the company to optimize its capital raise by understanding various scenarios and the resulting returns to each investor.
Path 3B (g): Inorganic Growth: Significant value creation is possible through M&A activity given the proper assessment of price, terms, and strategic fit (i.e. synergy value). Finding, vetting, analyzing, pricing, structuring, and integrating merger partners can change shareholder returns markedly – and quickly. However, M&A can be a double-edged sword. Performed incorrectly, value is destroyed. Additionally, complex ownership structures and derivative securities must be properly analyzed and valued, earnouts need to be effectively constructed, and incentive compensation and roll over equity must be carefully thought through in order for acquisition values to be maximized.
Real example: I assisted a publicly traded industrial packaging products and services company in completing seven acquisitions in two years by developing a valuation model that allowed the firm to better vet potential targets as well as estimate potential synergies and the stock price effect of each deal. As a result, the company grew over the two-year period from $2.8 Billion to $4.2 Billion in revenue, a 22.5% compound annual growth rate.
Conclusion – Value Creation through Board Selection
These all-important decisions and value drivers are critical to creating (or destroying) value for an enterprise and its shareholders. While industry knowledge and specialized expertise are certainly of vital importance, the insight and clarity brought by data and financial analytics should not be compromised. Expertise in analytics, scenario and simulation forecasting, compensation and incentive planning, and financial modeling is key to having an impactful board that can help Management make the right decisions for its shareholders.
For more information, contact:
Mr. Hanan is the President of ValueScope, Inc. and an expert at value measurement and value creation. After his engineering career, he began a decades-long career in valuation consulting working for thousands of clients in numerous industries. His successes include developing econometric models to quantify growth and value creation opportunities through structuring strategic partnerships and acquisitions, margin improvement strategies, executive compensation and LTI plans, and hedging-risk strategies. Mr. Hanan has held public, private, and non-profit board positions in a national restaurant chain, a multi-media company, a home improvement company, and a State-run emerging technology fund. Mr. Hanan holds a BS in Electrical Engineering (Illinois-Champaign Urbana) and an MBA in Finance (Loyola-Chicago), is a Chartered Financial Analyst (CFA) charterholder, and has earned various securities licenses.
If you liked this blog you may enjoy reading some of our other blogs here.