It could be so that you already have a will, but when last was it revised? It is critical to update it regularly, especially after a significant life event such as a birth, death, marriage,divorce, or any major asset purchases.

Furthermore, who have you entrusted with the power of fulfilling your last wishes? The administration of an estate can be as challenging as navigating a maze blindfolded. Therefore, it is important to appoint a trusted person, preferably a professional, to lead this process in ensuring that your property is divided according to your wishes and settling any outstanding debts.

If you need assistance with the drafting of a customised will, codicil, or living will, please get in touch with our team here.

The post Do you have a will? appeared first on Creative CFO.

Business advisory firm Creative CFO has recently launched Creative Growth Capital, its very own investment vehicle to meet the high demand for flexible funding solutions that are better geared toward SME business models. Creative CFO has coupled its longstanding expertise in working with SMEs with making flexible investment capital available to SMEs to unlock sustainable growth opportunities and consequently create a positive and measurable impact in more communities in South Africa.

Creative Growth Capital will offer growth capital to SMEs by way of tailored deal structures using an array of investment instruments including debt, equity and combinations of these instruments to craft bespoke deal terms for these businesses.

“SMEs are largely underserved by capital markets, specifically in emerging market territories. Traditional financiers lack the flexibility and risk appetite to provide the right type of capital to support SMEs. SMEs are the backbone of the economy and their success should be prioritized to ensure a well-functioning local economy.” (Creative Growth Capital)

 

Anchored by an investment from one of the largest institutional investors in Africa, Creative Growth Capital has recently made a debt investment into an artisanal ice cream company based in Cape Town.  The loan will enable the business to grow its production capacity and expand its delivery and distribution channels to a broader network of customers, both important prerequisites for scale.

Recognizing that private investment is essential for small business growth and job creation, the USAID Southern Africa Regional Economic Growth Office has supported Creative CFO with the establishment of Creative Growth Capital. USAID’s support of these vehicles through its INVEST initiative reflects a growing consensus that private investment is critical to inclusive, sustainable development. In support of the shared commitment to invest for impact, all of Creative Growth Capital’s investments will embody targeted social development objectives, including but not limited to scaling women and minority-owned- businesses, expanding local business operations and supporting job creation. Creative Growth Capital, with USAID support, will continue to fund SME growth within the region, bridging the demand gap between small and medium-sized enterprises and affordable, flexible financing.

“Creative Growth Capital aims to uplift entrepreneurs and support businesses that make a real contribution to society by creating jobs, up-skilling their employees, and fostering a thriving and inclusive SME ecosystem. We view investing in SMEs as being the most-impactful mechanism with which we can improve the livelihoods of others and inspire the greatest change in our country and eventually abroad.” (Creative Growth Capital)

 

About Creative CFO

Creative Growth Capital is part of  Creative CFO , an international business advisory firm that, over the past nine years, has been advancing its vision to create a world where more SMEs succeed.

The post Creative CFO Launches New Investment Vehicle to Back High-Growth Small and Medium-Sized Business in South Africa appeared first on Creative CFO.

We recently performed a valuation exercise for a client who intends to swap shares in a successful South African application software company for those of a similar company in the Netherlands. While these companies operate in the same industry, we found the comparative valuations to be vastly different.

The 3 factors that had the greatest impact on the valuation – the ” triple edge sword” –  were the valuation multiples, the cost of debt, and the cost of equity.

Valuation Multiples

When we perform valuations, we use search parameters to screen hundreds of companies within a comparable industry and/or geographic region. Through this process, we derive a range of companies deemed comparable to our subject. Without regard to a specific industry, we found that the median EV/EBITDA multiple (i.e. the value of a company over its earnings) of selected listed companies in the Netherlands was just under 12x, whereas in South Africa, the multiple was just over 6x. Assuming that our South African and Netherlands companies achieve the same currency-adjusted EBITDA, our South African company takes a valuation hit of about 50% before we even consider the cost of capital for the business.

A report compiled by the CAIA Association echoes our findings, stating that EBITDA multiples in Europe during 2020 approached 12.6x, while in Africa, multiples were between 4x and 8x.

Cost of Debt

The CAIA Association also alludes to the second edge of the sword –the cost of debt – suggesting that higher valuations are likely a result of prolonged quantitative easing and low-interest rates in developed countries. Access to debt at low-interest rates benefits a business from a valuation perspective, as the weighted average cost of capital (“ WACC” ) used to discount the company’s cash flows is lower (lower discount = higher value). The OECD reports that SMEs in the Netherlands have access to debt at an interest rate of 3.3% per annum, whereas we know from experience that an SME in South Africa will be lucky to service debt at less than 15% per annum. In our example below, if both companies were financed entirely by debt, a South African company would achieve a valuation of about 30% lower than a Netherlands comparable.

Cost of Equity

The third edge of the sword and the second component of WACC –the cost of equity – is essentially sharpened by the stark contrasts in the economic climate between Europe and South Africa. Using the capital asset pricing model (“ CAPM ”) to derive a cost of equity, our starting point is the “risk-free rate”. As mentioned, developed countries have benefited from a period of quantitative easing which sees the yield on 10-year government bonds (a proxy for the risk-free rate) in the Netherlands at 1.4% at the time of writing, versus a yield of just over 10% in South Africa. This makes South African bonds an attractive investment but greatly elevates the cost of equity which is detrimental to a South African company’s valuation.

The other levers for the CAPM formula are the market risk premium and “beta”. The latter measures how a company reacts to systematic market risk and is generally lower in developed markets vs emerging markets. Put simply, this means companies in developed markets are less exposed to downturns in the market. The measure is highly dependent on industry and would not be considered a main component of the differences in valuations between European and South African companies. Market risk premiums, however, can increase the discount rate considerably. A South African equity risk premium is circa 7%, versus circa 4% in the Netherlands, based on research done by Prof. Damodaran of NYU Stern. Interestingly, the combined difference in risk-free rate and market risk premium results in a South African company achieving a valuation that is again 30% lower than the Netherlands comparable (again, assuming all else equal).

There are, of course, many other factors to consider when performing a valuation; however, based on these 3 simple metrics alone, it is clear to see why South African business owners look outside of the country to unlock greater value for their companies.

References

CAIA Association. (2021). African Private Equity Returns, Risk and Potential in a Global Context – Part I | Portfolio for the Future . [online] Available at: https://caia.org/blog/2021/11/23/african-private-equity-returns-risk-and-potential-global-context-part-i   [Accessed 19 Aug. 2022].

OECDiLibrary. (n.d.). Financing SMEs and Entrepreneurs: An OECD Scoreboard (The Netherlands) . [online] Available at: https://www.oecd-ilibrary.org/sites/d339ecf2-en/index.html?itemId=/content/component/d339ecf2-en   [Accessed 19 Aug. 2022].

Tradingeconomics.com. (2022). South Africa Government Bond 10Y . [online] Available at: https://tradingeconomics.com/south-africa/government-bond-yield [Accessed 19 Aug. 2022].

Tradingeconomics.com. (2022). Netherlands Government Bond 10Y . [online] Available at: https://tradingeconomics.com/netherlands/government-bond-yield [Accessed 19 Aug. 2022].

Damodaran, A. (2021). Country Default Spreads and Risk Premiums . [online] Nyu.edu. Available at: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html . [Accessed 19 Aug. 2022].

The post European vs South African Valuations – A Triple Edged Sword appeared first on Creative CFO.

Like launching a rocket into space, a business needs a thought-out and refined plan to have any hope of lifting off. A key step in assessing the viability of a business plan is forecasting what could be achieved, taking into account as many factors as possible. Such factors include expected sales, customer types, product and service pricing, human resources, capital expenditure, and financing requirements.

How do we consider this plethora of factors effectively, you may ask? Enter the Financial Model.  A Financial Model, as the name suggests, seeks to model the potential performance of a business by combining relevant inputs and assumptions into a financial forecast. A Financial Model can be used as a budgeting tool, to stress-test different scenarios, to calculate the financial impact of a new project, to allocate corporate resources, and to determine the value of a company.

The first step in developing an effective Financial Model is to apprehend the environment in which a business operates and to identify inputs that will impact its performance. At Creative CFO, we have prepared Financial Models for companies like Wingu Academy, BancX, and Automata;  all three of which are exciting, high-growth companies, but operate in significantly different business environments.

For Wingu Academy , the inputs we considered include student enrolment numbers, subjects and classes per student, books per student, and the number of classes a teacher can manage. For BancX , we factored in banking certification costs, volumes of accounts and cards, interchange fees, interest rates, and platform fees. For Automata we needed to consider the manufacturing process for robots, including production capacity, supplier terms, shipping policies, customer warranties, and commission structures for their sales team. Because no two businesses are the same, the specific inputs to every Financial Model are unique.

Once the inputs for the Financial Model are determined, the second step is to consider how these inputs may change over time or how they may be influenced by different scenarios. Again, the way this step plays out is dependent on the specific business. For Wingu Academy , the scenarios we considered hinged on the number of enrolled students, for BancX the scenarios were driven by the number and type of customers that were onboarded, and for Automata the scenarios were driven by considering business performance for different levels of demand and stress-testing whether production could keep up with each scenario.

We develop a “low road”, or worst-case, scenario based on the premise that things don’t quite go according to plan (e.g. low student intake, low volume of accounts, or inefficient manufacturing processes). This gives the business owner an indication of the risk involved in embarking on the business journey. On the other end of the scale, we build out a “high road” scenario that portrays to business owners and investors the results that the company has the potential to achieve. Somewhere between these two extremes is the “middle road” scenario where we use more conservative estimates and assumptions for each of the required inputs. An effective Financial Model allows the user to toggle between every scenario with the click of a button.

Finally, we need to arrange the inputs into a format that allows business owners and investors to easily observe and evaluate the financial performance of a company over time. The format is known as the 3-Statement Model. It is a combination of an Income Statement, Balance Sheet, and Statement of Cash Flows. These three statements are presented on one page, allowing the user of the model to observe how income and expenses generate assets and liabilities and translate into cash for the business. The final line of the 3-Statement Model is typically Free Cash Flow to Equity (“FCFE”) – this figure is the cash that can be distributed to the shareholders of the company as dividends after all expenses, reinvestments, and debt repayments are taken care of. FCFE can also be altered into Free Cash Flow to the Firm (“FCFF”) by adjusting for debt. FCFF represents the cash flows available to both shareholders and lenders. Both of these figures are vital metrics that investors use to arrive at a Business Valuation.

A Financial Model is an essential step in making sure your business doesn’t get stuck on the launch pad. Get in touch with our investment team to ensure your business is ready for lift-off.

The post Financial Modelling for Business Lift Off appeared first on Creative CFO.

As anyone in the professional world will be able to attest, the pandemic has fundamentally changed the environment in which we do business. This, in turn, has altered our investment decisions and the necessary checks and audits that need to be performed.

What is Financial Due Diligence

Due diligence is something that companies normally perform in order to avoid committing an offense and to ensure that they are operating within the boundaries of the law.

Similarly, financial due diligence (FDD) is the term used to describe an inquiry or investigation into a potential investment to confirm the facts that could significantly influence investment decision-making. The purpose of this could be for a merger or acquisition, issuing new shares, or any other transaction where risk is relevant and necessary to make a decision using reasonable care.

An FDD is commonly misunderstood as an audit. The key difference between them is that an audit looks back, while an FDD looks both backwards and forwards, to uncover vulnerabilities and opportunities, and to reveal a realistic future for the company.

The primary purpose of an FDD is an assessment of the financial health of a business.

What do we mean by “Financial Health”?

Financial health can be summarised in four main internal areas of a business:

• Liquidity is the cash on hand that can be used by the business today.
• Solvency compares the assets of a business to its liabilities to measure whether a company can meet its long-term financial obligations.
• Profitability measures profit against revenue and costs, to give a broad overview of a business’s current financial position and viability. The gross profit, net profit and EBITDA margins are good indicators for understanding and strengthening profitability.
• Operating efficiency measures operating costs against sales to show how profitably a business is serving its customers.

These four aspects taken together make up the overall health of the business, and they can be used as a measure of present performance and future success.

Why perform an FDD?

FDD’s are very useful, especially where investment transactions are concerned. For starters, investment transactions that undergo a due diligence process offer higher chances of success.

Due diligence contributes to making informed decisions by enhancing the quality of information available and identifying all material risks. Such risks will need to be managed should the acquirer proceed with the transaction.

The risks may also be used as negotiating power for the acquirer in determining the value at which the transaction takes place. Alternatively, if the risk is outside of the acquirer’s appetite, the process might result in an unsuccessful transaction.

A systematic process helps to ensure that buyers and sellers are on the same page. This helps to prevent any entity from unnecessary harm to either party throughout a transaction.

FDD’s Post-Covid shift

With market stability returning in what we are tentatively calling the ‘post-Covid era’, FDD’s focus has changed and there are new factors to consider in a business environment that is fundamentally different.

An FDD looks both backwards and forwards, and it is therefore useful for envisioning a realistic future for a particular company. FDDs will now need to assess how businesses responded to the pandemic and how they may have carried on differently. Investors may specifically consider new post-pandemic liabilities. Identifying a company’s ‘new normal’ – in other words, the way that it does business now and in the future – may be necessary.

Furthermore, we expect there to be a focus on areas such as supply chain risk, health and safety, financing arrangements and cybersecurity, given the accelerated digitisation in many sectors of the economy. A business’s digital capabilities will be of utmost importance.

Also, going forward, force majeure clauses in fundamental legal agreements will be relevant especially with the possibility of future waves of the pandemic.

In the current environment, we are seeing an increase in ‘quasi-distressed’ deals coming to the market which is where companies are needing to dispose of assets to support their core business post-pandemic.

While Covid-19 hasn’t changed the overall purpose of an FDD, it is important to assess the impact that the virus has had on the FDD process. It would be difficult to find even one company that has not been affected by the pandemic in some way, so it is only natural that financial and professional advice is needed now, more than ever.

If you think you might need professional assistance in assessing the risks of a potential investment transaction, contact Creative CFO for FDD support.

References

Arnoldi, M. (n.d.).   Pandemic has influenced due diligence priorities for M&A activity, says law firm. [online] www.engineeringnews.co.za. Available at: https://www.engineeringnews.co.za/article/pandemic-has-influenced-due-diligence-priorities-for-ma-activity-says-law-firm-2020-09-14/rep_id:4136

International, B. (n.d.).   Post-COVID Due Diligence. [online] blog.benchmarkcorporate.com. Available at: https://blog.benchmarkcorporate.com/post-covid-due-diligence

https://www.nortonrosefulbright.com/en-za/knowledge/publications/2021/q1. (n.d.).   Due diligence in the time of COVID. [online] Available at: https://www.nortonrosefulbright.com/en za/knowledge/publications/ce966575/due-diligence-in-the-time-of-covid

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We weren’t always using rands and dollars. Money, just like technology, language and life itself, evolves. In fact, the most recent form of money, fiat, will only be 50 years old in 2021. More on this topic in a moment.

The traits of sound money 

Examples of primitive forms of money are numerous: shells, salt, glass beads, cattle, rare stones etc. These early forms of money were by no means perfect and lacked several of the characteristics of sound money as outlined below:

The hardness of money is its resistance to unpredictable supply increases and debasements of value. Fungibility requires that units are interchangeable and indistinguishable from one another. Portability is the ease with which monetary units can be transported and transmitted across distances. Durability entails the resistance of monetary units to rot, corrosion or deterioration of value. Divisibility is the ease at which monetary units can be subdivided or grouped. Security is the resistance to counterfeiting or forgery.

Of the traits listed above, hardness is the most essential. Historically, only truly scarce and hard-to-acquire items could function as a reliable form of money – scarcity was the critical element. This scarcity could be unlocked by expending tremendous amounts of human time and energy. In other words, it was a challenging process to come into the possession of this scarce item. The harder it is to create this money by expending time and energy, the harder the actual money is. That is why humanity eventually settled globally on gold as the superior form of money: it had an annual inflation rate that was closest to zero and satisfied the majority of the critical traits of money. Eventually, even silver was demonetised in most parts of the world as the supply could more easily be inflated by expending more energy. With gold, this was the hardest to do.

Money hacking and the birth of inflation

Terrible human tragedies have occurred in the past where different groups of people came into contact with others using relatively “softer” forms of money. Inevitably, one group’s money could easily be “hacked” by the technologically superior group.

For example, when Portuguese and other European traders came into contact with West Africans exchanging tiny glass beads on the Gold Coast, known as aggry beads, they realised that the West African people had no interest in their foreign money. The Portuguese, however, had access to Venetian glass-making technology which was lightyears ahead of the West Africans at the time. These traders went back to Europe, accumulated many cheap glass beads, and flooded the Gold Coast’s “scarce” money with cheap money. The aggry bead had been hacked. The Portuguese proceeded to trade everything of actual value – food, clothing, cattle, land and so on – for worthless glass beads. It was time and value theft on a monumental scale. The scarcity of West African money was corrupted, and a world of value was confiscated.

There are various other examples of this type of “money hack” occurring throughout history. Another interesting example of this happened on the island of Yap in Micronesia, where the Yapese’s precious Rai Stones could be quickly and cheaply created by an Irish-American captain and his crew who got shipwrecked on the shores of Yap.

–  Rai Stones on the Island of Yap

Today, this same surreptitious form of theft is happening on a global scale that dwarfs these historical scenarios. The mechanism that makes this possible is commonly referred to as inflation, whereby more money is created and injected into the economy, supposedly to stimulate spending and economic growth.

Inflation is taxation without representation – everyone who holds cash pays this tax – but since it’s not a direct payment, nobody notices or realises that their hard-earned value is slowly melting away. Historically, the rate of devaluation has been too gradual for us to feel the diminishing value and purchasing power of our money (much like the proverbial frogs in boiling water). Still, there is reason to believe that this is about to become increasingly evident in the years to come.

What happened in 1971?

The reason that we’ve been able to uninhibitedly create money out of nothing for the past 50 years (as of 2021) is because of the following oft-forgotten moment in history:

In 1971, President Richard Nixon effectively abandoned the global gold standard. You can find the whole speech online, but here’s the crucial snippet for context:

“In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation’s currency is based on the strength of that nation’s economy — and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators. I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.”

– President Richard Nixon’s address to the nation, 15 August 1971.

Notice that word “temporarily”? Well, as it turned out, it was permanently. Thanks to the Bretton Woods Agreement, which was introduced after World War II, the dollar was backed by gold, and all other currencies were pegged to the dollar. Since Nixon suspended the convertibility of the dollar to gold, the tie to gold for the whole world was effectively broken. And so we entered into the age of fiat currency – the softest money we’ve ever had, controlled by governments and central banks (and by extension the wills and whims of those at the helm of these institutions).

Humanity’s money has changed and morphed throughout history based on relative scarcity and the technological capabilities of the time. Since our tie to gold was broken in 1971, money is no longer scarce. It is being created with no particular expenditure of time or energy at the discretion of global governments and central banks. It’s all heading in one direction, sharing the inevitable fate of all fiat currencies throughout history: hyperinflation and ultimately, worthlessness.

This form of money has profound implications on the state of society itself: rampant consumerism and short term preferences are a natural result of a form of money that incentivises immediate gratification (i.e. our collective time preference as society becomes higher and higher – we increasingly tend to neglect the longer-term consequences of our decisions in favour of the short-term).

Where do we go from here?

The global fiat monetary experiment celebrates its 50th birthday in August 2021. Perhaps we should rather consider it the 50th anniversary of the gold standard being hacked. This seems more apt (and less celebratory).

Here is the main problem with having a select group of people able to control something as powerful as money itself: the temptation to breach the trust of the masses and abuse this power for personal gain is too great to resist. As the old adage goes: “Power tends to corrupt and absolute power corrupts absolutely”.

In the next instalment of The Melting Ice Cube Series, we take a closer look at inflation from a numerical perspective and how seemingly small figures, compounded over time, melt the ice cube at an ever-increasing rate.

The post The Melting Ice Cube Series – Part 2: A Brief History of Money appeared first on Creative CFO.

In an office-based work environment, smart shoes are essential. However, as the recent pandemic has shifted meetings from board rooms to video calls the need for formal attire has become limited to clothing seen from the waist up. This, in turn, has caused the demand for comfortable shoes to climb through the roof, while the need for formal footwear, like stiletto heels, has dropped sharply – pun intended.

The German footwear brand, Birkenstock, was ready for this transition with their famously comfortable sandal. Birkenstocks are adored for their arch support and hipster appeal – hardly the purview of high-finance – but at least two private equity firms expressed an interest in buying the sandal manufacturer, which was valued at between € 4–4.5 billion*. L Catterton, the company behind fashion giant Louis Vuitton, finally won the bid, purchasing Birkenstock in February 2021**.

The purpose of a Business Valuation

While most can only dream of selling their business for that amount of money, it is important to know how one goes about valuing a business, no matter what the size. A valuation may be required for periodic reporting (i.e. feedback to investors), investment analysis, capital budgeting, raising capital, selling shares in the company, or selling the entire business, as is the case with Birkenstock.

Birkenstock is a well-established company (over 200 years old) and the valuation techniques used for this golden oldie are very different from what would have been used if the company was still in its infancy. Aligned with our vision at Creative CFO to create a world where more SMEs succeed, we will focus on explaining the valuation techniques that would be helpful for the “next Birkenstock”.

How do we value a business?

There are various methods of valuation that are acceptable in terms of the International Private Equity and Venture Capital Valuation (IPEV), and using two or more is considered best practice for valuing a company. This allows for the business to be seen from different perspectives, resulting in a more comprehensive and reliable view.

The methods we often use to value companies in the start-up and growth phase include two Discounted Cash Flow (DCF) methods, the Venture Capital (VC) method, and two qualitative methods:  the Scorecard Method and the Checklist Method. The DCF methods, which we will be describing in this article, represent the most well-known approach to company valuation. These methods are recommended by academics and are also used as a daily tool for investment analysts.

The DCF methods: The go-to guys

The two DCF methods are “DCF with LTG” (Long Term Growth) and “DCF with multiple”. Using these methods we attempt to derive the value of the company today based on projections of how much cash a business will generate in the future. From a technical perspective, we derive the present value of the projected cash flows that the company is forecasted to generate each year in the future by discounting these cash flows by a market risk rate. In essence, this takes into account the time value of money and reduces the cash flow each year – acknowledging that R100 in a few years’ time isn’t worth as much as R100 today.

In South Africa more than 70% of SMEs fail within their first 5 years. This means that it is extremely important to weight projected cash flows by the probability of an SME’s survival. In determining an appropriate risk rate, we consider risks related to the specific industry that the company operates in, the company’s size, stage of development, and the company’s perceived profitability.

Long Term Growth or a Multiple?

Once we have modelled the cash flow over a specific period by constructing a financial forecast , we need to assign a Terminal Value (TV) to the business. The TV represents potential future cash flow, beyond the projections we determined through the financial forecast.

To calculate the TV we use one of two DCF methods: DCF with LTG or DCF with multiple. DCF with LTG assumes cash flows will grow at a constant rate beyond our forecast, while DCF with multiple assumes the TV is the exit value (the price the investor receives upon sale) of the company which is computed by incorporating an industry-based multiple of EBITDA. The multiple is derived by taking into account the EBITDA average of recently acquired companies compared to their value (e.g. if Company X was sold for R10 million but has a TV of R800,000, the applied multiple would be 12.5).

Once we have calculated the projected cash flows and the TV of a specific business we apply an illiquidity discount to complete the valuation. Illiquidity (the opposite of liquidity) refers to how difficult it is to convert an asset into cash. The illiquidity discount is therefore built in to acknowledge that selling an SME (liquidating) is not as easy as selling a large, well-established company like Birkenstock.

The illiquidity discount essentially means that a big, Birkenstock-type company will be more expensive than a small anonymous one. Therefore there will be a more substantial discount for the buyer of the small company because it would be harder to exit (sell).

Using more than one method

Aligned with best practice, we use the other three methods mentioned above to derive a weighted average of the valuations. This leads us to our final valuation – how much we think the company is worth. The weights of each method are applied according to the stage of the business (i.e. idea stage, development stage, start-up stage, and growth stage). The DCF methods make up the majority of the weight once the company is in the start-up stage and beyond.

A Business Valuation requires consideration of a plethora of different factors and can be tricky to get right, especially for a company in the early stages of operations. Knowing the value of a concept or a business model is vital to upscaling into a world-class company.

At Creative CFO we love to see the SMEs of this world become the Birkenstocks. Get in touch and let us help you out with the first step.

References

*Birkenstock sold to LVMH-backed group in €4bn deal. The Financial Times. 26 Feb 2021. https://www.ft.com/content/5d511022-46db-403e-9784-eb3807f918f9

**Bain, Marc. The company behind Louis Vuitton is now backing Birkenstock. Quartz. 26 Feb 2021. https://qz.com/1977953/birkenstock-has-been-bought-by-a-lvmh-backed-private-equity-fund/

The post Birkenstock’s Billions: Getting Comfortable with Business Valuations appeared first on Creative CFO.

The moral of the story is that we do not always understand the fundamental nature of things that surround us every day. Just as the younger fish did not have any concept of water, many people today do not fully appreciate the nature of that thing that is so ubiquitous to us humans – money.

Here, at the dawn of a new decade, humankind faces a predicament when it comes to money:cash, the simplest form of money, is losing value faster than ever before. This will affect businesses and individuals alike, especially if we are unaware of the fact that it is happening.This series of blog posts attempts to uncover the ways in which businesses can mitigate the effects of the rapidly declining purchasing power of cash.

Cash: a melting ice cube

Money is a technology. It has evolved over millennia to facilitate exchanges of value between people, and to store that value over long periods of time to be used as and when the holder of that money sees fit. We’ve seen various iterations and manifestations of money over the years: shells, precious stones, glass beads, gold, and, most recently, government-issued “fiat” currency.

Fiat currency is not backed by a physical commodity but relies on a shared faith in the power it holds. Being disconnected from a commodity means that the purchasing power of fiat currency can vary. Inflation results in the purchasing power of fiat currency dropping, and this means that you get less bang for your buck.

Many people are surprised when they learn that the world’s currencies are no longer backed by gold reserves. This is why, since the outbreak of Covid-19, central banks the world over have been able to stimulate the economy by creating new cash and injecting it into the economy. The Federal Reserve in the United States has created around $9 trillion since March 2020. To give you an appreciation for the scale of that injection, approximately 20% of all dollars that have ever existed were created last year.

This is shocking, and it has a direct impact on every person and business holding cash. This is because the purchasing power of cash, in real terms, is being diminished at an alarming rate. Cash has steadily lost purchasing power to inflation over the last 50 years, and the rate of loss is now increasing more and more rapidly. Michael Saylor, founder and CEO of MicroStrategy, has dubbed this a “melting ice cube”.

The decline in purchasing power of the US dollar between 1913 and 2019.

Creating a buffer

If your business holds significant amounts of cash on its balance sheet, you may need to consider creating a buffer against incoming inflation to prevent erosion of the value that your business has already created.Monetary inflation and “quantitative easing” by central banks is a surreptitious force which steals time and value from businesses and citizens alike by inflating away the purchasing power of the cash that they hold. This may have sounded like a conspiracy theory ten years ago, but now it is becoming a fact that most economists and “finance people” agree on.

The question arises of what to do about this precarious situation. Clearly, we must take some form of defensive action against the approaching inflationary storm. Ignoring these economic realities in the hope that it sorts itself out is not a proactive strategy. In fact, it is no strategy at all. First, we must be aware of the underlying problem. Then we must formulate a solution.

A business needs cash on hand to move quickly, and to be flexible and responsive on short notice to changes in the external environment. The cash a business holds on its balance sheet is like an internally generated insurance policy to deal with unforeseen circumstances in the short term.

Varying degrees of accessibility

Now, this “insurance policy” need not be held 100% in the form of cash in the bank. It can be broken up into tranches of various degrees of liquidity and accessibility, depending on the needs of the business.

For example, if a business holds three months’ worth of operational expense cover in cash, it can be held in different forms, ranging in short-term accessibility. The table below shows an example of this type of diversification.

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Just as you would check your car’s dashboard while you drive, so you should also keep an eye on your KPIs as a business.

“Key Performance Indicators indicate how well your business is performing in key areas.” 

Although KPIs are not compulsory, they should be included in a management report pack where they can be regularly viewed and, where necessary, investigated.

Designing your KPIs

When designing a set of KPIs for your business, you should ask the question: “What information do we need to make decisions based on the core operations of the business?”

This enquiry should be your point of departure and the KPIs will naturally emerge from the answers to this question. Answering this question will also help you to crystallise a deep yet simple understanding of the nature of the business.

Less is more

There is always the temptation to overcomplicate the KPI creation process. This often leads to a myriad of vague KPIs across the board, most of which will be of little use in making mission-critical decisions. Moreover, a weak set of KPIs will inevitably dilute crucial insights. We should guard against this over-the-top approach. KPIs are, after all,  key  performance indicators.

To return to the vehicle analogy, the dashboard shows you only the most important readings for your car. A cluttered dashboard is distracting and essentially useless because the crucial indicator should be evident at a glance. The same applies to KPIs for your business.

In order to whittle down the various indicators, we need to align our priorities and focus on the few measures that are truly indicative of the performance of the business. The idea is to be able to answer this question at all times: “Are we winning or are we losing?”.

“We need to align our priorities and focus on the few measures that are truly indicative of the performance of the business.”

Keeping score

Behavioural psychologists have proven that people play a game very differently when scores are being kept. In this sense, KPIs can be used as the scoreboard within an organisations’ incentive structure to motivate the team to play harder and assume more ownership of their deliverables and responsibilities. Everybody wins, and when they know they are winning, that is good for the whole business.

“KPIs can be used as the scoreboard within an organisations’ incentive structure to motivate the team.”

When designed correctly, these incentive structures can lead to positive feedback loops within the organisation. This has the potential to unleash greater human ingenuity, which is arguably one of the most valuable commodities in any organisation.

Lead, don’t lag

In their book   The Four Disciplines of Execution  Sean Covey and his team make a distinction of particular relevance to KPIs: the idea of lead and lag measures.

Lag measures  are reported after the fact. They typically shed light on what has already happened. Little attention is paid to the causal factors of this historical data. By contrast,  lead measures  are predictive and future-orientated. So while lag indicators look backwards, through the rear-view mirror, lead indicators look forward to the road ahead. In essence, lead measures are proactive, taking initiative for the future journey.

“Lag measures are reported after the fact; lead measures are predictive and future-orientated.”

Let’s use the vehicle analogy as an example. Our lag measure is revealed when we do a roadworthy test. Let’s say the car failed the roadworthy because the tyres are slick and one brake light is broken. The lead measures in this example are regular service check-ups on the car, to ensure that broken lights get fixed and tyres are in good order. When we concentrate on lead measures (regular car services), we can be more confident about the lag measure of “roadworthiness”, and that our vehicle will pass the test.

To put it simply, attaining lead measure targets invariably leads to the attainment of lag measures. This is far better than looking at a lag measure of, for example, revenue growth at the end of each month, and hoping that it will look better next month. Instead, we should be focused on lead measures, for example, reducing machine downtime through routine preventative maintenance. We predominantly want to make use of lead measures because this puts us in control.

Qualitative and quantitative indicators

Not all KPIs need to be finance-orientated. In fact, it’s a good idea to have a blend of both quantitative (hard numbers) and qualitative (softer and more subjective, but still measurable) indicators.

Quantitative indicators  will zoom in on things like revenue growth, machine downtime and physical output.  Qualitative indicators  bring awareness to the more subjective and ethereal dimensions of the business. This includes customer and employee satisfaction and motivation levels, the success of training programs and awareness campaigns, as well as other elements which are harder to quantify in absolute terms. Although they are slightly more difficult to measure, however, we should not neglect them.

“Quantitative indicators focus on things like revenue growth and physical output, while qualitative indicators bring awareness to things like customer and employee satisfaction and motivation levels.”

There are significant lead measures to be uncovered on the qualitative side of the KPI dashboard. Take the time to figure out how best to collect the data to gain these insights. As an example, Creative CFO uses OfficeVibe to gauge the morale of its team anonymously. It is a great way to keep tabs on the more subjective side of running a business, which can be just as illuminating as the hard data.

Final thoughts

When identifying a business’ KPIs, what are the key takeaways?

1. Keep it simple. When designing your KPIs, distil them down as much as possible to gain only the most essential and illuminating insights.
2. Are we winning or losing? Ask this question of every KPI.
3. Lead, don’t lag. Concentrate on being proactive and focus on lead measures that will invariably help you achieve your lag measure targets.
4. Blend qualitative and quantitative indicators. Don’t focus exclusively on hard statistics, but look at the affective aspects of your business performance too.

Ultimately, every set of KPIs will be as unique as the business that designs them. They should be tailored to reflect the key drivers of value, as well as the best way to interpret these. The process of building out a business’ KPI dashboard should take time and careful reflection, which can be seen as an exercise in setting priorities.

Business owners have often been impressed by the clarity and decision-making capabilities that emerge from this exercise. Moreover, the exercise empowers business owners to initiate effective action to take their organisation from strength to strength.

No matter the size of your organisation, there will be those few key indicators of unparalleled importance. Identify them, track them, refine them, and let them lead your decisions.

If you require some assistance in this process, please reach out to us. We would be happy to cast a KP-eye over things.

Happy reflecting!

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