In its most basic term, success means to achieve ones goal. So to achieve success, there has to be goals. In this article, I will be discussing financial success from a business owner’s point of view.
Most business owners I see define success by the amount of revenue they bring in. It feels good to say I bring in over a million dollars in revenue. However, I have seen business owners who bring in over a million in revenue but are laden with debt. So we can see revenue alone, does not define success. If you cannot live the life you envision, no amount of money can make you successful.
So if revenue does not define financial success what does?
What does business success look like? I think most business owners will agree with me that being successful in your business falls into 2 main categories namely:
- Accomplishing personal goals
- Meeting financial goals
However, personal goals are often ignored as most entrepreneurs strive to achieve financial goals. Why should one be in exclusion of the other? Entrepreneurs need to learn that a business exists to meet your goals
and not the other way around. Being married to your business is not useful to you in the short or long run. In the short run it causes excessive stress and in the long run it makes your business unsellable. The more you strive for revenue, the more profits run away from you.
Even more stress – striving for financial goals.
Maybe as an entrepreneur you skimmed on a few personal goals. The consequences will not be as bad if the entrepreneur did not also mess things up financially. A lot of entrepreneurs I meet are not very smart in financial matters. Most have an income goal but never even think of having a net worth goal. As an entrepreneur, how do you define value in your business?
Business value is defined by how much a willing party is willing to pay to acquire your business. The more an acquirer is willing to pay, the more value your business has. If no one is willing to pay anything for your business then you really need to rethink your strategies because you are running a worthless business
regardless of how much income you bring in. What you have created for yourself is a job and not a business.
The amount an acquirer is willing to pay is a function of risk. One way to evaluate the value of a business (what an acquirer is willing to pay) is:
Business Value = Present Value of Cash Flows, discounted back at the discount rate.
The discount rate has 2 elements – the cost of capital element and risk element. The discount rate is increased if potential buyers believe your business is risky. The cost of capital – is the rate that you must pay to obtain funding from lenders or equity investors. In other words, if the cash flows to the firm are held constant, and the cost of capital and risks are minimized, the value of the firm will be maximized. By minimizing risks, you maximize the value of your business. Simultaneously, the higher risk, the higher your cost of capital. Your first task as an entrepreneur is to de-risk your business so business value can be maximized. There are several ways to do this but that is not the focus of this article.
Re-evaluating debt financing: Using debt to increase business value
Every day you make decisions that affects the value of your company. One of those decisions is choosing to finance your growth with debt. While I do not encourage personal debt, business debt can actually be a good thing if used wisely. Business assets are either built from equity or debt. If you can use debt to increase assets, then it is better for the business.
So, when is it good to take on new debt?
For debt to affect value, there has to be a tangible benefit. There are 3 scenarios you should consider:
- Benefits exceed costs – when benefits exceed cost, the returns on the investment exceed the cost of the investment. When this is the case, the business owner will have an increase in income which causes an increase in equity, assets and value. For example, a retailer borrows $80,000 from a line of credit to buy inventory, the interest rate on that inventory is 6% per annum. The retailer knows they can sell the inventory within a month and pay the amount borrowed plus interest with no problem and still have $70,000 left after both principal and interest payment. In this case the retailer pays $400 to make $70,000. I see no reason why the retailer should not go for this. When benefits exceeds costs, there will be an increase in value.
- Benefit and cost are equal – when benefits exactly equals the cost of investment, then business value is not affected. In scenarios like this you should have other compelling reasons to take on the investment.
- Benefits are less than the cost: If the benefits are less than the costs, increasing debt will lower value. In this case, debt becomes a value destroyer.
Your optimal debt to equity ratio, is the one that maximizes your overall business value.
Summary
Eighty percent of businesses today are worthless.
To have value a business owner must manage risks effectively. Value is a function of risks. Everything you do that mitigates risks enhances value. Moreover, a business owner must be able to create value above the businesses’ required rate of return/ discount rate. Any investments executed below the required rate of return should be rejected because this will destroy value.
Build a good foundation before growth. Growth in itself does not necessarily generate value. Slow down
and form a solid foundation. Every business should have a rhythm which drives up value. Remember, business success is not achieved until you can live life like you envision it. The way to do this is to focus on creating value rather than simple income goals. You are in control of your business, you should use your business to get what you want from life and not the other way around.
Take some time to reflect on the following questions before doing anything else:
- Who do you want to be?
- What do you value most?
- What kind of life do you want?
These are the values that will direct your business and determine your definition of success ….