Checkers or Chess?

Thoughts from Midas Manager by Rob Slee

Every so often the rules of business change. In the past two hundred years this occurred several times. First, the Industrial Revolution in the early Nineteenth century ushered in the Machine Age. John Henry may have beaten the mechanical spike-driver in lore, but machines have dominated in every other way for more than 150 years. Then came the Information Age. This era started in the 1950s, and reached a climax with the rise of the Internet in the 1990s. Computers changed the way we work, mainly enabling routine tasks to be performed at ever lower costs. During this Age, knowledge workers manipulated information in highly analytical ways. Now we have entered the Conceptual Age.

 

The Conceptual Age marks the intersection of globalization, logistics, and advanced technology. This Age is defined by multi-dimensional thinking. In other words, business owners must think their way to success. This contrasts greatly with the previous two Ages, where the ability to work with machines was the critical skill set.

 

There are various ways to describe the behavior required for creating wealth in the Conceptual Age. Perhaps the most important skills center on the human mind - or more precisely, on the two hemispheres of the brain. The Information Age worked the left side of our minds; whereas, the current Age relies on the right side of our brain.

 

Dan Pink, author of A Whole New Mind, explains that we do heavy analytical lifting using our left hemisphere; whereas, our creativity emanates from the right hemisphere. While left brain capabilities powered the Information Age, they are still necessary but no longer sufficient in the Conceptual Age. The skill sets required going forward are based on design, market knowledge, empathy and story. In other words, our ability to be "artsy" will in large part determine success. In a world where the major resources are available to everyone, it is the ability to conceive of doing more with less that separates winners from losers.

 

Most current Midas managers are right brain driven. They also understand how to use their brains to play the game.

The Game of Business

 

Rockefeller said that all business is a game: whoever knows and plays by the rules the best wins. The rules have definitely changed in the Conceptual Age. Perhaps the proper analogy is that business managers were playing checkers in the Computer Age, but now they are required to master chess.

 

Although checkers and chess could be played on the same board, the games could not be more different. Checkers is a fairly simple game, with straightforward, diagonal piece movements. Chess, by comparison, is fairly complicated to play, as each piece moves in different ways. Chess is a tactical game, in that the next move is reactive and one dimensional. Chess, on the other hand, requires strategic thinking, since it demands collaboration between pieces that move multi-dimensionally.

 

Which Game Are You Playing?
Checkers	Chess
Left brain activity	Right brain activity
Tactical approach required	Strategic approach required
Solo mentality	Collaborative mentality
Minimal player movements	Complex player movements
Goal is to wipe out competitor	Goal is to kill the King

 

Checkers, then, is a left brain game; while chess is a right brain endeavor. Only a small percentage of managers know how to play chess, or how to think about business strategically.

 

The Strategy Thing

Most business owners are vision-rich, but strategy-poor. Strategy, as Michael Porter explains, is a race to an ideal position. Sound strategies enable managers to meet their vision or goals. Most private business owners are not strategic toward their business. Rather, they are tactical. Tactics are the activities that support the strategy. Tactical activities represent the operating decisions that move the ball up the field. Perhaps an example will help.

 

Jack Ripley, a Midas manager who is described later in the book, desired to own a company that produced earnings of more than 25% on sales, while reducing the risk normally associated with owning a small company. As a self-professed niche-aholic, Jack chose a niche strategy to meet his goals. Jack created a novel way to illustrate his niche-centric approach. He likened it to niche branches hanging from an intellectual capital (know how) tree. His ultimate goal was to establish at least five niches, with one or two additional branches constantly under development. Jack was a realist, so he figured that even the best niche would eventually be noticed and attacked by the competition. Thus, he needed to constantly be on the lookout to convert business opportunities into niches. By implementing this strategy, Jack built a company that earned several million dollars on about $9 million in sales. Ownership risk was reduced since his company was not vulnerable to a broad-based attack.

 

Jack's goal was to create a company with a risk/return imbalance, such that he could create large returns with a minimum of risk. He employed a niche-based strategy to meet his goal. He used a variety of tactics to successfully implement the strategy. Tactics included installing financial systems that enabled product line profitability analysis; acquisition of branded products; and cooperating with competitors, in order to play to everyone's strength.

 

The New Rules of wealth creation described in Chapter 1 have caused a change in how wealth creation must be considered. New strategies must be developed and deployed in order to create value. There are numerous strategies for each New Rule. For example, let's review New Rule #1 and associated strategies:

 

1. Every person working in or for a business must create wealth to remain employed.

 

Before wealth-creating strategies can be developed, we need to understand the broader implications of this rule. Implication 1: nearly all stakeholders are included: employees, vendors, consultants, and even the owner. According to Rule #1, all of these parties need to create value to remain employed. Implication 2: individuals, not institutions, are responsible for wealth creation. Each individual who works for a vendor, for instance, needs to create value for the vendor so the vendor's product or service is value-added to the customer. Implication 3: each stakeholder, especially the manager, must continuously increase their skill levels to compensate for increased competition.

 

Strategies can now be designed to maximize each of the implications noted above. For example, to achieve Implication 1, the manager might adopt a value creation awareness campaign such that all of the stakeholders understand that they must create value. A strategy aimed at Implication 2 might include launching a value creation program such as Lean Principles. Lean programs involve systematically identifying and eliminating waste within the value chain. Less waste means more efficiency, and usually an increase in value. Finally, there are continuous improvement programs, such as Six Sigma, that could help achieve Implication 3. Six Sigma is widely used by large companies as a tool to constantly improve results, especially as it relates to customer satisfaction. The key here is holistic thinking: to conquer each of the Rules, a manager probably needs to launch several strategies.

 

This book organizes wealth creating strategies into four types: Arbitrage, Business Models, Decision-Making, and Value Worlds. Each strategy type section of this book houses a number of "Midas strategy" story chapters. Midas strategies are told from the perspective of the Midas manager who is illustrated in the chapter. Each story chapter concludes with "Steps to Replicate." These Steps give managers a blueprint to implement the particular strategy. A premise of this book is that it may take a Midas manager to create a Midas strategy, but almost anyone can replicate it.

 

The following describes Midas strategy types.

 

Arbitrage

Arbitrage is my favorite word in the English language. French in origin, arbitrage translates into "riskless profit." This group of strategies refers to creating value by taking advantage of inter-market opportunities. Or, in other words, managers create an arbitraged return when they understand capital markets well-enough to discover and exploit a risk/return imbalance in one of the market segments. If properly implemented, arbitrage strategies enable a manager to receive a return greater than the underlying risk of the investment.

 

The principles underlying Arbitrage are introduced in Chapter 5.

Business Models

A business model represents the way a company organizes to meet a goal. The strategies in this section enable a manager to create wealth by implementing and leveraging a global business model. To compete globally, most companies need to rethink their business model. The way a company organizes to meet its goals is crucial Domestic business models - those that define their activities purely in domestic terms - are unlikely to create wealth. The Business Model chapters included in this book show how to implement a global business model.

 

The concepts underlying Business Models are discussed in Chapter 12.

 

Decision-Making

This group of strategies enables a manager to create wealth by making better financing and investment decisions. These decisions tend toward operational issues, such as whether value is created by hiring a key person, or by purchasing a machine or other asset. Some decision-making strategies involve the use of economic value analysis, which enables the implementer to decide if value is created before the investment is undertaken. Other strategies help get the most out of existing resources.

 

The concepts underlying Decision-Making are discussed in Chapter 18.

 

 Value Worlds

Value worlds are conceptual places where business value is measured and created. For instance, open market transactions occur in the world of market value. This group of strategies enables managers to create value by planning in one value world, and transacting in another. These strategies split in two: some offer substantial tax saving opportunities; some promise to grow the value of the business.

 

Value Worlds strategies are discussed beginning in Chapter 24.

 

Midas strategies are housed in a wealth matrix. This matrix organizes strategies by type and by variables that affect value. The schematic below depicts the matrix.

 

Wealth Matrix

 

Creating business value means employing strategies and tactics that increase the market value of the company in the future. Market value is the highest purchase price that the marketplace of investors will pay for the business. In a perfect world, carefully planned strategies lead to substantial increases in market value.

 

Market Value

 

All valuation is an attempt by an interested party to balance risk and return. Market valuation is focused on the behavior of the marketplace of investors. In the market value world, return is the benefit of owning the company; while risk is an estimation of the likelihood that the benefit will be achieved.

 

The benefit of ownership is usually stated as an income stream that the buyer expects to receive in the future. A typical income stream in the market value world is recast earnings before interest, taxes, depreciation and amortization (EBITDA). Recast items include adjustments for one-time expenses and various discretionary expenses of the seller. For instance, if an owner takes $1 million from the business in annual compensation, the portion of this expense that would not be incurred by the new owner would be added (recast) to the company's income. Earnings are measured before interest since market valuation assumes a debt-free basis. Recast EBITDA is stated on a pretax basis since the market value world typically does not consider the tax status of either party. Private companies often are non-tax paying flow-through entities, such as S corporations or limited liability companies. Since there are significant differences in individual tax rates, valuators cannot determine tax rates for various parties with certainty. A pretax orientation enables the parties to view the business on a similar basis.

 

As with the determination of the income stream, the risk of achieving the stream is specific to the buyer. Risk may also be viewed as the expected rate of return that investors in the private capital markets require in order to fund a particular investment. In the parlance of academia, risk converts an economic benefit stream to a present value. Thus, risk can be stated as a discount rate, capitalization rate, acquisition multiple or any other metric that converts the benefit stream to a present value.

 

The primary difficulty of estimating risk and return is that they change depending on the specific buyer. Each buyer views risk and return of an investment specific to their interests. This estimation occurs in the world of investment value, because every buyer's perception, and therefore price, is unique. Market value results when a group of investment values are obtained at roughly the same time.

 

Perhaps an example will help illustrate the market value concept. Suppose Mr. Mark Midas is owner of a fictitious company, MidasCo. Mr. Midas wishes to sell 100% of MidasCo, and hires investment banker Jim Dealmaker to conduct an auction that should yield the company's market value. MidasCo reports an EBITDA of $1 million, plus another $500,000 of various recast items. Thus, MidasCo has a recast EBITDA of $1.5 million. Dealmaker exposes the company to six different buyers, all of whom are competitors. Dealmaker has done his homework and finds that industry buyers typically pay '6' times recast EBITDA for companies like MidasCo. Can Dealmaker determine MidasCo's market value?

 

It seems obvious that MidasCo's market value is $9 million ($1.5 million recast EBITDA times 6 acquisition multiple). However, this probably understates MidasCo's value. First, the income stream of $1.5 million does not include all of the benefits that the buyers will enjoy in the future. This is because synergies typically exist between competitive companies. Synergy is defined as the increase in performance of the combined firm over what the two firms are already expected to accomplish as independent companies. For example, assume that MidasCo's distribution would be merged with the buyer's operation after the closing. This might result in savings of $1 million per year. The seller should enjoy some part of this $1 million in the form of an increased income stream. Assume that a buyer shares one-half of the savings with Ms. Midas, thereby increasing MidasCo's recast EBITDA to $2 million. Even if this buyer paid '6' times the income stream, the resulting in a purchase price of $12 million, some $3 million beyond the non-synergy valuation. Each buyer enjoys a different level of synergies with MidasCo; each also has a different appetite for sharing synergies.

 

Each buyer also views the risk of achieving the income stream differently. Some buyers would understand the nature of MidasCo's income stream better than others. For instance, a competitor in many of the same niches as MidasCo would view the income stream as less risky than a company with only passing knowledge of the customer base. Although the average acquisition multiple is '6' in this example, some buyers may view this as a less risky investment and offer '8' times or more. Let's assume that one buyer offers to share the $1 million in synergies equally, plus offers '8' times the $2 million income stream. This price is $16 million: a small fortune away from the obvious $9 million valuation determined at the outset.

 

Managers can therefore increase the market value of their companies, if they:

1. Increase return without increasing risk

2. Decrease risk of achieving the return

3. Increase the market position of the business

Nearly all of the strategies in subsequent chapters are designed to maximize these three positions.

 

Strategy types are offered only as organizing devices. The more important issues regarding wealth-creating strategies involve several insights that should be well-understood before proceeding to the strategy chapters. These are:

 

• Good strategies enable a manager to meet his or her financial goals. It is assumed in this book that two of these goals include creating substantial personal and business wealth. Some managers, such as family business owners, may choose not to take out substantial sums from the business each year or sell to an outside buyer. The strategies herein support wealth creation, even if it stays within the family.

 

• Good strategies are not enough to create wealth: they must be coupled with good tactical implementation. Tactics will be listed for each of the strategies offered herein. The manager charged with implementing a strategy will need to decide what, if any, outside professional support will be needed for a successful implementation.

 

• Managers should choose strategies that match their appetite for risk and return. Perhaps the best way to achieve this is by setting a wealth-creation goal. For instance, if a business is currently worth $3 million and the manager wants it to be worth $10 million in 5 years, certain strategies are more appropriate than others. The manager should use scenario-planning to determine which strategies will help meet his or her goals.

 

• Managers should prepare themselves for a good game of chess.

Successfully operating a business requires balancing on a three-legged stool. The three legs are market knowledge, operations, and finance. Most owners are comfortable with the first two activities, but not with the third. The next chapter covers the third leg.