A Hidden Valuation Gap

In business, we favor the concrete—and this numbers-bias can cause us to miss critical valuation factors.

Numbers make sense and benchmarks give us comfort. After all, the numbers don’t lie, so we labor to unearth the truth around cash flow, EBITDA, Quality of Earnings (QoE), SG&A, debt, etc. Every private equity firm invests in sophisticated tools and smart people to develop numbers-based valuations.

So, why do acquiring companies still get it wrong so frequently?

As with a prospective employee, we can get enamored with skills and miss the person. According to a 2022 Stanford Business study, 27% of search fund acquisitions analyzed resulted in equity losses. Of the 73% that resulted in gains, many only generated modest multiples on invested capital (MOIC).

The culprit often was not part of the number-set at all. The culprit was a gap in the valuation process.

The gap isn’t a lack of base due diligence (an assessment of market potential, client base, contracts, pipeline, production efficiency, marketing capabilities, and expense management). The gap comes from overlooking the company’s operating system.

An OS Checkup

The operating system is the integrated internal mechanism that consistently and effectively harmonizes the moving parts of a business and channels human energy. Without it, a business functions, but it doesn’t function with consistent excellence. Success comes either from raw power or dumb luck. Neither is sustainable.

So, how do we determine if a target company’s operating system is healthy? We need a structured means of assessment that answers the overarching question: Does this business’s M.O. foster smooth growth, or daily firefights and never-ending surprises?

One of the more popular operating systems (utilized by over 30,000 companies around the world) provides an excellent evaluation framework. It distills the most important operating elements into six fundamental aspects of every business: Vision, People, Data, Issue Resolution, Processes, and Traction.

Let’s walk through the framework and example questions that can help unearth the strength of a company’s operating system. In every case, depth, consistency, and clarity are paramount.

The 6 Operating Elements

1. Vision: Having clarity and alignment on where the company is going and how it’s going to get there.

Why vision alignment is important: Deviations on the vision of the company mean there are pieces of the organization pulling against each other. Over time, even small deviations in direction and priorities mean internal conflict, wasted resources, and missed opportunities.

Questions (These should be asked consistently across the leadership team):

• What are your core values and how are they utilized? (Hiring and employee management)
• What is your company’s purpose?
• What is your company’s focus?
• How are the purpose and focus utilized? (Filter distractions)
• How do your long-range, mid-range, annual, and quarterly objectives connect?

2. People: Jim Collins (Good to Great), coined the terms “Right People” and “Right Seats”—with “right people” exhibiting your core values (connected to Vision above) and “right seats” delivering their required output with excellence. Right People fit your culture; Right Seats get their jobs done well. It sounds so obvious, but people issues are the number-one challenge within small- and medium-sized businesses (SMBs).

Why the right people and right seats are important: Simple: no great vision can be achieved without great people. Friction (wrong people) or incompetence (wrong seats) hold back or even kill companies with great ideas.

Questions:

• What tools do you use to ensure employees consistently exhibit your core values?
• How do you consistently reinforce the importance of exhibiting your company’s core values?
• How do you ensure employees have clarity on what’s expected of them from a performance perspective? (Note: Detailed job descriptions are usually ineffective. An employee should be able to articulate their core responsibilities in about five bullet points.)

3. Data: Using concrete facts, metrics, and data as the company’s key decision drivers.

Why data-driven decision-making is important: SMBs move fast. They often lean on gut feel, intuition, and whims of the leadership team. Unfortunately, those bases provide inconsistent results and don’t scale.

A data-based mechanism, like a simple scorecard, ensures decisions tie to the company’s focus and objectives, and enable to company to quickly course-correct if something is off.

The scorecard (or dashboard) captures quantifiable performance measures that are leading indicators (usually activity-based).

Questions:

• What leading indicators are monitored by the leadership team?
• How are results consistently discussed at weekly leadership team meetings?
• What steps are taken when a performance indicator is off-track from its goal?
• Does every leader have at least one measurable on the scorecard?

4. Issue Resolution: Quickly solving problems so they are dealt with once and for all.

Why structured issue resolution is important: Companies that struggle to solve problems waste time and resources dealing with the same issues repeatedly. Sound issue resolution is about two things: culture and process. Culture in that everyone must be comfortable pointing out issues, and nothing is allowed to lurk in a corner. Process in that issue resolution requires a consistent way to uncover root causes, evaluate options, and take action. Otherwise, issues linger and worsen.

Questions:

• How often does the leadership team resolve important issues the first time they are brought up?
• What issues have blindsided the leadership team in the past?
• What is the process by which employees bring issues to the table?
• How does the company go about solving key issues?

5. Processes: Having a simple set of steps to complete key operations within the business, and ensuring those steps are routinely followed.

Why simplified processes are important: Simply put, detailed SOPs are rarely read or followed. A better format, especially for an SMB, is to document the major steps of the process that deliver the bulk of the desired results. Employees are held accountable for following those core steps and managed to that standard. The process commitment improves consistency and scalability.

Questions:

• How is each of your core processes documented?
• How do you ensure compliance with those core processes?
• How is training conducted for these processes?

6. Traction: The greatest vision in the world, even if embraced by the entire company, means little if execution stinks. Traction means executing on the vision with discipline and accountability.

Why traction is important: Most companies struggle due to a lack of execution. Excellence in execution stems from accountability at every level.

Questions:

• How are employees aware of teammates’ performance? (Team meetings, in which all members report against objectives, encourage higher performance across the group.)
• In what format and frequency do employees talk with their managers about performance, expectations, and their role within the company? (Formal cadence versus ad hoc.)
• How are employees empowered to push the envelope of performance?
• Revisit the questions under the People element.

Probing around these six business elements uncovers the true degree to which a target company adheres to an operating system that will produce consistent, repeatable results. It mitigates the risk of hidden chaos, a company unprepared for new leadership, or a money pit of needed fixes—all of which can shift the valuation considerably. Digging deep will provide a more accurate picture of an organization’s health and a valuation that more accurately reflects the potential deal ROI.

Jon Wilhoit is a Professional EOS Implementer based in Atlanta. He has over 40 years of experience working with and for small and medium sized businesses, helping them increase revenue and profitability, and building high-quality teams. Jon can be contacted at jon.wilhoit@eosworldwide.com.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit acg.org.