My partner bought a horse named Pinky for his children. When Pinky
arrived she seemed sluggish so they took her to the vet. "No problem,"
the vet said, "she will be a lot more playful after the pony is
born."
Although they may not be as obvious as the pony embedded in the mare,
the hidden real options embedded in your business can have real value
too.
Every successful business has the potential to be even more valuable
if the owner takes the proper steps to develop its nascent opportunities.
For example, the unexploited opportunities to add a new product line,
expand overseas or engage in e-commerce are hidden assets that do not
appear on a company's financial statements and have not contributed
to its historical cash flow. When you buy a company you often get these
real options for free.
The value of real options depends on how likely they are to be realized,
just like the financial options traded in the stock market. Financial
options analysis is fine for securities held by passive investors. But
owning a business is not a passive exercise. The owner has a real job
to do, providing governance, managing capital and helping a business
achieve its potential.
Real options are the secret that allows an investor to both pay a fair
price for a business and earn extraordinary returns for investors.
In my day job, when I am not writing these columns, I am a private
equity investor. I view our job as creating equity value by finding,
cultivating and harvesting the real options embedded in a business.
Here are some real options you can look for in your business. One real
option is the ability to do regional acquisitions, as I wrote in Duct
Tape Corporations on September 20. We own a small ($50 million sales)
company in the optical products industry, for example, that has a great
reputation with its doctor customers, terrific people, very efficient
sales and fulfillment systems and the number one market share in the
industry. By using this company as a foundation for buying smaller regional
competitors we can earn very high returns on incremental capital --
typically 30-50% -- by consolidating overhead, fixed assets and inventories,
and improving service levels for customers. Sellers of the regional
add-on acquisitions can participate in our success by taking stock as
partial payment. We have five in our sights right now.
A second real option is using technology to increase sales. For example,
we added an e-commerce channel to a fitness company in November and
added more than a million dollars in incremental sales in the first
three months. The increased profits paid for the cost of the project
in six weeks.
Joint ventures are a third hiding place for real options. Our custom-framed
art business, for example, has the unique ability to centrally fulfill
the needs of our national retail store network from a large facility
in Memphis. We arranged a joint venture between our company and a major
Internet seller of art products to handle the printing, framing and
delivery to their customers. Both companies will benefit.
Under-managed brands can also be a fertile source of real options.
By taking a profitable brand into new products or new markets you can
often invest additional capital at high returns.
Don’t overlook the factory in your real option truffle hunt. We
increased the capacity of our Mexican evaporative cooler company by
adding a powder paint line that increased our market share and our margins
during an especially hot summer while improving product quality. And
we reduced inventories and paid down debt at its sister company by converting
their factory to demand flow manufacturing.
I should warn you, however, that developing real options is not always
easy. Picking the wrong platform, with weak people or systems, or bungling
the integration (I have done both) can drive customers away and kill
a franchise. Technology must be managed. Extending a brand into the
wrong products can undermine the brand’s value. And you can kill
a good factory. Proceed with caution when you decide to change a company
that is working well. Here are a few pointers that I have learned.
1) Exciting real options in a weak franchise are worth nothing.
2) Evaluate a company’s embedded options before you buy, not after.
3) Get managers to agree to a plan to change the company up front.
4) If you have to change key people, do it before you invest.
5) Overcapitalize the company. Surprises will scare your bankers.
6) Keep the founders in the ownership. You will need them later.
7) Manage the real option process. Measure the results. Tie compensation
to success.
8) Most importantly, protect the core franchise. Don’t forget where
the pony comes from.
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