Earlier this month, at our 7th Annual CEO Summit at Wharton, we had a session with Prof. Michael Roberts on “Creating a Value Culture.” When I first heard the session title, I automatically thought of company culture, things like transparency, empathy, curiosity, comradery – all those “soft” words that are hard to measure concretely, yet create immense value for companies, helping with employee and customer retention, growth, efficiency, among others.
Instead, Professor Roberts – my spirit animal – dove immediately into MBA quant 101. “Finance,” he said, “is to make better decisions.” How should CEOs and the management team think about their company strategy and value using numbers? Lively discussions followed, involving frameworks and tools to apply one of the most fundamental equations in business: Value = Benefits – Costs. Distilling a semester-long Corporate Finance MBA class (and here, I’d be amiss if I didn’t give a shout out to my fellow quant-oriented Columbia MBAs; it may have been years since business school, but it made us all gearheads), below are the three key takeaways that stayed with us for the two days that followed, and, no doubt, also returned with CEOs to our companies:
- Find Your R. In breaking apart Value = Benefits – Costs (adjusted for risk), benefits (money in) and costs (money out) are measured by cash flows of a business. However, every business has different risk profiles – so then how do we adjust for risk? Risk – R – is the discount rate used for deriving value from cash flows, your cost of capital (WACC, opportunity cost, required rate of return, discount rate, etc.). It sounds simple, and used in all variants at public companies, but are we thinking enough about our R in private, growing companies? At Edison, we believe transparency is critical to achieve alignment, talk through how we think about investment risk with our CEOs before and after the investment. But even so, does R matter to private-company CEOs? If we think it does, what should R be? And what role does it play in value creation and innovation initiatives? R needs to be more than just a Finance consideration.
- Know Your Numbers. “Finance is to make better decisions.” R is one of the most basic factors driving business decisions. When you know your R and your numbers, you can apply various decision criteria – NPV, IRR, payback period, and more – to make decisions and act. Those DCFs your bankers did, and those IRRs we in private equity talk about? We’re making measurable decisions, better decisions, driven by facts and figures. Value, turns out, can all be distilled into a couple of cells in an Excel spreadsheet. All those unit economics and value drivers – which by the way, vary by business – then allow decisions spanning timing, tradeoffs, targets, expansion, efficiency, and….
- Disciplined Innovation. Innovation is one of those words that get thrown around in various contexts with people assigning different meanings to the actual word. As a result, innovation is generally viewed as an esoteric concept, or sometimes viewed only as moonshots, rather than concrete, measurable business decisions. Certainly, not everything is a perfectly calculated 1+1=2, but at minimum, numbers-driven decisioning is possible with key assumptions that can be adapted and fine-tuned as you go along. Innovation, too, is a combination of valuation and ROIs. (And, as we learned from James Thompson, innovation is not innovation unless it delivered value/return. A failed attempt at innovation is merely an experiment.)
We, in growth equity, are in the privileged business of enabling pioneering entrepreneurs to dream and innovate. Making better decisions and creating a value culture are the fundamentals of those journeys.
So then – what’s your R?