Role of the Board in Value Creation

enterprise value governance Aug 10, 2020

Part 1 of 2

by Gerard McInnis, CA.CPA, CBV, ASA, CFE, ICD.D (Principal, Ozone Advisory Group)

Introduction

As you look around your Boardroom table you are likely seeing other board members that do not necessarily look like you, dress like you, or think like you. As Boards grow increasingly more diverse, what creates the link or a common bond that brings them together?

The simple answer is a shared vision or goal for the organization which is anchored in a shared purpose. This purpose manifests itself in the form an organization’s strategic plan which cascades down into the tactical operational activities commonly referred to as the business plan.

Purpose is itself multi-faceted and in this era of social responsibility most definitely must contain objectives inextricably linked to some greater good that cannot be measured strictly by financial returns.

The concept of the triple bottom line (social, environmental, financial returns) is not a new one but in recent years has gained renewed traction with increasing societal pressure to have more equal weighting to the three.

How therefore does a Board exercise good governance to monitor and measure performance and alignment to purpose? This article addresses one aspect of this being the measure of financial return – otherwise referred to as Value Creation. Part 2 of this series will address Board role in overseeing and stewarding ESG performance.

Value Creation Objective Defined

Value as a concept is perhaps the most readily used and least defined measure for private enterprises. How many times have you had discussions or heard references to the decisions of Management and the Board “adding value” to the business? Likely these decisions have been guided with proper intent but rarely do decisions get examined objectively to further define how much value the actions will contribute and whether the opportunity for creating value is properly offset by the assessment of the corresponding incremental risk being assumed. Value creation should be measured in cash equivalents as a financial metric – i.e. do the incremental net increases in cash flow appropriately compensate for the risks associated with the investments required?

Let’s break it down into its component parts. Value creation as a financial metric is inherently a measure of the return on invested capital. The lenders/investors expect and deserve a financial return for taking the risks and allowing Management to use their money to operate the business. How much return is warranted depends on the lenders/investors assessment of the riskiness of the business and their expectation that not only will capital be preserved and ultimately at some future date returned to them, but also that excess returns can be earned. Value is created only by assessing the returns commensurate with the risk expectations. This is often times referenced by Management as ROI, or ROE or IRR. These are all related (but slightly different) measure of financial return. However neither the returns (company profits) nor the return expectations (dividends, interest rates, share appreciation) remain constant. Accordingly, those with direct responsibility for the use of cash (i.e. Management) must constantly be making decisions to optimize the use of cash and the effectiveness of operations to generate the returns.

The Role of the Board

If Management has the direct responsibility as outlined above, then what is the role of the Board?

In actuality, the framework for evaluating decisions in the Board room directly mirrors the value creation formula:

decisions that impact on the use of cash and the ability of the organization to generate returns on invested capital
decisions that affect the expectations of the lenders/shareholders for the risks they assume having entrusted their money to management

To bring this framing to life let’s look at an example. Let’s assume Management brings to the Board a proposal to invest $100 million in a plant expansion project. Management will have developed financial models that demonstrate incremental free cash flows generated by the expansion, and they will calculate the return based on the investment required. These invested dollars may have come from lenders or investors which impacts what the weighted average returns need to be. The Board’s critical role is to help Management frame the investment and assess the risks to ensure the weighted average returns, allowing for risk, exceed expectations.

Knowing this, questions a typical Board could ask would include:

Regarding the incremental profits:

Can you demonstrate capacity constraints in the current plant and provide evidence to support lost opportunity?
What alternatives to meet demand have been explored?
Is the demand level expected in the long term and what is the life cycle of the plant expansion that is being assumed?
How confident are we in the investment project cost estimates and what level of contingencies are assumed?
How have future operating costs been determined and to what extent do the incremental project returns rely on assumed synergies?
How sensitive is our financial model to changes in key assumptions?

Regarding the invested capital:

How are the funds for the project being sourced?
What is the return expectation for each class of funder?
What is our capacity to borrow / raise capital and at what prices and is this a good time in the markets for such capital raises?
How do we allocate capital between competing project investment needs?
If not this project what are existing other alternatives available to us today?

These are sample questions designed to demonstrate that value creation can and should be a discrete and objective exercise. Reference points for changes in value can come from public market comparables or from spot-testing private company enterprise value with formal valuations at interim stages.

Conclusion

High-performing Boards and Management teams understand their job is to create value for the lenders/investors and continually be aware of the value they are creating as a result of their decisions. They should also be prepared to return money to their lenders/investors if they cannot generate the expected threshold returns.

Publicly-traded companies should see this on their long-term share price. Value creation is more difficult to assess in private companies. Ultimately the long-term measure of success from these decisions should be noticed on the balance sheet and income statement, which inherently will drive enterprise valuation. High-performing private company boards either develop a proxy for enterprise valuation or retain a professional business valuator to provide a baseline model.