How Business Owner Perceptions Change
Businesses start with founding owners who produce. An individual uses a set of skills and considers the opportunity to use those skills and earn money as something like a job. As the business grows and evolves, the individual skills become part of a system that can be learned and utilized by more than one producer. As the number of producers grows through training and experience, so does the need for management. An owner who has been a founding producer, then a manager, and then solely an owner will have evolved through three perspectives of the business (job, compensation, and value).
Where the perception of an owner-manager change from that of a manager, a compensation perspective, to that of an owner, a valuation perspective, is a critical point. The owner’s failure to change from a compensation perspective to a value perception has significant consequences, which can prevent the business from returning full value to its owners.
At the beginning of the business cycle, the start-up, the perception of producers, managers (if any) and owners is the same – survival. How will the business be profitable to succeed in the short term? As the profitability of the business becomes more assured, the perception of the owner can become different from the perception of the manager. The manager will continue to focus on the short term – on meeting goals of performance and profitability. The owner will begin to perceive a system - an aggregating of procedures - that has created a business system that did not previously exist. This system of creating a sustainable cash flow over time is a business that has value and the potential of providing wealth to the owner – much more wealth than the cumulative amount of compensation payments.
The source of business value is cash flow, and the cash can stay with the business or be paid out of the business. A significant amount of the cash flow of a business is paid out as compensation, but as the business system evolves there will be a need to cultivate and enhance the system – those expenditures are capital payments.
After the point of profitability and where the owner has experienced adequate ongoing cash returns, given that cash remaining in the business increases the strength of the business system and its ability to create a cash flow, the owner will benefit more if cash is used for capital expenditures than if cash is distributed as compensation. Increasing the capital of the business should increase the value of the business. The owner is the one who benefits from an increase in the value of the business. This leads the owner to take a long-term or strategic perspective.
The resulting tension is that distributions of cash flow as compensation benefit managers, while retention of cash flow in the business as capital results in an increase in the value of the business benefiting only the owner. Solutions to this tension are not easy, and sometimes outside capital must be used. Nonetheless, from a strategic planning perspective, the best interests of the owner will be served by the allocation of more cash flow to capital rather than compensation – the value perspective. Managers and producers will have a sense of cash flow and resent the failure to allocate cash flow to compensation – the compensation perspective.
The owner-manager’s perspective is schizophrenic in that the owner-manager benefits from both compensation and business value. Where the owner-manager does not change perceptions (from compensation to value) and fails to strategically plan for the business (running a business as a cash cow, paying out most of the cash flow as compensation), the potential valuation of the business will not be realized. On the other hand, not paying adequate compensation and losing skilled producers also will jeopardize the business.
The wealth-building lesson for business owners is that until an owner adopts the value perception of the business, recognizing the benefits of building the business as a system as well as keeping productive and management elements of the business engaged with proper compensation, the maximum benefit of owning the business will not be realized.