Friday, October 28, 2011

Growth (Part 4): Growth and Management Credibility

If you buy a growth company, the bulk of the value that you attach to the company comes from its growth assets. For these growth assets to be valuable, though, not only do you need high growth potential, but the company has to be able to scale up its growth while ensuring that it generates returns that exceed its cost of capital, while delivering this growth. That is tough to do, and it should come as no surprise that most young, growth companies do not make it through these tests. Investors who are able to look at a large group of young, growth companies, and separate those that will survive from those that will not, will see immense payoffs. But can this be done? Those who are firmly in the value investing school argue that this is the impossible dream and that there is too much uncertainty in this process and too many variables that cannot be controlled for this strategy to work. However, if this were true, how do we explain the success of some venture capitalists and growth fund managers? Are they just lucky? I don't think so. In fact, these investors share a characteristic: they are excellent judges of management at companies, since so much of the value at young growth companies comes from trusting managers to make the right choices and to follow through. Here are some of the dimensions on which managers of young, growth companies should be judged:

Does the management have a vision for the future that is grounded in the product/service offered by the company?
As noted in part 1 of this series, the revenues of a young, growth company are bounded by the potential market for its products and services. A management that defines its business too narrowly is limiting its growth potential and by extension, its value. If a management defines its business to broadly, the vision becomes unrealistic and thus not credible. In a sense, management needs to have a vision that is both large and grounded in reality at the same time... Not easy to do, but why is that a surprise? If it were easy, we would all be founder/CEOs of our own businesses!

Is there an operating plan to bring this vision to fruition?
As businesses have found through the ages, a soaring vision and/or a great product is just the first step. Without the grunt work of operations (production, marketing and distribution), commercial success will remain elusive. Since relatively few visionaries have the patience or aptitude for the "nuts and bolts" of operations, this will require having the right people in place and the willingness to delegate power to these people.

Is there clarity on the trade offs that the firm faces for the future?
It is true that the founders of young, growth companies have to sell investors on their potential for success. Many founders, though, view this mission as requiring them to sounds relentlessly optimistic and highlighting only the positives. However, the most persuasive pitches are made by founders who are open about the trade offs involved in success and the risks they face, and are willing to outline how they plan to make their choices. Thus, a CEO who talks about growth potential without mentioning how much she needs to spend to deliver this growth (and how she plans to finance it) and/or the competition she will face is less credible than one that talks about growth and then goes on to discuss how the company plans to deliver this growth and what it will cost.

Is there flexibility built into the plan?
No matter how well thought out a concept may be, young, growth firms will be buffeted by unexpected occurrences, some bad and some good: that is the essence of risk. One key test of managers in young, growth companies is whether they have contingency plans for "bad" events. It may be mark of a brave soul to embark on a mission with no second thoughts or escape hatches, but for young businesses, that could be suicidal. Just as critical a test is how well managers have prepared for success, since success will bring with it different types of tests: new competitors, financing needs and staffing requirements. In fact, you will learn a great deal about a company, when you see it navigate through its first few crises and opportunities.

Are managers willing to trust you (as investors) with news (especially bad news)?
When you invest in a young company, you know that the pathway to success is never  smooth. You recognize the risks involved and price the company accordingly. However, you do need managers of the company to keep you in their confidence, giving you both good news and bad news promptly and without shading the truth. A failure to do so only magnifies your risks. As a cynic, you may wonder why managers would ever do this. I would argue that it is in their own best interests, since so much of the value comes rests on their being credible. A growth company that burns its investors will face immense trouble getting them to believe again...

Are managers willing to trust you (as investors) with the power to challenge them?
I start with a simple presumption. If a company wants my money (as capital), it should give me a say (limited by share of the company) to how it is run. While most CEOs claim to be willing to listen to their stockholders, there is a much more tangible measure of whether they trust their own stockholders in the voting power that they grant them. In an earlier post, I noted the spread of the Google dual voting class model to other technology companies. This graph from the Wall Street Journal is telling:

By giving the founders/insiders 150 voting rights per share, Groupon effectively is issuing common shares with no voting rights. They are telling me that they want my money but not my input on how the company is run. That is their prerogative but I will exercise mine and not play this one sided game.

If you are interested in investing a young, growth company, pick up a filing for a prospective IPO or the annual report for a and review it. Make your best judgment on whether the management sounds credible, truthful and is worth trusting.. and also look for the clues on whether they trust you back. And keep updating your views, based on how the company responds to events.


Blog post series on growth

16 comments:

Nishant Kashyap said...

awesome!!...Thanks....

Anup Bagchi said...

I have one question for you what would be the premium to voting rights would you assign or how would you approach it. Tata Motors non voting is trading at 45% discount to voting shares and as you know tata is a good name, as a practitioner I hope I can take the liberty of seeking answers to issues we encounter with real data.

Aswath Damodaran said...

See the paper I have on valuing control, where I extend the concept to value voting rights.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=837405

Dave said...

Do you have any thoughts on how to convert these ideas into numbers on a spreadsheet?

Dave said...

Also, the graphic won't maginfy (at least on my computer), making it almost impossible to read it...

Anup Bagchi said...

Thank you very much fur guiding me to your paper, it is well explained. In fact control premium is also intuitively we understood. The flow through the voting /non voting is also well explained with real examples.

In the case of tata motors, none of the implications (pg 51) applies and in fact while the firm has done much better last few years and the discount has widened. I am using discount and not premium since the company otherwise is valued well and non voting is a steal and yet while we saw lot of institutional investors buy it because of value, it has become "deep value". There might be an angle of class of investor interest which may have to be looked into while arriving at the premium value. Thus the current shareholding,changed shareholding by each class of investors and their power to effect changes also needs to be used as a variable to make the list of issues driving the phenomena collectively exhaustive.

The case of private equity investor buying control is a very different case as they can indeed make a change and so may have a different value attached. There are many classes of investors who cannot buy into non voting making the demand supply imbalanced.

I would be very keen to know your views on this. Do let me know if there is an error in my thinking through this issue.

Regards

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Ari Kalliala said...

I've been reading all of your article and it seem your management credibility is really high.Excellent.

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