I have always admired how an entrepreneur can take an idea and turn it into a business that delivers a valuable product or service. In many cases, they commit to delivering a product or service before they even know how they’re going to do it. It takes a lot of confidence, determination, and creativity to follow through on an idea.
Over time, the entrepreneur’s confidence grows as they successfully navigate through the ups and downs of building a business. It’s only natural to become more self-assured with every small taste of success. One of the greatest joys for an entrepreneur is to do what others thought was impossible. This is both gratifying and confidence building.
That same confidence and creativity that helped the entrepreneur get their business off the ground can also become their downfall. With each passing year, they believe more and more that their way works. And who’s going to question them? Many entrepreneurs don’t have outside investors or an advisory board, so they don’t have to answer to anyone.
Contrast the entrepreneur’s situation to a publicly traded company where analysts, investors, and the general public have access to financials, disclosures and annual reports detailing every aspect of the public company’s performance and strategy. With every press release, quarterly report and sometimes rumors, the publicly traded company is instantly judged by the marketplace as reflected in the price of their stock. Although many changes in the stock price don’t follow the logic, it’s still an instant barometer for the leadership team to gauge the perceived value of the public company. We know that many CEO’s of publicly traded companies are compensated on how well they can grow the value of their company.
The entrepreneur often goes years without any true understanding of the value of their company, and more importantly, the rate of return on the time and capital they’ve put into their business. Most entrepreneurs can tell you how much money they’ve put into their organizations, but very few tracks how much sweat equity they have poured into their company. And while the financial statements of their company give them some clues to the value of their organization, it’s often dramatically different than the perceived value in the marketplace. It’s only when a company is sold that the entrepreneur knows the true market price of the company and they have some idea of the return they received for their hard work and investment. In many ways, the publicly traded company has the advantage of always knowing the market’s perception of their value.
Comparing the entrepreneur’s situation to the common act of purchasing a stock, mutual fund or even real estate, even an amateur investor is aware of how much they paid for their investment and what their expected return will be. When we receive our annual investment reports, the first thing we look at is the rate of return we achieved for the year. The media has taught us to expect a 7-10% annual return on our investments. Sometimes we do a little better. Sometimes we do a little worse. But ask any entrepreneur what’s their current rate of return on their business, and they’re likely to be clueless.
I’m convinced that if entrepreneurs knew the value of their company and the annual rate of return they receive on their investment, they would make better decisions. Compare the situation to how most people make decisions about their house, often the most valuable assets an individual owns. It’s easy for the homeowner to know the approximate value of their home through numerous sources: similar homes for sale in their neighborhood, the annual property tax statement, online real estate tools like Zillow, or by asking realtors to provide an appraisal. If you ask any homeowner, they can probably tell you instantly what they think their home is worth. Knowing your home’s value influences your decision-making about maintenance, home improvements, and landscaping. Most people take care and invest in their home to maintain and even build the value of their house.
Entrepreneurs should do the same thing – consistently measure the value and rate return on their investment in their business. Then they can make better decisions about how they manage their company. For example, if they knew that they are earning a 50% rate of return from their business, they might be less inclined to take distributions (money out of the business) to only put the money in a retirement account earning 5-10% return. And while a 50% rate of return may sound astronomical, an analysis by Crabtree, Rowe & Berger of an aggregate of 50 of their clients that includes companies from all of the basic industries (manufacturing, retail, services, technology), shows that the average rate of return is actually closer to 75%!
The first important step for an entrepreneur to make better decisions is to start treating their business as an investment. The entrepreneur needs to consistently measure the return on investment in their business. It may sound easy to treat a business as an investment, but it’s amazing how few entrepreneurs do it. Maybe they’ve gotten too confident and comfortable with their current level of success.