Self-employment and building a business are not the same things. In both cases, the founders are entrepreneurs and are playing a critical role in the economy. The difference comes in when those founders want to go off and do something else.
In a self-employment situation, the founder does all or almost all the work. This is typical of small services businesses like home bakeries or beauticians. Landscapers, plumbers and accountants often fall into this category.
Even larger operations with more employees can easily be classified this way. Restaurants create jobs for kitchen, service and cleaning staff, yet there is usually a key founder involved without whom the business would not survive.
Structures that include managerial staff are slightly better equipped to survive the founder leaving the business, although not by much. You don’t have to look far to find an entrepreneur who complains about the business falling apart when he or she isn’t around.
The real test here isn’t the number of people in the business, but rather the number of strategic minds who understand what makes the business tick. There are very few entrepreneurs who reach this level. It’s an extremely difficult path to take, but it’s the only way to build a sustainable business that can be sold one day for a significant valuation.
Private companies in South Africa with strong succession planning, diversified client bases and defendable market positions can sell for up to 6x annual earnings. In some cases, a higher earnings valuation can be achieved, for example where there is attractive intellectual property that isn’t being fully monetised yet.
Alternatively, such a business can be retained by the family of the founder as a legacy business, thereby creating generational wealth. Either way, the primary benefit of building a sustainable business is clear: value is maximised for the founder.
In practice, this requires the founder to make long-term decisions, often at the expense of short-term profits. Even before we consider the genuine difficulty of building an asset of lasting value, the inherent conflict of long-term benefits vs. short-term gratification is enough to put most entrepreneurs off.
For those willing and able to see the bigger picture though, strategies can be put in place to create something that will survive long after the founder has moved on.
It’s worth touching on how this differs to the concept of a “startup” in its traditional form. Startups are typically built-to-be-sold businesses where founders spot a specific gap that can be addressed with an accelerated build of a product or service. Funded by venture capitalists and exceptionally cash-hungry along the way, these startups aspire to be acquired by a corporate or private equity firm once the product has been established.
In many cases, startups haven’t made profits by the time the founders sell them. Corporates often acquire startups because it might be easier to buy a solution than it would be to develop one. It’s unlikely that a corporate team will develop a product or new market with the speed and voracity of a team of founders who stand to become millionaires if they are successful.
Although startup founders also aspire to build a business that has value without them, this certainly isn’t the same thing as building a legacy business. Without ongoing cash injections from venture capitalists, startups fail very quickly. Entrepreneurs in established businesses don’t have that luxury, especially in non-tech sectors.
The art of building a legacy business lies in balancing the cash needs of the founder against the cost of a succession plan. Introducing other strategic minds into a business is a costly but necessary exercise for founders who hope to retire or exit one day.
Importantly, this isn’t always advisable and doesn’t always work. Sometimes, businesses embark on a corporatisation journey that introduces so many costs that the profitability is ruined by the end of the process and the company can’t be sold anyway.
Entrepreneurial, agile businesses can be suffocated by the introduction of policies and systems that are designed to pass a due diligence rather than retain the innovative culture of the business. It’s incredibly challenging to bake robust systems and redundancies into a business without ruining the overall recipe.
Sometimes, the answer isn’t to corporatise. Objective, considered analysis is required to assess whether such a strategy could achieve a materially better outcome for the founders, taking into account the risks along the way.
There is no blanket solution.
If you are thinking of embarking on a journey like this, you need a strategic mind alongside you who takes a practical approach to value creation, risk management and due diligence preparation.
This article is a collaborative effort between The Finance Ghost and Arete Advisors – all rights reserved.