“How do I grow my business?”  It’s one of the most fundamental questions that a business owner or chief executive considers; it can also be one of the most confounding given all potential answers.  At its core, there are questions of whether to:

• Do more of what a business is currently doing
• Find new customers
• Enter new geographies
• Develop new products/services

All of which may require additional expenses before revenue comes in the door.  As a result, we have found that many business owners and CEOs tend to be more reactive to the existing market rather than proactive in deciding where to allocate resources for the greatest growth. 
 
In his seminal book, The E-Myth Revisited (Amazon here), Michael Gerber popularized the importance of “working on the business, not in the business.”  The idea is that business leaders need to step out of the day-to-day managing of the operations, which are often reactive, and devote time to thinking through what needs to be accomplished to develop a growth engine. 
 
For example, at ValorBridge, we work with our CEOs on developing “VSD Plans.”  VSD plans define the Vision – Strategy – Drivers for a business so that a growth path for the medium to long term can be charted.  Or, as we consider it, if you don’t know where you’re going, how will you get there?
 
We actively work with our business owners/CEOs on answering the question “How do I grow my business over the next 10 years?” using the VSD plan framework.  Digging into the three VSD components
 
Vision – Vision is “The What,” as in, what do we want to be in 10 years? 
 

In the first two pieces in 3 Keys to What We Look for in an Investment (Part 1, Part 2), we highlighted what it is about the business and people that are critical to what we look for.  In this post, we’ll focus on the third – valuation, or the price we pay. 
 
Price
The third of the 3 Keys We Look for in an Investment is price paid relative to what we believe the business will be worth in future years, typically 5-10 years.  We measure whether the price is right by focusing on the internal rate of return (IRR) of the cash we invest over our long holding period.
 
No valuation tool is perfect and we attempt to keep our valuation approach simple.  What we like about IRR is that there are only 3 variables we must make assumptions about to determine whether the valuation to buy an ownership stake in a business makes sense to us.  Those 3 variables are –

1. How fast the free cash flow of the business will grow during the period of our ownership?
2. How much of that free cash flow will be distributed back to the owners vs. how much will be retained and reinvested in the business?
3. What a reasonable multiple of free cash flow in a normal environment a business with this quality, free cash flow characteristics and growth opportunities would be valued at by a rational private investor?

From our assessment of these three variables, we are able to estimate an IRR based upon different prices paid today for the business.  If the IRR is high enough to meet our standards (i.e. above our opportunity cost), then it is an investment that has a compelling price.