The concept of knowledge might seem fairly straightforward. Most would

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1 CHAPTER 9 The Role of Knowledge Arguably, the core issue of knowledge is the following fact: With technology and access to information, a well-conceived plan can be disruptive to any industry. If the knowledge offered is common and easily accessed, it will become commoditized and have nominal value to end users. The concept of knowledge might seem fairly straightforward. Most would suggest it is having information. Arguably, analysis of information to cull out the relevant from the minutia and the ability to act in order to provide something uncommon may be a more appropriate statement. In the military, the distinction between information and intelligence is to have sufficient collaboration by two or more distinct sources that makes the result actionable. Otherwise, most decisions would be made almost purely on assumptions. Many see entrepreneurs as seat of the pants types willing to take risks against the long odds; however, those who have created a sustainable business are usually quite risk adverse. Think of it as gambling at the blackjack table. Starting with a $100 bet and winning against the house three times results in $800. The initial stake may have been small, and if lost, the gambler might just walk away thinking no harm, no foul. If a start-up has nominal costs and ease of entry, this could be likened to the first $100 with many betting and as much losing (if not more) than those winning. However, if the first bet was $800, the stakes are higher and so is the desire to ensure the success of the venture: especially, if the cash is from a credit card advance (debt needs to be repaid, so essentially the bet can lose twice). There are fewer staking this bet as the fear of loss usually outweighs the desire to win. Now add some zeroes to the $800 and call it a business. Equity Value Enhancement: A Tool to Leverage Human and Financial Capital While Managing Risk. Carl L. Sheeler 2016 by John Wiley & Sons, Inc. Published 2016 by John Wiley & Sons Inc. 241

2 242 EQUITY VALUE ENHANCEMENT Each incremental win usually makes the owner more cautious because both years of time and serious financial investment are now at stake. It would stand to reason, the owner wants to be more informed; however, wanting and becoming more informed is often the challenge. As sheer volume of business grows, the same skills to start the business differ from those to sustain it. Simply put, no matter the good intention, desire, and hard work to do more with less, at some point an owner must acknowledge she is at capacity and must augment with other s involvement. Often it s a spouse or child, but that too will quickly reach the need for additional insights from advisors and staff. Knowing something and acting on it becomes more critical as decisions become more incremental as the risks grow. The point of this introduction is to have the reader reflect that successful owners recognize making too many assumptions to justify actions is akin to building a foundation on sand. Therefore, the greater the access and speed to relevant and actionable information, the more decisive and nimble an owner and her organization can be. When one considers human capital, it s what we uniquely know as a collective that allows for differentiation in the marketplace. It is having the structures and culture in place under governance to allow information to flow and be acted upon that allows a company to be dynamic. It is having the executed strategy for internal and external relationships in place to reduce risks and pursue opportunities. Gareth Jones states, Knowledge must be transparent, complete, accurate, reliable, relevant and timely. 1 Donald Kuratko points out as part of knowledge management, Strategic Leaders must enable their organizations to develop, exploit and protect the intellectual capital contained in their citizens knowledge bases. 2 Dr. Kuratko emphasizes the importance of collaboration. According to Marc Dollinger, knowledge is difficult to copy when it is tacit, nonteachable, nonobservable in use, complex, and multidimensional, or requires interdependent skills. He also categorized this as the unique relationships of human capital. Emphasis is also placed upon its protection by establishing barriers to its imitation. 3 Often-cited and well-regarded valuation expert Robert Reilly dedicates an entire chapter of Valuing Intangible Assets to the importance of human capital as an intangible asset. 4 His chapter s focus is on a trained and assembled workforce orienting to knowledge and less so to relationships. There is consideration for tenure and cost to recruit, hire, and train; however, governance is not referenced. The 2006 Nobel Laureate in Economics, Edmund Phelps, of Duff-Phelps fame, recognizes the impact of knowledge:

3 The Role of Knowledge 243 Even the worker of ordinary education can be engaged in or can gain intellectual development from the formation of skills a type of knowledge arising from problems that are put to him or her in the workplace or could be put to him or her if the workplace were desirably organized. 5 This quote speaks volumes and lends credence to the importance of having governance and a corporate culture that embrace human capital as being something of a wisdom differentiator if well-harnessed. Arguably, the core of the issue of knowledge is the following fact: With technology and access to information, a well-conceived plan can be disruptive to any industry. If the knowledge offered is common and easily accessed, it will become commoditized and have nominal value to end users. This last statement rattles a good deal of advisors. This is because most are trained the same way to achieve the same result. Law and code dictate what the usual actions should be by an attorney and accountant. Investment theory tends to drive allocation and wealth advice. Rates and terms are comparable as the cost of capital for most banks is near the same. So, meaningful differentiation becomes increasingly more difficult because so much of what is generally needed may be accessed from the Internet. This is why a good portion of this book is geared towards fellow advisors and how owners can best utilize the skills of those who are differentiated or wish to become so. Further, it s important to realize that knowledge is quite broadly defined; it can be associated with patents, logos, trademarks, trade secrets, copyrights, and so on. Thinking about knowledge from the perspective of an owner, an advisor, or an entire business justifies deep contemplation and potential revisions to the other three areas of GRRK: governance, relationships, and risks. All three elements are indivisible and influence the relevance and focus on knowledge. Knowledge is often a company s secret sauce, something difficult to replicate and worthy of protecting by all means possible. It s what should differentiate one organization from another. This may also be a challenge of articulating the difference as I have endeavored to do by coining the term strategic value architect as being much more than a run-of-the-mill business appraiser. It is that important to find a way to express that difference as most clients will not invest the time in researching what good enough, good, and great ought to be like. So, think very, very carefully and ask Why you? Why your company? Now be honest, how much difference do you think your response is from that of your professional peers (competitors)? Try again ad nausea until you have found your own unique response. More likely than

4 244 EQUITY VALUE ENHANCEMENT not, it s your story, that of your company, or both: We know how to make good coffee. We excel in banking relationships. We are current on tax law. All are fine claims but would the competition say anything different? What if a banker said, We know more about your specific industry and how to use debt to grow a more profitable business. That is knowledge that most owners could distinguish, differentiate, pursue, and embrace. Using the example of a CPA, being current on tax code and regulations is expected; therefore, differentiation would be where a firm recognizes that the tax-tail should not wag the business-dog. The firm s expertise should ensure a more profitable and successful business client. That kind of thinking acknowledges that company issues may be operational, structural, or regulatory in nature. It also is couched in terms of what the business owner needs, instead of what the accounting firm has to sell. A similar type of thinking holds true to the business itself. What solutions are being provided sufficiently that are difficult to replicate, ever improving, and that address current market needs that may contribute to changing the way an industry operates? CASE IN POINT Wells Fargo s trade secrets a subset of knowledge or intellectual property include its approach to the market and rejection of certain risks, which has allowed it to be a big bank standard. Contrast that to Bank of America and its troubles with various regulatory bodies resulting in billions of dollars in fines and an exodus of customers and investors that s reduced its stock price dramatically. A MATTER OF CULTURE A company s culture can and should harness knowledge. Most relevant is understanding the business is comprised of tangible and intangible assets. The human capital of knowledge deals primarily with the latter, but influences the former. Here are two examples of million-dollar ideas based predominantly on knowledge: 1. Consider the manufacturing process for shoelaces. Anyone who s worn laced shoes has experienced the laces coming undone, even when they re

5 The Role of Knowledge 245 double-knotted, requiring them to be retied. Along comes a shoelace that provides a twist in the lace so upon tying the laces, friction keeps them from becoming untied. 2. A similar disruption occurred when barbed wire was invented. By inserting occasional spikes and twisting the wire, a relatively low-cost but strong means of keeping cattle in or out was created. These seemingly innocuous inventions made their founders wealthy. Of course, not every new concept will be a million-dollar idea, as the television series Shark Tank demonstrates. But following existing methods certainly isn t going to shake up the market; it s why most midsize sedans, regardless of manufacturer, all look about the same. When it comes to ensuring the unique distinction provided by company knowledge is maintained, some organizations believe everything ideas, processes, policies, unique relationships, key staff, and so on should be protected through all legal means. The late Steve Jobs ran Apple, Inc., that way, akin to the Fort Knox of protecting its intellectual property, with a culture that was secretive by design. That philosophy is often found in sectors where the majority of revenue is derived from knowhow. A simplistic example would be Microsoft, which has expended billions on its operating suite, resulting in a competitive advantage even though many users love Corel s WordPerfect. In the case of Microsoft, its system is closed source, so it relies on consumers to beta test it, identify and report flaws, and wait for those errors to be fixed. That is very different from open source, where any qualified code writer can make fixes and patches. A big proponent of open source is Elon Musk, founder of Space X and Tesla, two successful companies. He recently took his proprietary methodology and elected to make it open source available to the market with the logic being to accelerate the change from petroleum-based fuels to alternative energy, mostly electric. The business reason behind this decision is brilliant. The secret sauce to Tesla s genius isn t just the fact that it produces a cutting-edge electronic vehicle; the mass production of batteries lowers their cost, and guess what? As mentioned earlier, Tesla invests in battery production and storage. Musk s strategy and vision are game changers, and this includes what s happening at Space X, which is among the first commercial companies to produce rockets NASA uses at a fraction of the cost. The takeaway here is that knowledge is valuable when it pushes the envelope from current practice it s disruptive and even when replicated in time, the next iteration leaves competitors catching up. For this innovation to occur, it s important to have a culture that permits mistakes so as not to exclude groundbreaking

6 246 EQUITY VALUE ENHANCEMENT ideas that are too costly or too far ahead of the curve. A good example of that failing to occur is found at AT&T, which produced one of the first video phones, 20 years ahead of its time. It also produced the first tablets (two decades ago), but the combination of cost to market, lack of infrastructure to support and strengthen demand, and inability to articulate its value caused the products to fail. Conversely, Domino s Pizza adhered to its early success by cracking the 30-minutes-or-less delivery code success it believed would continue. Sales then flattened as competitors matched the delivery times with better quality alternatives. Instead of ignoring the market, it went back to strategy, giving customers a voice as to what was needed to be the predominant player in a saturated market of me-too products. This novel approach is part of Domino s trade secret, part of its knowledge. There is a significant people (human capital) component to knowledge, so companies must consider that disgruntled employees may share their knowhow with clients as well as new employers. Every company must consider to what lengths it s willing to go to protect this knowledge, perhaps requiring non-competes or pursuing legal remedies for breaches of intellectual property. Mary Kay Cosmetics, a 50-year-old direct-selling organization, certainly understands the value of its multilevel marketing. Its three million beauty consultants worldwide are independent contractors. Their agreements make it quite clear that the company will use all means available, including legal remedies, to prevent the sale of its products in any other ways than what s permitted by their contractor agreements. For example, consultants can t arbitrarily discount products without written approval. In addition, if they sever the relationship, they may not sell Mary Kay products, or solicit existing customers or current or past consultants for cosmetics or any other business opportunity including after they retire. The penalties for breaching the agreement include having Mary Kay terminate any retirement compensation that s directly related to their prior performance as a consultant (goodbye to that pink Cadillac). In this example, Mary Kay has clearly assigned and protected its rights, but it s not always so clear. For instance, when an employee develops a better mousetrap, do those rights belong to the individual or the company that employs him? Along the same lines, there are a number of industries that are primarily driven by knowledge of the client list, like professional services. In a perfect world, an individual s relationship with these clients may remain the company s property, but as banks, insurance companies, wealth advisors, and even attorneys and CPAs know all too well, when that individual either chooses to form a practice or leaves for another organization, oftentimes those clients follow. That is where relationships and perceived knowhow

7 The Role of Knowledge 247 overlap. Arguably, the most valued advisor is one who not only knows his technical areas cold, but is capable of vetting other trusted advisors from the herd to provide clients value-add services across a broad spectrum. HEALTHY KNOWLEDGE What is healthy knowledge? It s an intangible that allows companies to differentiate themselves and owners to leverage in-house knowledge by taking a holistic approach to their businesses, ensuring that constituent relationships translate into an ecosystem where legitimate benefits can be derived. These benefits more often than not exceed just monetary gain, but allow businesses to be community stewards. Owners who do this best have the ability to acknowledge that not knowing isn t a weakness, while not acting on not knowing is. As was noted earlier, it s certainly not necessary to be the smartest person in the room, but it is important to be surrounded by those who should be. The ability to wield knowledge in a timely, efficient, and effective manner can create extraordinary success. Think back to high school, when some people knew where the best parties were; they had knowledge that was beneficial to those interested in the party scene. As it pertains to business, being plugged into industry, vendor, or client associations or tangential organizations like those dealing with leadership, negotiation, executive learning, and more all are examples of developing an interconnected web of knowledge where early adoption often becomes a competitive advantage. Sensing is another kind of knowledge that will set a company apart. If a company s tentacles are spread far and wide, the result is access to disparate information that with analysis can recognize trends and opportunities as they unfold. Conversely, a degree of isolation or operating in a bubble can severely limit growth as new knowledge is untimely and/or limited. Mark Cuban of Shark Tank, Broadcom, Mavericks, and other holdings fame has expressed he reads three hours daily (as do I, but I don t have a $B after the last zero of my bank account, not for the lack of trying and doing). His reason is simple. If there is just one knowledge nugget derived from a periodical, newspaper, or the Internet, the investment is well worth it. (I wonder if the television network hosting Shark Tank has considered engaging the audience by having them text their preferences to the value proposition and offer some kind of crowd-funding, so even losers might have access to capital and winners may be able to decide that they want the human capital that Mark and his fellow successful peers offer along with their funds or opt for the capital offered by the

8 248 EQUITY VALUE ENHANCEMENT television viewers. Undoubtedly, there is some SEC regulations that may need to be overcome.) Owners and sometimes advisors lament there s just not enough time for them to know everything. This type of thinking is considered adverse and could lower a company s value because it s indicative of an owner who fails to realize the importance of delegating information gathering to others. By far, the primary reason companies tend to have flat or declining growth is that in the absence of evolving which means transforming from new knowledge and to leverage the nimbleness in order to pursue dynamic capabilities they are reacting to the market instead of seizing new opportunities. BE TRANSPARENT One of the most important characteristics of healthy knowledge is transparency. The more clearly investors, customers, and employees understand roles, relationships, and the benefits derived, the better they can see opportunities and share them. A simple example that may seem trite occurs after the purchase of a new car, when a buyer becomes aware of all the other identical models on the road. Whether reading an article, listening to the radio, or attending an industry meeting, the more one is attuned to one s purpose, the greater the likelihood that an advantage may be identified as new information is filtered and acted upon. For instance, some investment companies are using data analytics to look for global, geopolitical, social, and financial disruptions and what they might mean to an investment. They are looking for opportunities even before the trends fully evolve. What would be the advantage to a company that became aware of the issues between Greece and its banks a precursor to the fact that the country was expected to default on its obligations? Having early knowledge creates a distinctive advantage, in the same way that Facebook tracking applies sophisticated algorithms to determine users likes. This is done so user preferences can be reflected on their screens. While some people are concerned with sharing too much information, it s necessary to weigh the benefits against the risks. The more knowledge is accepted and shared, the greater all the eyes and ears within and outside of a company can be leveraged. This is why great pains are made to express the need for owners to ensure all their advisors are looking for those knowledge-adding opportunities. The knowledge they provide must transcend the knowledge available from other professionals in the same sector; otherwise it is at risk of being commoditized.

9 The Role of Knowledge 249 ENCOURAGE TWO-WAY COMMUNICATION In the best situations, knowledge is bidirectional. In many companies, the organization chart looks like a pyramid that narrows toward the top (the board and CEO) and widens as different layers are added: others in the C-suite, executives and senior management, middle management, supervisors, and line workers. Those in the ivory tower express needs that occasionally trickle down in a timely and accurate manner, but there should also be solicitation of the impact and needed resources of those requested actions. Often there are bottlenecks or misunderstood or corrupted communications that lead to incorrect, incomplete, or no action at all. All constituencies should be encouraged to express ideas and concerns that flow as quickly back up the chain of command. Otherwise, it s an organization where everyone follows orders because of the adverse risk of standing out. Among the worst thing that can happen is for individuals to be aware of a problem but remain silent because they re not encouraged to express themselves. When this manifests into a crisis, at whose feet does the blame go? If it s the workers clearly, a systemic issue is present within the company. In an ideal (or should I say idea) organization, information flows in both directions and the pyramid may even be turned upside down, based on the notion that the leaders function is to empower and support those with the greatest amount of external contacts in the company s ecosystem. This two-way flow is an important part of healthy knowledge. With respect and consideration, assuming no crisis is occurring, processes, procedures, and policies If it ain t broke, don t fix it should be challenged, reviewed, and updated on a regular basis. Clearly, there must be a distinct mechanism, committees, or open-door policies that encourage improvement through new knowledge that transforms. KNOWLEDGE AND HUMAN CAPITAL Neal Beaton, ASA, CFA, is the National Partner in Charge of Grant Thornton s valuation services. Several of the knowledge factors 6 he examines are: Assessment of management team Compelling nature of the value proposition Evaluation of the intellectual property

10 250 EQUITY VALUE ENHANCEMENT In Human Capital Analytics: How to Harness the Potential of Your Organization s Greatest Asset, Gene Pease recognizes the impact of human capital on intangible asset value and dedicates an entire chapter to the importance of alignment to ensure all stakeholders ( constituents ) are involved in the process as well as the problem ( risks ) or opportunity to be solved due to their varied perspectives and ideas ( knowledge ). By doing so, deeper partnerships ( relationships ) are formed. Further, the analysis should focus on root cause with issues that are core value drivers associated with the organization s culture and values ( governance ). Pease goes on to emphasize the relevance of cross-functionality to create synergies ( value ) and minimize resistance. Finally, he emphasizes the need to address resource gaps at every level from conception to final review and implementation. 7 What is evident is these authors identify intangibles which are primarily human capital. Most venture-backed companies assess the human capital from application of knowledge to commercially viable product and service lines as part of their go no go investment criteria. The same risk/opportunity criteria would apply to more mature companies when contemplating future growth. Given that management s history and ability to forecast is often relied upon to develop equity/enterprise values, the risk identification to develop the discount rate of future cash flows is paramount. This is especially true as the terminal value that requires sustained growth estimates can often reflect a large portion of the present value + terminal value equation. Thus, the elements of GRRK are certainly interconnected, and one of the most direct ways that knowledge ties back to governance is in how companies use knowledge strategically or tactically. With regard to customers, would it make sense to know what they perceive as growing trends that might affect business? Getting in front of those trends may provide new business opportunities as a solutions provider rather than merely a vendor that provides a product or service. Thinking is strategic when this becomes ingrained into the culture of an organization. It s particularly necessary in industries where trends change rapidly, such as in outerwear and accessories. With respect to personnel, the issue may be identifying a better approach of interaction and delivery to customers. The approach would be tactical, but the empowerment is clearly strategic, ergo, In this company, we value all staff opinions that allow us to better serve our constituents. To have healthy knowledge, particularly in the corner office, requires a degree of humility and is expressed in the concept of servant leadership or

11 The Role of Knowledge 251 stewardship. When leaders recognize their own limitations, it allows for the elevation of others, should they feel their contribution is validated. There are those who believe that true wisdom is knowing what needs to be known and where to find answers. By reverse engineering from the destination where a company wishes to be headed and awareness of where the company currently stands, a strategic roadmap is crafted. The gaps in resources and information will be identified and can then be filled, which is a wholly different approach from learn as you go. These gaps will sometimes occur because dealing with everyday operational issues can be all-consuming regardless of someone s level on an organization chart. A healthy organization will allocate certain internal and/or external knowledge workers to ensure strategy receives adequate time and resources so knowledge can be leveraged. Looking over the horizon is what differentiates companies that have 8-, 9- and 10-figure revenues and double-digit growth rates. Either wittingly or not, they all have strategies they keep their eye on the prize and aren t distracted by daily issues. They almost always tap the knowledge of those within and outside the organization and solicit advisors with special skills in developing and executing on strategic roadmaps. An exceptional advisor not only provides maps (or playbooks), but can also partner with and augment staff and other advisors to ensure alignment and execution of the strategic plan. In large part, this is what I do as a strategic value architect. One of the best indicators of a knowledge-based organization is one that seeks to answer questions like what if? or why not? Perhaps Marilyn Kourilsky, author of The E-Generation, summarizes knowledge and/or its absence best. The number-one (56% of respondents) reason people start their own business is to be their own boss. They feel the knowledge gained from education, life experience, and working at another business prepares them to be a business owner. Yet, actual business leaders feel education did not prepare them for: seeing opportunities others may not see; combining ideas and information in new ways; making smart use of time; budgeting wisely; managing and motivating others; coming up with solutions where everyone is better off; listening to others; the ability to distinguish between good and bad opportunities; preparing to start a business; and what prices to charge. 8 Confucius said: When we see men of virtue, we should think of equaling them; when we see men of contrary character, we should examine ourselves. Hubris is a terrible thing if it causes an owner or advisor to be blind, refuse to see, or lack the humility to see that thinking they know and knowing they know are not the same thing.

12 252 EQUITY VALUE ENHANCEMENT KNOWLEDGE MEASURES The overarching message with respect to knowledge is that the more unique, timely, transparent, and encouraged it is, the better. We ve talked about it in esoteric terms, but its presence or absence can be measured. Some examples include: Are processes, procedures, and policies documented, and is there evidence that they are regularly reviewed and updated? Is there an allocation and active management of intellectual property? Is there an understanding of where revenue comes from (perhaps intangible assets), so there can be an adequate allocation of future resources? Is there a methodology to the development of new intellectual property, its acquisition, or divestiture? How robust are efforts to brand and license as appropriate? If the company is in the knowledge business (i.e., professional services and many business services), are there whitepapers or articles that it posts on its website or shares in the media or within the industry? How much is invested in R&D and how is the investment determined and tracked? How does the company go about protecting its knowledge assets and the transition planned (retirement) or unplanned (death or disability) of key personnel? How often are agreements checked and updated based on internal and external factors such as new-to-market products and ideas to ensure adequate protections and optimal receipt of revenues? How often are there meetings away from the day-to-day distractions to challenge current methods and encourage brainstorming and thought leadership? How much of the company s annual expenses are invested in professional services such as tax and legal advice and best practices for operations, market development, and leadership? How much money is allocated annually to better educate staff, regardless of white or blue collar? If there are key performance indicators, how are they developed, shared, and assessed, and how often are they revised? I assert that while there are numerous books written on intangible assets and intellectual property, the largest contributor to company value above tangible assets is how much the company is worth based on its human capital. Knowledge is part of human capital as is governance and relationships.

13 The Role of Knowledge 253 A considerable amount of time was expended on risks. Combining that information with what s found in this chapter demonstrates that the more uncommon knowledge is, and the more it s protected and leveraged lessening risk the higher the value of the business. With refreshed knowledge, there can be dynamic capability where governance and strategy can be leveraged by sensing and seizing opportunities, minimizing risks, and transforming an organization to pursue opportunities. It is important to remember, particularly for companies that provide services that clients are apt to have fee bias, so one of the greatest challenges is being able to articulate and differentiate the investment in uncommon knowledge to create the very real benefit of being a steward and receiving a premium as a result. NOTES 1. Gareth Jones, Introduction to Business: How Companies Create Value for People (New York, NY: McGraw Hill Irwin, 2007), Donald Kuratko, Strategic Entrepreneurial Growth (San Diego, CA: Harcourt College, 2001), Marc Dollinger, Entrepreneurship: Strategies & Resources, 2nd ed. (Upper Saddle River, NJ: Prentice Hall, 1999), 37, Robert Reilly, Valuing Intangible Assets (New York, NY: McGraw Hill, 1999), Edmund Phelps, Mass Flourishing (Princeton, NJ: Princeton University Press, 2013), Neal Beaton, Valuing Early Stage and Venture-Backed Companies (Hoboken: Wiley Finance, 2010), Gene Pease, Human Capital Analytics: How to Harness the Potential of Your Organization s Greatest Asset (Hoboken: Wiley, 2013), Marilyn Kourilsky, The E-Generation (Dubuque, IA: Kendall Hunt, 2000), 23, 58.

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