Building a Winning Formula

What determines Enterprise Value? Many formulas exist but the fundamental understanding is that it comes from what is repeatable, transferrable and scalable. In other words, value is systematic success.

The right method for valuing a company depends on its market and industry. One method, the Earnings Multiple Method is based on the future cash flows of the organization, taking into account historical results with some adjustments for future outlook. The basic formula is a simple factor of Normalized EBITDA (Earnings before Interest, Taxes and Depreciation & Amortization) x Enterprise Value Multiple (comparable to recent relevant transactions).

For a potential investor or creditor to consider the future return on investment potential, they must assess the quality of earnings of a company, the Normalized EBITDA (proxy for cash flow). An enterprise has intrinsic value based on its ability to generate proven profitability that is sustainable and predictable. Whether the process is around client acquisition, financial management or talent optimization, Enterprise Value does not come from the individual results but the systems to enable the realization of consistent results.

The San Antonio Spurs System

In the National Basketball Association, a business so focused on raw athletic talent, pundits don’t usually refer to San Antonio’s run of success as a dynasty like most teams. Instead, it is referred to as the San Antonio Spurs System, and they are generally regarded as one of the best-run organizations in the league and all of sports. On May 19, 2021, the Spurs were eliminated from reaching the NBA playoffs. What is remarkable however, is that this does not highlight the Spurs failures as an organization, but rather its reputation for an expectation of consistent success. This would mark the first time in its nearly 50 year history they have not reached the playoffs in consecutive years. No other team has even come close to such a feat, not only in the NBA, but in all of professional sports.

The face of the Spurs System is none other than 3-time NBA Coach of the Year, Gregg Popovich. Their reputation for consistent success is based on more than just having the best talent on the floor. From top to bottom, front to back office, scouting to player development to coaching staff, the infrastructure is aligned from end to end. Each piece respects one another and collaborates with the bigger picture and overall system in mind, placing winning as an organization above anything else.

From 1997 to 2020, the Spurs reached the post-season a record-setting 22 years in a row, achieving a 69% winning percentage, while winning 13 division titles and 5 NBA Championship titles. In a 30-team league specifically designed to ensure parity, that’s a 22% championship winning percentage over a 20+ year period. And although the Spurs have benefited from the Hall of Fame talent of Tim Duncan during most of this period, a two-time MVP player himself, most of these championship titles came in years after he was recognized as the best player in the league. The number one lesson that can be learned from the Spurs System is that while talent is an integral element of organizational success, sustained greatness requires strong management, infrastructure and systems around that talent.

Studies have shown that only 30% of family enterprises survive beyond the first generation, and only 12% beyond that. The reasons surely vary from situation to situation but clearly entrepreneurial historical success is not in of itself a surefire predictor of future self-sufficient success, especially when it is rooted in unique skills or relationships that are proprietary to one individual in the organization. In fact, when calculating Enterprise Value, assets which are not deeply integrated into the core operations of the company are usually eliminated from its calculation. Building a success story is difficult, and oftentimes companies may want to believe that talent is the missing piece. But if sports have taught us anything, it is that trying to buy success with talent is expensive and risky. In fact, oftentimes it has proven to not be a very good strategy at all.

Some may point out that there is a risk of being too talented. An over-reliance and belief in individual skills may be self-sabotaging, leading to conflicting egos and cultural dysfunction. Coach Popovich once spoke about the need for the system of accountability and the character to uphold those standards for all. “You don’t have a different system for Duncan, Parker and Ginobili [the star players] than you do for number 12, 13 and 14. A lot of people are afraid of that.” He continued, “You need to have the same standards for everybody. You can treat them differently because each one is different, but they all have to march to the same drummer, the same standards.” The greatest threat actually comes from leadership itself, as they must resist the temptation of a “special deal” for their superstars. Coach Popovich continued with the challenges of star players expecting preferential treatment a, “I have to have the fortitude to be able do that. The more character that kid has, the easier it is for me to show that fortitude to go after him. But if he has no character or I’m weak, as far as being honest, the harder it’s going to be.”

Renowned organizational psychologist, Adam Grant points out that in the 2011 off-season, the Miami Heat managed to lure the three most talented free agents to form the NBA’s first super team, including LeBron James. Many viewed them as a championship or bust team and although they made it to the NBA finals in their first year, they went on to lose to the more experienced Dallas Mavericks. They did win it all the following year in 2012 though. The missing piece, Grant highlights, was Shane Battier, the “No Stats All-Star”: a player fundamentally known for consistently improving the performance of the superstars around him by supporting them in subtle and unnoticeable ways.

In all, the Miami Heat’s short-lived 4-year dynasty included four trips to the NBA Finals and two championships with their second coming against the San Antonio Spurs in 2013. The team ultimately responsible for ending their reign and dynasty? None other than the very same San Antonio Spurs that went on to beat them in 2014, nearly twenty years after Coach Popovich took over as the architect of the Spurs System. Ironically, if there has been one criticism of the Spurs System, it is that it is considered by many pundits to be too boring for an entertainment-based industry. Some even say that the system works too well, that it covers up the talent deficiency of its players. In other words, it’s too successful.

Built to Last

The NBA is a superstar league. Like in business, it starts with recruiting and acquiring talent. Prior to the 2019 Toronto Raptors championship run, no team has ever won it all without a top-10 drafted player. This means, that success is nearly impossible without the best talent. That does not however mean that it guarantees success. Losing teams have the benefit of drafting at the higher end of the draft board. But there is a reason that certain teams consistently have that opportunity. The New York Knicks have drafted within the top 10 position nearly 50% of the time since 2000 and have compiled the worst win-loss record in the league over that time frame, with a 40% winning percentage. Meaning that for certain organizations, having the best talent doesn’t mean they necessarily know what to do with it. They may even ruin it.

Since 1997, only three first-overall drafted players have won an NBA title as starters on a championship team. One is LeBron James, arguably one of the best players ever to play the game, who actually had to leave the team that drafted him in 2001 to win his first title. He returned to join Kyrie Irving (rookie of the year and 2011 first overall pick) in Cleveland, whose record was 97-231 during his absence. The other first overall pick to win a championship with the team that drafted him, is Tim Duncan, who spent his entire career building and upholding the San Antonio Spurs System, nicknamed the “Big Fundamental”.

In the same year that ‘Coach Pop’ was unable to lead his team to the playoffs in consecutive years, he remains one of the most well-respected leaders in professional sports, the highest paid coach in the NBA and is currently preparing the USA Men’s Basketball team as head coach for the 2021 Tokyo Olympics. The winning formula to maximize Enterprise Value balances the age old question of nature vs nurture. Although the short-sighted may often credit the raw superstar talent for a team’s success, it is the system and its architects which will be the key to sustainably unlocking greatness.

Prioritizing talent is a key element of the formula but the process of identifying, managing and optimizing that talent is equally important. After all, the problem with individual raw talent is that it is neither scalable nor teachable. While prioritizing and rewarding talent is important, it is the systematic development and management of overall talent which determines whether the Enterprise Value is built or borrowed.

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