Why do some entrepreneurs become billionaires while others barely make enough to live on? The answer is really quite simple: one has figured out how to create value; the other hasn't.
A primary goal for anyone starting a business should be to create real value or to earn a higher return than an investor could earn elsewhere for the same risk. The concept of value is one of the central issues in finance. Understanding it helps entrepreneurs make better business decisions.For example, let's say an entrepreneur starts a business with an investment of $100,000, and the business generates $10,000 per year. If an investor could buy a bond that offers 10 percent interest and has the same risk as the business, then there is no real incentive for him to invest in the business because he can get the same return by investing in a bond -- therefore, there's no real value created by the business.
But if the entrepreneur could create a business that generates $15,000 per year at the same risk as the bond, then the business would be worth $150,000, and the entrepreneur will have created $50,000 of value -- often referred to as "net present value." The ability to generate net present value is the key to building wealth.
So, how exactly does one create net present value?
First, be different. If you intend to earn 15 percent returns when everyone else can only get 10 percent, you have to do something different. Perhaps you have a unique product, a superior reputation for service or quality or can customize your service to better meet the needs of your customers.
The entrepreneurs who have created businesses with the greatest real value have done so by innovating. They have changed the nature of the product, the process for making the product or even the structure of the industry.
In "Competing for the Future," one of the best books on business strategy in recent years, authors Gary Hamel and C.K. Prahalad emphasize the need to develop a core competence. Their simple idea is that there must be a piece of the business pie that you bake better than anyone else. You don't have to be better at everything, but you must be better at something, and that something must be important enough that it makes up for the other areas in which you do not have a competitive advantage.
Identifying and exploiting that core competence is the key to creating value.
Second, be hard to imitate. You need something that makes it difficult for others to do what you are doing. Often, simply being first and building a customer base before anyone else does can be enough. Being in the best location can also give you an advantage. A patent, copyright or trademark can also prevent competitors from simply copying your idea.
Building a reputation to match yours can also be an insurmountable barrier to imitators.
Third, be a moving target. Eventually your competitors will figure out a way to imitate you, improve on your innovation or get around a patent or copyright. As a result, you can't sit still. You must constantly innovate and build on your core competence. By the time your competitors figure out what you've done and imitate it, you've moved on to an even better position.
Every business decision you make must be based on an understanding of what creates real value. Earning 15 percent when everyone else can only earn 10 percent takes innovation and constant improvement, but the rewards can be impressive.
And valuable.
Hal Heaton is a professor of finance who works with the BYU Center for Entrepreneurship. He can be contacted via e-mail at cfe@email.byu.edu.