Not understanding valuation can kill your credibility. Here are the basics in plain English
An entrepreneur with a promising business can lose all of their credibility in an instant. You only need to watch a few episodes of Shark Tank or Dragon’s Den to see how quickly this can happen.
And often it comes down to one thing: valuation.
If you get the valuation wrong, it shows very quickly that you don’t know what you’re doing.
And yet, people continually go with a guess that feels about right. Or they farm it out to their accountant or some other “numbers guy” without ever understanding the inputs or the numbers that come out.
Something about valuation just feels complicated and intimidating and I think that is why many people don’t try to understand it better. I get it, there is a lot of finance jargon, but it doesn’t have to be that way — it really is simpler than you think.
Think of your business like a cow
This was the advice that I got from a finance professor in one of the top-ranked business schools in the world. My first thought was maybe this school isn’t as good as I thought it was…
But over time, this is a lesson that has stuck with me and I’ve used it countless times since to explain valuation to other entrepreneurs, especially those without any type of finance background.
Imagine you are a farmer and you are looking to invest in a new cow for your farm. You set out to the local market with your wagon and you are ready to make the big purchase.
But once you’ve picked out the cow that looks right for you, how do you know how much to offer?
Well, you probably have a couple of ideas of how you would go about this:
- You can see how much similar cows have sold for recently
- Or you can calculate how much value the cow will give you over the course of its lifetime
And once you do have a number in mind, that is just a starting point to begin your negotiation. You don’t want to pay full sticker price, you want to get the best possible deal on your cow.
And yes, this is more or less what big investment banks do and how companies actually get valued.
It just sounds a lot more complicated when complicated industry terms are thrown into the mix.
That sounds a bit more complicated doesn’t it?
All this means is that you are comparing similar transactions that took place over the last few years.
Now think back to the cow. The first step is to find the records of all similar cows that were sold recently.
You don’t want to go too far back (no more than a couple of years) because market conditions may have changed significantly since then and you will lose credibility in your negotiation if you are citing deals from 10 years ago.
Also, key to note here is that you want similar cows. You need to take into consideration:
- Location: a cow sold down the road may attract much less interest and demand than a cow in a completely different country or region
- Type: you don’t want to use a bull as a comparison for a milk cow
- Current Size: 200kg cow will probably be much cheaper than a 500kg cow
- Growth potential: is the cow fully mature or does it still have some room to grow?
- Seller’s motivation: was the seller bankrupt and having all of his livestock liquidated?
- Buyer’s motivation: was the buyer in desperate need for a source of milk at the time and they overpaid?
Usually, when someone is valuing a company based on comparable companies, they intuitively understand that they need to pick a company in a similar sector.
But then they slip up on one or all of the other points. All you need to do is watch a few episodes of Shark Tank or Dragon’s Den to see how quickly a valuation based on bad comparisons can be picked apart.
However, if you have picked a few companies that are in the same industry, about the same current size, with similar growth prospects, from the same country or region, where there were no special motivations influencing the sales price, you have a pretty good basis for comparison.
But remember, this is still a negotiation.
And in a negotiation, you will always be trying to point out flaws in the value that the other side is claiming.
There are a couple of flaws that are inherent in using comparable transactions that you should keep in mind:
- Time: you may struggle to find enough recent transactions and the further back in time you go, the less credibility your comparison has.
- Adjustments: all of your comparison will not fit exactly the same criteria as your business, so you will need to estimate how that translates to a change in value. For example, you have a 300kg cow, but have comparisons for 350kg and 325kg cows. You will need to take this into account by slightly discounting the value of your cow, but how much that discount should be will be very much up for negotiation.
Given these downsides to using comparables, there is another technique that you should have ready as well.
Discounted Cash Flow (DCF)
Don’t run away now, its not as scary as it sounds. Again, think back to the cow.
The other way that you could value your cow, is to calculate how much value it is worth to you over its lifetime.
So you would do something like this:
- Estimate how much milk the cow will produce each year and how much that milk is worth
- And estimate how much the meat of the cow could be sold for at the end of its life
That’s it - that’s actually the basic components of valuing your company with discounted cash flows.
In the case of your business, the milk will be the cash that your business can generate each year for the next 5 years. And the meat, will be what you could see your company for after this 5 years is over.
One key thing to understand here, is that a dollar 5 years from now is not worth as much as a dollar today. For anyone who has studied finance in the past, this is a key concept called time value of money.
This is where the discount in discounted cash flows comes in. Essentially, you will have to discount the value of the cash that your company generates each year against what you could have earned by investing in the stock market, for example.
Don’t get too caught up on this. There are lots of assumptions that can go into a DCF valuation, and the more complicated these are the more bankers and consultants can justify their fees.
They will look at a whole bunch of different ways to project cash flows and to determine the optimal discount rate, but just keep it simple:
- Use the the net income that your business will generate over the next 5 years as an estimate for the cash
- And take the average return of the stock market as the amount to discount by (about 10%)
This is not technically perfect, there are lots of tweaks and adjustments you can make to improve this, but this is more than sufficient to justify your position and to understand what’s going on.
The additional layers of complexity just make it more difficult to challenge the other side’s position in a negotiation. But if you understand very clearly in your head, what your business is actually worth, you won’t be distracted by this.
I won’t go into the exact formulas and how to calculate this for now, but I will plan to do a couple of future posts to give you some very simple templates and walk you through them.
But for now, just remember, valuation isn’t as complicated as it seems and it is too important to not understand. Don’t be intimidated and overwhelmed by unnecessary detail, just remember the cow.