I’m not a person who watches a lot of television; it’s been almost a decade since I’ve had cable. But I do have Netflix! And I started watching episodes of Dragon’s Den, which is a Canadian (actually it’s global, but I watch the Canadian version) show, that was copied in the United States and called Shark Tank (which I’ve never seen by the way, so I can’t compare the two). All I can say is that I love this show! And that’s surprising, because I’m really not into this new modern day format of psuedo-scripted, reality TV, and the whole ‘last man standing’ type of show. But Dragon’s Den holds my attention for several reasons.
I haven’t seen every single season, but I really respect the fact that they find a pretty diverse set of investors (or “dragons” as they are called on the show) who have become successful in a variety of ways. They are from different industries and have different business philosophies. My favorite of course is Arlene, the marketing guru of course. Even so, it’s clear that not every dragon can help every contestant and sometimes they have to pool resources to help out a product or company live up to its greatest potential.
But whatever, I could go on and on about why this show appeals to the MBA side of me. But this post is going to be about the recurring problem that contestants bring to Dragon’s Den. This is the one problem that has caused many contestants to walk away with nothing at all from the dragons. That problem is company valuation.
So for those who have never seen the show, for the most part, company valuation (for their purposes) becomes a factor of the investment capital they are asking for compared to the equity they are giving up. For example, Sally Sue wants $50,000 as an investment, and she’s willing to offer up 50% of the equity in her company in exchange. So her company evaluation (again, for the purposes of the show) is $100,000.
Now in real life, company valuation is a bit more complex, and you need to have some sort of grasp of net present value and all other sorts of finance and accounting terms that most entrepreneurs don’t have a clue about. And that’s fine. The most important thing for an entrepreneur to understand is profits and cash flow, and if a business is sustainable enough over time to grow in these areas. Understanding and being confident about this is the best way to get an investor to put money into your company.
Numbers vs. Emotion vs. Realization
Before I go on, let’s watch a clip from the show so that you can see what I’m talking about:[youtuber youtube=’http://www.youtube.com/watch?v=iVvGxHALfns’]
Ok, so from the clip above, here’s the main takeaways:
- They were asking for $750,000 for 25% of their company (so $3,000,000 valuation)
- The product is some sort of kooky alarm system for a desktop PC
- They’ve been developing their product for 5 years, and have already invested $500,000 (que triste)
Alright. So the dragons figured it was a bad deal, and declined to invest. You don’t really need to be a finance expert to understand why. Let’s completely ignore the numbers for a moment. Business is driven by emotion and needs. Which is why market research is so important. Aspiring entrepreneurs are free to sit around and think of all the fantastic business ideas they want. But before they go out and start spending money, they should at least attempt to find out if there is even a demand for their product. Once you get to the point of asking investors to give you money, you most definitely need to demonstrate that your product is in demand now, and will continue to be in demand in the foreseeable future.
Breaking the Crystal Ball
Ok, so the previous example was extreme. Let’s say you are a rational entrepreneur looking to grow your small technology startup company. For sure, part of your company valuation will be subjective (just don’t think that tech startup = $1 Million in valuation). But it will all ultimately come from your existing assets, your income, and your target market.
This includes your inventory, machinery, patents, and staff. To an extent, it also includes your portfolio of current clients, and previous investments in the company.
This consists of both gross and net income. You also want to take into consideration any licensing fees or royalty income (if applicable) as well (although this isn’t usually the case with startups trying to source investors).
This may seem like a will-nilly figure to try to come up with…but it’s really not. Identify your target market. Quantify the size and location of that market. Come up with realistic goals to grow your market share. Do not get bold in this area. Do not assume that Wal-Mart is going to pick up your product, and put it into the reach of 300 million consumers nationwide overnight.
When Life Gives You Lemons…
So let’s bring this all together into a very simple and understandable example…a lemonade stand. 🙂
We need to invest about $200 in a table, chairs, plastic cups, a juice dispenser, bags of ice, lemons, lemonade mix, sugar, utensils and signage. Although it will take some manpower to make the lemonade, let’s just leave salary out of it to make things easy. Our initial investment will yield 500 cups of lemonade at $1.00/ea.
Oh wow, easy stuff right! Net profit is $300. Or is it? What if only 300 people live in the neighborhood? Well then it is very unlikely you’re going to sell 500 cups of lemonade….even on the best of days. But wait. Let’s say that you’ve come up with a secret ingredient to add into your lemonade…making the demand higher. Yes…just like Walter White’s blue crystal meth, your lemonade will be chosen above all the rest that are available! But you still have to prove this to an potential investor.
So let’s say 6 months go by. Your special lemonade has sold 1,500 cups in six months…with minimal marketing and advertising. You’ve invested another $350 in your lemonade ingredients…but that’s the only additional expense that you’ve incurred. So this is what we have:
$550 – Assets
$1,500 – Sales
$950 – Net
Now let’s say that the rights to the special lemonade recipe is worth $200. And let’s pretend that the lemonade has a year-round demand. I could say that my lemonade stand is worth roughly $2,500; based on annual net profits, plus the amount of assets I brought to the company.
Now, let’s play the role of the investor. I could get 20% of the lemonade stand for $500. But then I only get $380 of the profits in the first year…assuming that sales remain the same. Now my second year in, I make my money back, and then some. But it’s not a great return. Sure you can offer investors more equity for more of your profits, but then you are “losing” your company and working for them. Kinda defeats the entire purpose of being an entrepreneur.
So hopefully this incredibly, oversimplified blog post on company valuation has been helpful or interesting on some level. When you create your own business it’s true that you do have to be a jack of all trades. But you don’t have to be a master in all of them. But you at least should be familiar enough to where you don’t shoot yourself in the foot before you even had the chance to get off the ground.