Planning, Startups, Stories


Tim Berry on business planning, starting and growing your business, and having a life in the meantime.

5 Things Entrepreneurs Need to Know About Valuation 2

Valuation is one of those four-syllable business buzzwords you’re going to have to deal with, eventually, if you either want to start a business or own a business. If it doesn’t come up when you start, it will come up later. Here is what I think you need to know, in five short points.

  1. The word has vastly Different meanings: don’t you hate it when the same words mean different things? Valuation means at least three different things:
    1. What a business is worth to accountants for legal purposes, such as divorce settlements, inheritance taxes, and gift taxes. A certified valuation professional, usually a CPA, makes a guess. Most of them use financial statements and analyze financial details.
    2. What a business is worth to a buyer. Small businesses go up for sale with  business  brokers. Hardware stores, for example,  get about 40-50% of annual sales plus inventory, as a starting point. Plus a bonus for growth and special strengths, or a discount for lack of growth and special problems.
    3. The pivot point in an investment proposal: it’s simple math, but tough negotiations. If you say you want to get $1 million for 50% of your company, you just proposed a valuation of $2 million.
  2. What’s anything worth? Like your car, your house, and a share of IBM stock, something’s worth what somebody will pay for it. The valuation in A is theoretical, hypothetical, but legal. With B and C, though, valuation is as real as agreeing to buy a house. It’s not what the seller says it is; it’s what the buyer is willing to pay. And this cold hard fact drives many entrepreneurs crazy.
  3. For Small businesses, there are guidelines and rules of thumb. If you do a good search, or work with a business broker, you can find general rules of thumb for what your long-standing small business is worth. For example, a hardware story is worth roughly half a year’s sales plus inventory, with bonuses for positive factors like  recent growth,  and discounts for negatives like lack of growth. You could read up on it in bizbuysell.com, bizequity.com, or business brokerage press. Or do a web search and check the ads for valuation experts.
  4. For Startups, it’s what founders and investors negotiate. Startups and investors and culture clash over valuation.  Investors care about valuation. Founders often misunderstand valuation. And never the twain shall meet. I’ve seen these kinds of problems many times:  Founders walk into the valuation discussion full of folklore and fantasy like stories of Facebook and Twitter. They want lots of money for very little ownership. Investors see two or three people with no sales history thinking their dream startup is already worth $2 or $3 million.
  5. Irony: sometimes traction, and revenues, make things worse. It’s easier to buy the dream than the reality. The same investors who’ll seriously consider a $2 million valuation for a good idea, business plan, and a credible 3-person management team – but with no sales ever — might just as easily balk at a valuation of $600,000 for a company with three years history, 20% growth, and annual sales of $300,000.  Despite the irony, it makes sense: few existing businesses are worth more than a multiple of revenues, but, still, before the battle, it’s easier to dream big. Or so it seems. I’ve been on both sides of this table, and I don’t have any easy solutions to offer.

If it hasn’t come up yet, it will. Every business deals with valuation eventually. The place any business sees it is during the early investment phases; but most businesses don’t get investment, so they can ignore it at that point. But then if it survives, or grows, valuation comes up again, because even if the business is immortal, the people aren’t: so eventually you either sell it or pass it on to a new team, an acquiring company, or your own family. And there’s the divorce and estate planning elements that require valuation. So every entrepreneur and business owner should have some idea what it is.

(Image: courtesy of wordle.net)

Planning, Startups, Stories


Tim Berry on business planning, starting and growing your business, and having a life in the meantime.

Looking for Investment? Understand Startup Valuation 0

How much equity do I have to give to angel investors? If you’re a startup founder looking for angel investment, you need to understand valuation. It’s a buzzword that people use in other contexts, too, which adds to the confusion. But it’s ultimately what determines how much of your company your investors will get, and how much you keep, if you manage to land an angel investment deal. So it’s a critical question that comes up a lot.

Equity means ownership. So 25% equity is 25% of the ownership of the business. Usually that’s a matter of shares. The math is fairly simple, but important: Logically, if an investor gives you $250,000, on a valuation of $500,000, that means half your company. The investor owns half, you own half. If the investor gives you the same $250,000 on a valuation of $1 million, then that means the investor gets 25%, you keep 75%. (Technically that’s what they call pre-money valuation, and there is also post-money valuation, but I’m not going to deal with that here. You get the point.)

Startup valuation in practice

What I’ve seen in practice, in nine years of membership in an angel investment group, is that valuation is an agreed-upon guess. There are no formulas commonly accepted formulas (although there are some formulas, such as you’ll see in this post from the angel capital association; it’s just that I rarely see them used in practice). In my experience, what really happens is all about saying no. Investors say no to valuations that are too high, startup founders say no to startup valuations that are too low. When the startup needs $250,000, the founders are rarely going to accept valuations of less than $1 million, because they need to maintain substantial ownership. When investors aren’t comfortable with valuations that high, they most often simply pass on the investment. I don’t see discussions in detail of components of valuation, like one sees in home buying transactions when buyer and seller go into details of square footage and comparable deals in the neighborhood.

Angel investment deals often postpone valuation by using convertible notes. The note is debt, supposedly to be paid off; but convertible means both sides intend to convert that debt to equity shares later, so that it should never be paid off, just converted to shares. In that case, angels are saying essentially, “we believe in you enough to give you this money, but we’re not sure of your valuation, so we’ll postpone that for later.” What both sides want is a follow-on investment, they hope for more money, from venture capitalists, to set the valuation later.

 

Five things you need to know about valuations

  1. The word has vastly Different meanings: don’t you hate it when the same words mean different things? Valuation means at least three different things:
    1. What a business is worth to accountants for legal purposes, such as divorce settlements, inheritance taxes, and gift taxes. A certified valuation professional, usually a CPA, makes a guess. Most of them use financial statements and analyze financial details.
    2. What a business is worth to a buyer. Small businesses go up for sale with  business  brokers. Hardware stores, for example,  get about 40-50% of annual sales plus inventory, as a starting point. Plus a bonus for growth and special strengths, or a discount for lack of growth and special problems.
    3. The pivot point in an investment proposal: it’s simple math, but tough negotiations. If you say you want to get $1 million for 50% of your company, you just proposed a valuation of $2 million.
  2. What’s anything worth? Like your car, your house, and a share of IBM stock, something’s worth what somebody will pay for it. The valuation in A is theoretical, hypothetical, but legal. With B and C, though, valuation is as real as agreeing to buy a house. It’s not what the seller says it is; it’s what the buyer is willing to pay. And this cold hard fact drives many entrepreneurs crazy.
  3. For Small businesses, there are guidelines and rules of thumb. If you do a good search, or work with a business broker, you can find general rules of thumb for what your long-standing small business is worth. For example, a hardware story is worth roughly half a year’s sales plus inventory, with bonuses for positive factors like  recent growth,  and discounts for negatives like lack of growth.
  4. For Startups, it’s what founders and investors negotiate. Startups and investors and culture clash over valuation.  Investors care about valuation. Founders often misunderstand valuation. And never the twain shall meet. I’ve seen these kinds of problems many times:  Founders walk into the valuation discussion full of folklore and fantasy like stories of Facebook and Twitter. They want lots of money for very little ownership. Investors see two or three people with no sales history thinking their dream startup is already worth $2 or $3 million.
  5. Irony: sometimes traction, and revenues, make things worse. It’s easier to buy the dream than the reality. The same investors who’ll seriously consider a $2 million valuation for a good idea, business plan, and a credible 3-person management team – but with no sales ever — might just as easily balk at a valuation of $600,000 for a company with three years history, 20% growth, and annual sales of $300,000.  Despite the irony, it makes sense: few existing businesses are worth more than a multiple of revenues, but, still, before the battle, it’s easier to dream big. Or so it seems. I’ve been on both sides of this table, and I don’t have any easy solutions to offer.

If it hasn’t come up yet, it will. Every business deals with valuation eventually. The place any business sees it is during the early investment phases; but most businesses don’t get investment, so they can ignore it at that point. But then if it survives, or grows, valuation comes up again, because even if the business is immortal, the people aren’t: so eventually you either sell it or pass it on to a new team, an acquiring company, or your own family. And there’s the divorce and estate planning elements that require valuation. So every entrepreneur and business owner should have some idea what it is.

(Image: courtesy of wordle.net)

Planning, Startups, Stories


Tim Berry on business planning, starting and growing your business, and having a life in the meantime.

True Story: Dollars vs. Eyeballs in Business Valuation 2

It was a warm late-spring day in 1999. I sat in my office with a venture capitalist, my lawyer, and my son. The sun beamed in the patio outside my office. We talked about Palo Alto Software and its web subsidiary bplans.com. At one point the VC said:

You wouldn’t be an attractive investment for VCs. You’re too profitable.

I chuckled. I thought it was a joke. We’d grown sales in four years from less than $1 million to more than $5 million annual sales. We had to be profitable because we had no outside money.

He said:

That’s no joke. It’s like the Oklahoma gold rush, a land grab, and the assumption is that if you’re profitable, you’ve stopped too soon. You should be spending more to build traffic.

Those were strange times.

(Image: iDesign/Shutterstock)

Planning, Startups, Stories


Tim Berry on business planning, starting and growing your business, and having a life in the meantime.

BizEquity Adds Tools for Estimating Valuation 0

I’ve posted here before on BizEquity, the “Zillow of small business valuation” site offering quick estimates of business valuation.

BizEquity founder Tom Taulli — a true expert in the field — has added some interesting new tools for the site. Most notably, a valuation wizard that can take your inputs and give you a quick and dirty estimate of what your business is worth.

I did a test run over the weekend, by inventing hypothetical numbers for an Internet company. I had it started just three years ago, growing sales to $350,000. It had little or no profits, a bit of debt, and a lot of dependence on the owner (the site’s auto wizard asked me the right questions). The estimate ended up at about $275,000, with interesting variations above and below that depending on how I set several sliders. You probably can’t read the details in the shrunken illustration below, but the sliders are asking how favorable the location is, the level of competition, and how you foresee the future financial performance.

Bizequity input

With the way the sliders work, you can see instantly how valuation would change with different settings.

Obviously, these are just estimates. As with estimates of house values, before you list your house, these estimates give you some idea, but are far from exact. They’re based on some standard formulas that estimate valuation using factors like sales, profits, assets, liabilities, and so forth. Don’t even dream of using this for a tax-related valuation, which requires a certified valuation professional; but it’s still a useful first look.

I think valuation is fascinating. What is a company worth? With the larger publicly traded companies you can easily calculate a valuation using the wisdom of the crowd, the market itself, by multiplying shares outstanding times price per share. But in the real world of small business, gulp, this is much harder.

Concretely: how much is your business worth? How much could you sell it for? How would you decide? What formulas would you use? More importantly, what formulas would your hypothetical or theoretical buyers use?

Ultimately, like it or not, just about anything is worth what somebody else will pay for it. Your business is worth what you could sell it for.

And what would that be? Well, that’s really hard to know, until you go to the market. Some people talk about 5 or 10 or more times profits, but then face it, in small business, in the real world, profits is a very vague number, an accounting conceit. Some people talk about 1 or 2 or more times sales, which eliminates a lot of the accounting fiction. Others talk about valuations based on book value, or assets.

I’m amused at how much of this stuff is loosey-goosey, even though it’s in the realm of finance, which is supposed to be mathematical and exact. And isn’t.

I posted here last Fall about BizEquity.com, Tom Taulli’s really intriguing site that’s attempting to create a database of first-cut estimated valuations of businesses all over the United States. I talked to Tom last month after the big meltdown, and found, happily, he’s still optimistic about the long-term value of the BizEquity site. They’re working on it. I suggested he take his September data and multiply it by about 0.5 or so; and I was only partially joking. Tom knows this area very well, but of course the whole volatility burst has been a challenge. Last summer might not have been the most opportune time for Tom and his backers to start.

So I was interested yesterday Monday morning as I soaked in coffee and I noted — thanks to Ann Handley in Twitter — Advertising Age‘s Simon Dumenco’s angry analysis of the Huffington Post’s recent venture capital infusion at a valuation of $100 million.

His title, unfortunately, is What’s $200 Million Divided by 2009 Reality. That’s too bad, because the $100 million (or less) estimated valuation was widely publicized when Oak Investment Partners announced the investment last November. Simon doesn’t enhance his argument by referring to the twice-as-large-as-fact figure, $200 million, that actually appeared much earlier, last Spring. The phrase “straw man” comes to mind.

That glaring error aside, he seems offended by the VC’s reported valuation. He has references to the big Internet bubble of the late 1990s. It should be only $2 million, according to him.

I think he exaggerates his point, not just by doubling the figure, but also by lowballing his real estimate. The Huffington Post has made huge (and well reported) gains in traffic. Furthermore, unlike a lot of the Web 2.0 sites he wants to knock, this one has an actual revenue model. For better or worse, the Huffington Post is almost like old-fashioned media. It generates readers with news and opinion, and it sells advertising. So somewhere in the numbers — which are not public — is a number for revenues, and a valuation based on (among other things) revenues as well as traffic.

And it all goes to illustrate my point, today: valuation is hard to figure. It’s also important. And, in the end, a company is worth what buyers will pay for it. In the case of Huffington Post, it’s not a vague theoretical guess. The VCs who invested in Huffington set a price, and, with that, a valuation.

The best readily-available valuation of business consulting services is 1.12 times annual sales. For automotive repair shops, it’s .41 times annual sales. Physical fitness facilities are going for .66 times gross annual profit. Grocery stores are going for .28 times annual sales, and sporting goods stores for .34 times annual sales.

There’s a valuation report in Inc Magazine’s April issue that turned me on to Business Valuation Resources, which sells information like the above, culled from data on actual transactions.  I registered (free) to get a free download of a complex chart — sophisticated, innovative, imaginative, but really hard to read. And I gather that the underlying data isn’t cheap, because I can’t find anywhere to send you for a link to the data table, industry by industry, that I used to do the snippets in my first paragraph.

Conclusion: if you’re dealing with valuation, this could be a good resource. Valuation information is something like insurance account numbers: you don’t need it very often, but when you need it, you really need it. Like when you want to sell your company, or sell part of your company, or predict valuation as part of an investment negotiation, or when there’s a divorce, and … well, you get it.

Gripe: once they’ve published the data and put it out into the world as hard copy, can I get it online somewhere? Oh yeah, I get it, there’s value to the data. Tough call for BVR, how much do you give away to promote your data?

(Note: I posted this on Up and Running yesterday. I’m crossposting it here for reader’s convenience. – Tim)

I really don’t like the word “valuation”; it sounds too much like an MBA buzzword. But I like even less the general confusion about the concept. We talk about starting businesses, we talk about running businesses, getting investment, getting financed, and we should take discussion of valuation for granted. Valuation is at the same time frequently necessary, obvious and extremely arcane. It is nothing more than what a company is worth. It becomes necessary more often than you’d realize, with buy-sell agreements and tax implications after death and divorce, plus financing and investment. It’s obvious because a business is worth what a buyer will pay for it. And then it breaks down into complex formulas and negotiations.

So here are 10 (I hope simple) rules for valuation.

  1. Valuation is what a company is worth. It’s like what a house or a car is worth–less than the seller says, more than the buyer says.
  2. A company’s ownership is almost always divided into shares. Let’s say your company has 100 shares, 51 yours and 49 your co-owner’s.Valuation
  3. Valuation equals shares outstanding times the price of one share. If the company is worth $500,000 and there are 100 shares, then each share is worth $5,000. (OK, there are exceptions, preferred shares and such, but leave the fine tuning for later.)
  4. Tax authorities say the price of a share is whatever it was at the last transaction. (There, too, there are exceptions, but let’s keep this simple.)
  5. When startups offer shares–equity–to investors, then that, too, is simple math. If you sell 20 percent of the company for $100,000, that means the company is worth $500,000.
  6. Investment deals frequently revolve around valuation. When investors question your valuation, they’re saying they want more ownership for their money, or want to invest less money for their ownership.
  7. Analysts often apply formulas. The most common formula is called “times profits” because it multiplies profits times some number. Another common formula is “times sales.” Companies might be worth two times sales or 10 times profits. There’s also book value, which is assets less liabilities. And there’s the estimated sale value of assets.
  8. Privately held companies are worth less than publicly traded companies. They get discounted for the disadvantage of not being able to convert ownership to cash easily.
  9. Growing companies are worth more than stable or declining companies.
  10. As with real estate, comparable sales matter. Analysts look for recent transactions involving similar businesses.

Are you looking for dumb investors?

investor money

investor money

“How can I find investors who don’t take much equity?”

“How can I find investors who don’t interfere with my running the business?

I first posted my objections to this kind of thinking nine years ago in Dumb Investors Dumb Idea, one of the earliest posts on this blog. That was before I joined an angel investment group and became one of those investors. My objections then are a lot stronger now. And I still see a stream of this kind of thinking in blogs and at my favorite question and answer site, Quora.com.

Valuation determines equity

The equity share from investment is simple math. If your investors put in $100,000, that’s 10% of a startup valued at $1 million, and 50% of a startup valued at $200,000. So what’s the underlying valuation? Read up on that with 5 things entrepreneurs need to know about valuation and understand startup valuation. So with normal angel investment, the startup founders want a higher valuation and the angel investors want lower. It’s a lot like negotiating to buy a house or a used car. Ultimately, both sides have to agree, or there is no deal.

Angel investors normally care and add value

Angel investors are overwhelmingly amateur investors, investing their own money, investing in industries they know or local startups. They are successful entrepreneurs giving back. They believe in their ability to select startups well, study them well (it’s called due diligence) before deciding on a deal, and to offer valuable advice and experience. I’ve seen dozens of pitches that ended with investors not interested in startups whose founders knew everything and wanted no advice. People who don’t want interference with their business are not going to do well with angel investors.

Normal angels choose angel investment instead of leaving their money with an investment advisor, bank, or some other institution. They know that investing in startups is risky, but they trust themselves and expect to be able to help.

 

 

 

Your lean business plan is no more than what you need to run your business. In the beginning, it might be as simple as an elevator speech. Be able to talk through those key points: the customer story, what makes you unique, how you’re focusing and on what you’re focusing, and, if it comes to that, your close — what you want from whoever is listening. Form Follows Function

 

Or it might be a simple sales forecast, and perhaps, a burn rate in the very beginning because you know what you’re doing — maybe you’ve been doing it for years already and you don’t need to verbalize it right at this moment — and you’ll set those figures down and start tracking them.

Lean planning comes in many forms. Think of it as analogous to motion in athletics. In so many different sports, the winners practice economy of motion, repeated muscle memory. Another way to look at it: in design and mechanics, the fewer moving parts, the better. If you have to squint conceptually to see the key points, squint down on the elements you’ll be able to track and then revisit.

It’s not about the text, or the form of the thing, until that becomes related to the function. When you’re doing a business plan as part of a graduate business school class, then yes, it has to be complete and look good and read well; editing and format matter. When you’re doing a plan for an investment group that is going to pass it around among the partners, then it matters. But you don’t want to get bogged down in format when it’s just you and your spouse and you simply want to think through what’s required.

So the plan is a collection of concepts in the middle, surrounded by specifics that have to be done. The core of the plan is strategy and tactics, as simply as you can put them, just bullet points as reminders. Around the core you put a collection of milestones; numbers to be measured and tracked (lots of them are sales, expenses, and the like, but not all); task assignments and responsibilities for different people, dates and deadlines, budgets, and so on. That’s your plan.

From that core lean business plan, you spin off various outputs. You take the highest highlights of the plan and 60 seconds or so to explain it in an elevator speech. That’s one output. Or you write it all out carefully, and add supporting information about the market and the industry and the backgrounds of the management team, and it’s a plan document. Or you create a 20-minute 10-slide summary with PowerPoint or Keynote slides, and that’s a pitch presentation for potential investors. Or you create a cover letter or cover e-mail, about a page or so, along with a 5- to 10-page written summary, and that’s a summary memo. Or you do none of these, you simply keep that plan as a collection of bullet points, of picture financial projections, and a list of things to be done by whom and when and for how much money, and share it with your team. In that last case you don’t ever edit or polish it, or sweat the page headers and page footers or font size. You just use it to manage your company,

Notice that none of these outputs stands as something you do instead of the plan. And none of these outputs is really the plan. The plan exists at the core, and you create the outputs as needed.

With all of these various iterations and outputs, always keep assumptions on top, where you can see them for every review meeting. Minding the changing assumptions is one of the significant advantages of the plan-as-you-go approach over the more traditional methods.

I ran a business for years during which the plan was shared only between me and my wife, mostly, enhanced by sales forecasts and burn rate. During those formative years there was no need for anything else. When it was time for an elevator speech, either one of us could do it. When there was need for a written business plan — it came up first when we first set up the merchant account to be able to accept credit cards, in 1988 — then we settled down for a while and wrote it out as it was, conceptually, at that time. We always knew what we wanted to do, but we also knew our key assumptions, and we tracked them as they changed, and revised the plan. A lot of that was verbal, between two people.

As the business grew, the verbal plan with the forecast stopped working. Things became more complicated. Employees needed to know about the plan and join in its formation and then its implementation. So we moved it into bullet points on the computer, and tied those to forecasts, and began tracking in a group, in more detail.

We then began to do annual plans more formally, writing out chapters, and conducting review meetings every month. With each annual plan we’d go out and take a new fresh look at the market. We had people doing nothing but marketing, and they developed segmentations and forecasts and supporting information. It was part of their job.

Are you recognizing yourself somewhere along this line?

Eventually we wanted to bring in outside investment. That was during the dotcom boom when valuations were very high, so we thought it would be a good time to lock in the value with some cash out. We produced very formal plans every three months during that period.

The speech isn’t instead of the plan, and the pitch isn’t instead of the plan, but that doesn’t mean you plan or don’t plan if nobody outside your company is going to read about it. Your plan should always be there as the source of these outputs, so you’re ready to produce them when you need to.

Sure, maybe you need the money. Maybe that’s what your business plan says. But seriously: Do you really want to have investors involved in your dream startup?

I’ve said it before: bootstrapping is underrated. I get frequent emails from people asking how they can get investment for their new startup, and I’ve admitted to being a member of an angel investor group. But let’s not forget, while we’re thinking about it, these 10 good reasons not to seek investors for your startup.

  1. It’s almost impossible to get investment for your very first startup. If you don’t have startup experience, get somebody on your team who does. Chris Dixon said it best: either you’ve started a company or you haven’t. And if you haven’t, and nobody in your team has either, that makes it very hard.
  2. You are selling ownership. Investors write checks to own a serious portion of your business. I admit that’s patently obvious, but you should see the emails I get in which people think of investors as if they were some sort of public agency. Once you get investment, you don’t own your entire company.
  3. Investors are bosses. You are not your own person when you have investors; you’re part of a team. You can’t decide everything by yourself. Politics matter. Investor relations matter. If you screw up, you do it in front of other people, and it hurts those people.
  4. Valuation is critical to them and you. Simply put, valuation means the price. If you want to give only 10 percent of your company to investors who pay $100,000, you’re saying your company is worth $1 million. And so on. Simple math, but wow, not so simple negotiation.
  5. Investors don’t make money until there’s a liquidity event. That’s why we always talk about exit strategies. You can be the world’s happiest, healthiest, most cash-independent company, but your investors won’t be happy until you get them cash back. The win is getting money back out of the company. Some big company stock buyers like dividends. Startup investors don’t.
  6. If it’s not scalable, forget it. The real growth opportunities are scalable. It used to be products only, but now there are some scalable services, like web services, for example. But if doubling your sales means doubling your headcount (that’s called a body shop), then investors aren’t going to be interested.
  7. If it’s not defensible, it’s tough going at best. Not that I trust patents as a defense, but trade secrets, momentum, a combination of trade secrets and patents, plus a good intellectual property defense budget … if anybody can do it, then investors aren’t interested. (Of course, what would I know, I thought Starbucks was a bad idea because I thought that was too easy to copy … there are always exceptions.)
  8. Investors aren’t generic. Some become collaborative partners and even mentors, some are nagging insensitive critics. Some are trojan horses. Some help, some don’t. (Hint: choose carefully which investors you approach.)
  9. Just getting financed doesn’t mean diddly. For an example of what I mean read this piece from the New York Times. You haven’t won the race when you get that check.
  10. Investors sometimes take your company from you. Well-known strategy consultant Sramana Mitra has a couple of eloquent minutes on that them in this two-minute video. She seems to be talking about India, but she’s well known in the Silicon Valley, and what she says applies perfectly well here.