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The guys talk about the different methods to value a startup, particularly when the business is pre-revenue.
Full Podcast Transcript
NASIR: All right. Welcome to our podcast where we cover business in the news and add our little legal twist to it like a little lemon at the end of a… what do you add lemons to? Fish and…?
MATT: Uh…
NASIR: Anyway, my name’s Nasir Pasha.
MATT: And I’m Matt Staub.
NASIR: I think most of the time you add lemons to a podcast. That’s the only thing I can think of.
MATT: Oh, you’re talking about the end, after something’s already made. So, that would be very common in a fish and chips setting.
NASIR: Oh, yeah, fish and chips.
MATT: I thought you were talking about something like a lemon peel garnish type situation.
NASIR: No, that’s way too fancy for us. We’re a fish and chips kind of podcast. So, welcome to our cooking show and food culinary arts.
MATT: I’ve actually ranked my top ten things to have a twist of lemon with, food-wise.
NASIR: Is one of them a podcast?
MATT: Podcast is number one.
NASIR: Okay. Great.
MATT: But, if I did have a business, let’s say I did start a business and it was solely based on what to put a twist of lemon on at the end, but the problem was I wasn’t really making any money but I’m presenting in front of some investors and I need to value how much this business is worth, how would I go about doing that? That’s our topic for today.
NASIR: Yeah, just sitting here, watching you find a way to transition it to our topic of the day is just entertainment in itself. There’s no lemon needed, in other words. Yeah. So, we’re talking about valuation today.
MATT: I’m sure a lot of people have seen Shark Tank or have at least heard about Shark Tank. But, if you’ve seen an episode, you know that, at least once an episode – actually, not even once an episode – in every single one, you see they come out and the first thing they say is, “I’m offering this percent of my company for this amount of money.” So, you know, you multiply that out and that’s how you get what the entrepreneurs value their company at and there’s usually a dispute between what someone values it at and what the sharks value it at. And so, I think that’s, I would say, for those people that are on that show, that’s probably the toughest thing for them to do because, a lot of times, sometimes, the businesses have some track record or some sales or specific industry things like that, but I think, a lot of times, they’re just kind of throwing numbers out there. They’ve looked at prior episodes and prior things and just tried to take a stab at, you know, what they think the value of their company is, and sometimes they get called out, especially Mark Cuban will do that pretty frequently.
NASIR: Yeah.
MATT: And the one guy in the middle, was that Kevin O’Leary? I think it’s his name. He’ll always because all he cares about is the bottom-line.
NASIR: Yeah, I like his approach. Well, I mean, he’s pretty harsh when it comes to valuation. He’s pretty aggressive in that respect. But you know what’s interesting about this topic – I think we should give a disclaimer because we’re not necessarily experts in business valuation. Obviously, we can give our legal perspective on this but it seems like everybody and their mother are experts on valuation. If you were reading online, it would seem that way, right?
MATT: Only mothers, no fathers.
NASIR: Is that the term? I don’t know. Everybody and their parents and their cousins and their brothers and sisters and sons and daughters seem to be experts in this field, and they come up with these rules like, “Oh, well, look, if you’re in your first year and you don’t have any assets, you’re a startup, automatic million-dollar valuation and then it starts from there. It goes up if you’re pre-revenue,” all this stuff. But, at the end of the day, we can talk about the different ways that people approach it but, to kind of cut to the chase, I think, at the end, it’s not a perfect calculation. It’s built on instinct and what the investor or whatever purpose of the valuation is – but, in this case, investors feels your company is worth – and that could be really different, depending upon the industry you’re in, depending upon the investor’s experience, and your expertise. It may not even have much to do with the numbers because you’ll see different companies in the same space with very similar numbers get very wide-ranging valuations and it has nothing to do with how much cash they have in their pocket or how many sales they have necessarily.
MATT: I mean, even when you see people – and you’re right about the expert thing of valuations but – even when you see people try to bust out all this math – because there’s a lot of numbers involved – you would think that would be very straight-forward because math is pretty straight-forward and pretty concrete. But, even with some of the formulas you’re using, you’re still taking guesses at and projections at certain things. So, to me, valuation is just what someone values it at or I guess, to me, the most important thing is the person you’re trying to get money from or investment from, what they value it at, and I know that’s a terrible way to define it but that’s really the most important thing. And so, I think, to people that are looking to value their young companies, there’s a lot of different options to look at and I think it’s just finding something that (1) makes sense and (2) they can explain or back up to the best of their ability. I think, if you come in with that, if you have numbers, great that you can back it up, that’s obviously great. But, I think, if you can back it up and explain why you valued it at the number you did, I think that’s going to be the best thing you can do walking into a group of investors.
NASIR: Yeah. But let’s talk about some of the ways that you can value a company. The most common method – I don’t want to say method, it’s the wrong word – the most common factors in the different calculations for businesses that have been established is using their revenue or EBITDA – EBITDA being earnings before interest, taxes, depreciation, and amortization. I mean, that’s a pretty standardized general accounting practice number. It’s an actual number and usually there’s a multiplier added to that, depending upon – I don’t know – the industry or what-have-you, right? There’s different standards and so forth. And so, usually, there’s different calculations based upon that. but, the reality is, if everyone used that, most of these startups would be worth basically zero because they’re usually pre-revenue.
MATT: Yeah, and basically what that is is taking the money if they do make revenue and throwing out all the not the bogus expenses but, like, when an NBA team says, “Oh, we don’t make any money,” but, yeah, you have all these expenses that you just listed, when those get backed out, it’s a big difference.
NASIR: Yeah.
MATT: If they don’t make any money, then, yeah, you’re still looking at zero. I don’t care what the multiplier is. I think any multiplier times zero is still going to be zero which makes sense.
NASIR: Yeah, that’s right.
MATT: Let me check.
NASIR: Yeah, put that in the calculator.
MATT: Yes.
NASIR: There is another way that startups could. I still don’t think it’s that common. It’s where you can use your assets that you have. I think maybe all startups, to a certain extent, use their assets. But assets aren’t necessarily the machinery and the supplies and the goods and your furniture and computers or inventory you have; it may be something else. It may be intangible. It may be your intellectual property. It could be your actual software and your development of that. It could also be the cash that you have on-hand from a previous investment and so forth. It could also be your goodwill too because maybe you have Twitter, right? You have a billion customers or a billion users but no one’s paying you anything. But, still, that’s an intangible property that goodwill is worth quite a bit. And so, I think that’s a little bit more common – it’s definitely more common that kind of the EBITDA earnings kind of valuation perspective.
MATT: Yeah, it’s more common, but you still kind of run to that same issue of how do you value? You know, you’re looking to value your intangible property.
NASIR: Yeah.
MATT: Obviously, you can look at building or if you own the land and see how much it’s worth but, I mean, obviously, that’s getting appraised too.
NASIR: Sure.
MATT: But the intangible property is going to be where the real money is or where the real value is or what your assets are. So, that can work, I guess, but it’s still you’re kind of taking a stab at what things are worth.
NASIR: Yeah. At the end of the day, this is not an exact science. There are literally – well, I should say this – there are literally scientists in this field. There are literally firms that all they do is value businesses and they have a whole, again, scientific method to it. They’ll break it down in different formulas. They’ll recommend a specific type of valuation, different circumstances based upon the industry, et cetera. But, you know, at the end of the day, there’s only so much you can do and, with startups, you don’t really have that option to go that route for getting a calculated valuation like that.
MATT: What about valuing the number of users you have and kind of projecting how much each one of those users are worth, you know? Taking that times whatever and get your value.
NASIR: That’s probably popular in kind of tech startups because maybe a user that’s paying X but it’s still projections. But I think that’s the most common way. People want to invest in you because of the potential, not what you’re worth now. Even though you may be worth less now but people are investing in your potential, your potential itself has value, right? And so, that’s where you can add a little padding to it, so to speak, and get past those traditional EBITDA calculations or multipliers.
MATT: Luckily, I found this startup valuation calculator.
NASIR: I saw that.
MATT: Well, I was typing it into Google and the thing that popped up was “calculator” and I was like, “Oh, I’ve got to click on this.” And so, the first question is, “What are the odds of your business surviving five years?” and you rate it from zero percent to 100.
NASIR: 100 percent I would say, right?
MATT: I actually didn’t run through this. Basically, you’re just guessing on what everything is and I ran through it but you had to put your email at the end in order to get your valuations. So, I didn’t go through with it.
NASIR: Oh, I went through with it. I just put some fake email. You don’t actually have to confirm your email which is cool. I basically put 50 percent chance that I’m surviving five years then I think – I can’t remember what industry I picked – and these are all good questions to go through so you might as well. So, how much cash and other assets does your business have including property and equipment? I just put zero. How much liabilities does your business have including bill payables, loan, and debt? I put zero. How much revenue do you expect your business will produce this year? I put $100,000. And then, how much revenue do you expect your business will make or produce five years from now? I put $3 million. And then, how much operating profit (loss) do you expect your business will generate this year? I think I put $90,000 or so.
MATT: $100,000 in revenue and $90,000 in profit, that’s pretty impressive.
NASIR: That’s right. Yeah, that’s a very low overhead, right?
MATT: Just the lemons.
NASIR: I thought of it pretty quickly. I wish I put more thought into it. And how much operating profit do you expect your business will generate five years from now? I think I put one million or so – I can’t remember exactly. Based upon that, how would you value it?
MATT: You actually put in those numbers?
NASIR: Yeah, I put in those numbers. What would you say?
MATT: Oh, I don’t know, $5 million?
NASIR: It was actually 0.8 million was the valuation.
MATT: 0.8 million?
NASIR: Yeah. So, yeah, you’re way off.
MATT: You had a 90 percent profit margin. I mean, that’s basically printing money.
NASIR: That’s true. I think that’s a good point. That’s a pretty good profit margin but maybe I was off. Maybe I said $10,000 or something. I don’t remember.
MATT: Oh, I guess you’ve had the odds of you surviving at 50 percent so I didn’t discount it for that.
NASIR: Oh, that’s what it was, yeah.
MATT: And you didn’t tell me which industry sector your business was in which was the second question so I probably would have guessed 0.8.
NASIR: This site – and I’m sure there’s other calculators – I guess it could give you an idea, but this is the same of going to anyone and, when it comes down to it, when you actually have to value your business because there’s some event – whether you’re looking for investment or what-have-you – to me, I’m thinking that you need to get as much information as possible and don’t rely upon any one opinion and see what you can get. Another thing that people say – and I see some wisdom behind this – in your first round especially, getting the best valuation and the most money is not necessarily your goal because, remember, you may have a second or third round and, a lot of times you want that to be a multiplier of your first round. If you don’t have that increase in growth then you may have some momentum issues as well.
MATT: Well, from what I can remember on Shark Tank, they seem to favor the multipliers.
NASIR: For sales? Yeah.
MATT: For a specific industry, they’ll mention the industry and they’ll mention the multiplier and stuff like that so that seems to be pretty popular. But my advice is what I said at the beginning that there’s no hard, fast rule. So, whatever you value it at, go with it and be able to back it up.
NASIR: Stand by it, yeah.
MATT: At least to the best of your ability, yeah. You know, at least if you’re confident and you can have some reasoning behind why you valued it that way then, you know, you won’t look dumb.
NASIR: I have a feeling we’re going to get some emails about this episode because people are really passionate about this issue for whatever reason and people just think that they’re right and I don’t mind hearing those opinions. I’m just saying that I just don’t think any one person or any one perspective has monopoly on how to approach this because maybe there’s a set way if you’re approaching VCs and Silicon Valley but not everyone’s doing that. Some people are looking for investors, not necessarily just as a tech startup but as a small business who’s operating a gas station or buying a car wash or what-have-you. And so, everyone’s in different roles and, depending upon the investor that you’re working with, depending upon the industry that you’re working with, and the people involved, how much you’re raising, these are all very wide variables, I would say.
MATT: Yeah, and just look at the list. Forbes does a value of the NBA franchises and theirs just came out. The Clippers which just very publicly sold for $2 billion earlier I guess 2014, they just got valued at $1.6 billion.
NASIR: That’s a great example.
MATT: And so, that’s too low. And some of these other ones like you were telling me, they’re just too low. I mean, people are paying exorbitant amounts for these NBA franchises. Even then, I can shoot these down with whatever.
NASIR: Yeah. So, according to them, the value is overvalued according to some formula or dollars and cents or some guy that is studying this. But, the frank of the matter is, people who study valuation aren’t the ones buying businesses, right? They’re customers, they’re consumers, just like you and I that, if they go to the grocery store and, if I go the grocery store right now and I buy a banana for a bundle of bananas for $5.00, I have no idea if I overpaid or not. It sounds a little high for me but, if it was $5.00, I think I’d be willing to pay that. But, you know, I don’t buy bananas every day. But I do like bananas.
MATT: This is great. Well, I was going to say something, but I’d like to just end it on the book ends. You started it with lemons and then you ended with bananas. So, you did two yellow fruits and I think that’s the perfect ending.
NASIR: All right. Well, thanks for joining us everyone. Don’t forget to rate us on iTunes which is an application that processes podcasts for us and you can rate us five stars. Thank you for joining us.
MATT: Keep it sound and keep it smart.
