Breakout Valuation (eBook)

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Valuation Matters to You!

“Just because Goldman says this is the right valuation, you shouldn’t assume it’s correct just because Goldman said it. My brother works at Goldman, and he’s an idiot!”

—Andrew Ross Sorkin

For Chris to get what she thinks her business is worth, she came to realize she needed to understand how investors value businesses and glean insights into why some businesses are perceived as very valuable. She noticed that many of these highly valuable businesses have one thing in common—a leader regularly communicating a magnetic vision of the future to anyone who will listen. She realized she has kept her vision for her business to herself. She mentioned this to her peers at their monthly meeting, and they encouraged her to outline her vision to them. She anxiously shared her vision, and her peers were awestruck. “We never knew you had robust goals for your business to achieve such levels of success!”

Chris recognized she had important work to do. It was still fuzzy to her at the time, but she knew she needed a way to better communicate her vision to her team and stakeholders. It then dawned on her that her vision needed to be shared publicly as well and used as a tool to attract investors and lenders to help grow the business.

I have seen Chris, many times, realize her business is being viewed by outsiders as materially less valuable than what she feels is fair. But what really agitates Chris, and rightfully so, is that her smaller competitors—some of them brand-new startups—seem to attract large valuations, capital, and excitement. Her agitation is fuel for her burning desire to understand what outsiders see in other companies but not in hers. Most of her “Aha!” moments will concern how investors and business buyers view valuation.

What Is Valuation?

How do you value your company?

Is your answer a mathematical equation?

Is your answer addressing any items that create value?

If you answered the question “How do you value your company?” with something like a multiple of EBITDA, revenue, or customers, we created this book especially for you.

Academics and finance professionals attempt to make valuation objective, but the reality (in the real world that you know so well) is that valuation is subjective. Valuation is highly influenced by the personal views of the participants in a transaction. Knowing why and how experts and professionals use objective valuation tactics will arm you with an advantage to get what you want—a Breakout Valuation.

Over decades of analyzing and valuing businesses, I have come to appreciate that valuation is simply a present view of what the company will produce in the future. Contrast this with most private market investors who want to value a business based on what it is producing today. Academically, investments, such as stocks traded in public markets, are based on the net present value of future earnings expectations. The challenge with the academic view of valuation is that it is based on a forecast of cash flows, which has a major drawback: no one has an accurate forecast, so all we have are expectations based on the biased viewpoints of the forecaster. Do not fret! This book is not about finance jargon and discounting cash flows. It is about helping you influence how the future of your business is viewed.

“Net present value” is an estimate of future value discounted back to what it is worth today. “Discounting” compensates for the risks, costs, and likelihood of future value being obtained. You will not need to know technical terms for this book. But we do share insights on technical terms, in the plainest language possible, to help reduce anxiety when you hear them.

Many books, several of them very intellectually sophisticated, have been written on valuation. There are whole professions built around performing valuations. This may give pause to entrepreneurs who mistakenly think that since it is such a studied subject, with professionals who dedicate tens of thousands of hours to it, “outsiders” cannot possibly understand valuation let alone become experts on it themselves. False. Wrong. I am going to outline for you exactly what you need to be your own expert. I promise this is easier than the complexity you fear. Many parties have a vested interest in you feeling like valuation is a complex financial formula or current multiples of some number like sales or EBITDA. All of that is misleading and unhelpful to you. Multiples and complex financial formulas are not what create value. You do!

EBITDA is the acronym for earnings before interest, taxes, depreciation, and amortization. It is irrelevant to most business owners, especially entrepreneurial businesses. Technology companies coined the term EBITDA back at the turn of the twenty-first century because traditional accounting methods did not accurately reflect the cash flow on their profit and loss statements. EBITDA was born in an attempt to articulate the financial performance of a business. We will use the term sparingly and only do so because it has become so mainstream (unfortunately).

Capital, Cash, & Money

Throughout this book, we use the term “capital.” Capital is analogous to “cash” and “money,” and using these terms interchangeably is largely not a problem. Capital is, at its core, the money in your business. We purposely use the term capital because it better defines the liquid assets being held or obtained to cover the expenses of the business. Capital can include all of a company’s assets that have monetary value, such as its equipment, real estate, and inventory. And capital, unlike other terms, is defined by where the money came from: debt (e.g., a loan from a bank), equity (e.g., stock sold to investors), and earnings (cash from the business). Capital is the money that can be used by the business to fund expenditures, and it goes beyond cash on hand.

There are two sources of capital: internal and external. Internal sources of capital are retained earnings (profits) and the money the founding owners contribute. External sources are investors and lenders, such as banks, private equity, private debt, and individual investors. We intentionally use the term “external capital” throughout this book to make it clear when we are discussing money from sources outside the business and its founders. The use of capital is a critical tool in growing value in your business.

Optimize

Optimization is a key concept throughout this book. Most business owners are doing “good enough”—good enough to where the business could fetch 3–5x cash flow at sale. Good enough does not cut it for breakout. Optimization is required to achieve a Breakout Valuation. Optimization is all about intentionally designing and strategizing all aspects of the business to be a valuable asset to its owners.

Entrepreneurs are very good at slugging it out. Making the next sale, fixing problems as they arise, that is the 99 percent. The rarefied few step out of the business to purposefully design it to not be dependent on them. Even rarer are the few entrepreneurs who intentionally work on building value in their business.

Most entrepreneurs believe that bigger is better and bigger creates value. They believe more revenue will solve all problems. That is not the case. More revenue and “bigger” businesses lead to bigger problems and exacerbate underlying business model issues. The goal of this book is to empower you to optimize your business to achieve Breakout Valuation. So, spoiler alert: when we discuss value drivers throughout the book, growing revenue is not one of them! In the coming chapters, keep optimization in mind. Breakout Valuation is getting people to see the future potential of your business and give you substantial credit for that vision because the vision is fortified with optimized designs.

Why Valuation Matters to You

Valuation is more important to you than to anyone else in and around your business. While you may have other shareholders, as the founding shareholder, you have the most to gain or lose from outsiders pegging a value to your business. Valuation is what your business is worth—and what it is worth is in the eye of the beholder. Valuation is the economic value (primarily cash) that will change hands when and if ownership of the assets and all the rights of the business are sold.

“So what?” you may rightly ask, especially if you do not have any current plans to sell your business. Valuation always matters to business owners who want to maximize their benefit from owning the business. Consider the following questions and how valuation affects each:

• At what price could employees have the right to buy stock (employee stock options)?
• At what price could people from outside the business have the right to buy stock?
• If you want to sell stock to investors someday to bring capital into the business, at what price will the equity be sold?
• How is the business valued if owners want to sell shares to each other or back to the business (commonly called “buy-sell agreements”)?
• How do all shareholders in the company view the value of their ownership?

Knowing what your ownership of the business is worth becomes increasingly important as the business matures. Understanding value may allow owners to pledge their ownership as collateral for loans, and it helps them make important financial planning decisions that impact their families and future generations.

Valuable...