Wednesday, 3 August 2011

How Much is my Business (Idea) Worth, and How to I Get Out?

Serial entrepreneurs often start up companies thinking about one thing, and one thing only : what is my exit strategy?

Put another way – how are they going to get out of the company when they either get bored, or have realized enough value that it becomes more worthwhile to sell it on (or shut it down and dispose of the assets accrued) than keep it ticking over.

The most clinical approach is to build the exit into the business plan, and use that as a way to see (indeed, test) whether the whole venture is actually viable. If the exit strategy is to sell the whole company on as a going concern for a value of 1 million pounds (Euros, dollars, etc.) in five years time, it becomes relatively easy to work backwards through the numbers to test for feasibility.

Other exit strategies also include going public (selling shares on a stock exchange) or selling the company purely on the basis of its value to a competitor or related business – think of Google’s acquisition of YouTube, or Twitter buying TweetDeck, for example – where the classic measures of revenue, profitability, etc. don’t really apply.

However, these are subject to specialist knowledge, market awareness and probably a healthy dollop of good luck, so to provide an empirical example, we shall assume that the business valuation is designed to provide value to an investor – be it 100% (disposal) or some fraction thereof (to garner investment, or when going public.)

This kind of valuation is usually based on current performance. Examples of companies valued on potential performance (the most famous being PayPal) can also be found, but these are relatively special cases : for those that manage a PayPal, there are many, many, successful serial entrepreneurs who never see that level of IPO success.

On the other hand, many start-up investors will also be looking at potential. However, given that it has to be grounded in the figures that reflect believable performance, the discussions about exit strategies also apply here.

There are many, many approaches to valuing a company:

Some reasonable, simple, valuations use trading figures and investor returns on equity to prepare a business plan that will provide targets that can be realized, and also help in the preparation of documentation for potential investors, from banks to angels.

A common measure is to take three to five times profit, and use that as a nominal value to establish targets for exit or investment. From the other side of the table, so to speak, if an entrepreneur needs 10,000 pounds (dollars, Euros, etc.) investment, for a 20% stake in their company, the investor will be expecting to be able to see at least 50,000 pounds worth of company value, as well as a return of 5-10% (using a better than bank rate) on their investment.

Using these techniques, it should be relatively easy for budding entrepreneurs to appropriately value their business idea, and potential of their start-up company.

Monday, 1 August 2011

Is My Business Idea Any Good?

Working out whether a business idea is any good is a tricky proposition. There’s the tried and tested ‘overnight test’ where the entrepreneur can leave the idea overnight and come back to it at a later date to see if it still holds water (and if they still want to do it!) However, as regular Dragon’s Den viewers will attest to, there are three key questions that often crop up.

Firstly, many investors, banks and Dragons included, will want to know the ‘margin’. This is the difference between the price of the product (usually wholesale) and the cost of manufacture; in the case of services, it is the difference between the cost or provision and price placed upon the service. In both cases, it is often quoted as a percentage, but it’s useful to know the actual numbers as well.

This becomes evident when the second question pops up : is the business idea scalable? In other words, are the processes, knowledge, and business activities replicable to the point that a decent return can be had, in terms of the margin? Does the business scale such that the return increases, at least in line, and preferably better than proportionally to the units sold?

A scalable business is attractive because it elevates the business from something that could make a living for one person working out of their own home to a profitable business that could make money for investors, employ staff, and perhaps go on to become a household brand. For example, if all the skill required to produce the product is non-transferable, it isn’t scalable, and therefore isn’t really an investable business.

Whether that matters or not will depend on the needs of the business owner – but even a scalable business needs to react to one final question : how big is the market? One person with a talent and a hungry market can make a living, but it needs a hungry market and a repeatable income generation process to become an investable business.

So, investors need all three to line up – the margin has to be interesting, the business scalable, and the market has to be big enough for it to scale into at those margins. Of course, there’s flexibility in there : higher margin products (houses) need a smaller market to generate the same amount of money as, say, biscuits.

Individuals such as human cannonballs who have a talent that is in demand, can only satisfy a finite market, and so are not examples of scalable businesses, even if they manage to build a profitable income for themselves. To become scalable, they would have to find a way to transfer that talent (stage schools take a similar approach) to others, and build a business that way.

If a business satisfies the margin, scalability and market criteria, and would be attractive to an investor, then it’s half-way to being a good idea, and certainly worth some additional thought!