As I’m reading Adam Penenberg’s book Viral Loop: From Facebook to Twitter, How Today’s Smartest Businesses Grow Themselves, 2 main themes have caught my attention. Firstly, the power and consistency of creating a viral loop for your business. Secondly, though the item I’m blogging about first, is how differently businesses can be valued.
I’ve written regularly about valuing small businesses based on the mantra “it’s all about profits”, and yet have learned of dozen’s of businesses worth hundreds of millions to billions of dollars with little to no profits to back that up. Penenberg references HotorNot, Hotmail, Paypal, Ebay, Bebo (even though they didn’t use their venture capital money), Myspace, Facebook, BirthdayAlarm, Netscape, Ning, Twitter and others that almost universally had substantial losses each month when venture capitalists started investing millions or 10’s of millions of dollars into these businesses. A good friend of mine, and MBA student, had argued with me many times that business is all about getting customers. I always countered that you can have a million customers but if you lose $1/month on each one, that’s not a good business. It seems, however, that both of us weren’t looking at the entire scope of business.
So when we value businesses, there are basically 3 primary groupings to consider:
- Small, closely-held businesses (which is what I most often write about)
- Internet Businesses
- Public Companies
In small, closely-held businesses, I am right. It’s all about profits and your business should be valued on that. If you’re buying one of theses businesses and it has a loss, you may just want to offer to take it off of the seller’s hands for them so they don’t continue to incur the losses. These are your every day “main-street” (pardon the cliche’) businesses that you find for sale on Bizbuysell.com and other websites. Theses businesses are generally your first step toward wealth creation.
Internet Businesses open up an entirely other ball of wax. These businesses rarely have any income and certainly no profits early on in their life-cycle, however manage to attract anywhere from hundreds of thousands to hundreds of millions of dollars in investment capital before turning a profit. Does that mean it’s not about profits for these businesses and that’s not their top goal? Of course not. That’s just crazy talk. The difference is simply this. These investors appreciate that their is profit potential when you’ve captured the daily attention of hundreds of thousands or millions of internet users. One particular story that caught my attention was the start of Hotmail. Initially Hotmail had no users, no website (didn’t even have the hotmail.com domain name) but they had an idea and managed to raise $300,000 for a 15% stake in a company with no customers or income or profits, in return for being the first company to come to market with webmail. About 2 years later, that initial $300,000 investment from the venture capital firm was turned into $60 million dollars as Hotmail was sold to Microsoft for $400 million dollars. Without going into the details, the power of a viral business model made this all possible. So our question is, how did the venture capital firm decide that a 15% stake in JavaSoft (which eventually became Hotmail) was worth $300,000? Negotiating. The only thing JavaSoft had was an idea. Through negotiating they decided the idea was worth $2 million and so 15% was worth $300,000. For the dozen’s of businesses I’ve mentioned above that have followed a similar trajectory, obviously there are hundreds that failed. Beyond that, Microsoft, has certainly profited far more than their original $400 million investment in Hotmail in the last 10 years so don’t ever lose site of the importance of profits. 😉
Public Companies can potentially bring another set of rules. Firstly, you can’t buy a public company for less than it’s stock is worth. In other words, if a stock is trading for $10 and there are 100,000 outstanding shares, the business is worth $1 million dollars ($10 x 100,000) and you can’t pay less for it. In theory, the company’s stock price should be based on it’s profits (generally called earnings) however many public companies have price to earnings values ranging from 5:1 to 50:1 or higher. This simply means that the business is “worth” anywhere from 5 to 50 times more than its profits. If a business is currently losing money, it’s price to earnings ratio effectively doesn’t exist. So, for instance, if the business above had $100,000 in profits, it’s PE or Price to Earnings ratio would be $1,000,000 to $100,000 or 10:1. Make sense? So the natural question is, what determines a business’ stock price? And the answer to a great degree is the same as with an Internet Business. It’s based a lot on speculation. More specifically, if a bunch of people think a business is a great business, and so buy a lot of stock, the price of that stock will go up regardless of whether the business has profits or not. In theory, over the long-term the stock price will match the actual value of the company which is how guys like Warren Buffet have made billions investing in companies that are undervalued.
So what does this mean to us? If you have no profits but can convince a bunch of people you have a great business anyway, you can make a lot of money. 😀
The reality is actually, if you can convince buyers, venture capitalists, or investors that your unprofitable business has the potential to return remarkable profits in the future, you may just be able to throw EBIDTA out the window and value your business on whatever feels right at the moment. In other words, no matter where or what your business is, your business is worth whatever you can convince someone to pay for it.
To your success, Bryan
P.S. If you’re looking for a real-life argument between a small business “profit is king” entrepreneur and a “customers are king” large business builder, check out Perry Marshall’s blog.