Be an Ethical Entrepreneur, Marketer, and Business Builder

Business Valuation – Public, Private, and Internet Businesses

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:

  1. Small, closely-held businesses (which is what I most often write about)
  2. Internet Businesses
  3. 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. ๐Ÿ˜‰

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. ๐Ÿ˜€

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 theย  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.

How I nearly doubled profits the first year of my first business…

My primary business was purchased April 7th, 2008. My goal was quite agressive in that I planned to double the business in year 1 and starting “buying back my time” in year 2. In other words, in year 2 I want to figure out how to keep growing the business, supporting myself, and not having to work 60+ hours per week. To be more specific, year 2 goal is to eliminate myself from the business almost entirely… I’ll keep you up-to-date on how to make that happen but for now let’s look at the year 1 summary…

Increase in gross revenue of 17% due mostly to a mid-year acquisition of another bordering franchise. Not quiteย  what I had in mind, however my unaudited books are showing an increase in net profit of around 95%!

Better than I expected on the profit side even if the revenue side was a bit lower than expected. Overall, a doubling of gross revenue maintaining profit margins or a doubling of profit put the same amount of money in my pocket and increase the value of the business the same amount so you can’t argue with that. ๐Ÿ™‚

So there are now 2 questions to answer:

  1. How did I manage to increase profits 95% in my first year?
  2. What would I do differently next time?

For this blog we’ll address how I managed to increase net profit 95%.

  1. I knew and watched the numbers. A few of the numbers I watch were listed in my blog on weathering the economy. Possibly the most important number at my business was the average revenue generated per day per technician. Nearly doubling that number has increased our profits a lot with zero increase in overhead.
  2. Converted our revenue generating team members to partial commissions. So the question that comes to mind is why aren’t they full commission? Because our small business can’t allow each team member to “specialize” enough to just generate revenue and I haven’t taken the time to figure out a better more “incentive-based” method of compensating.
  3. Cut overhead. We had 4 different phone companies and am still working on getting that down to 1. With Quickbooks we’ve been able to cut our accounting expenses a few hundred dollars per month. Started using Quickbooks Payroll to save about $100/month over Paychex or ADP with much more flexibility and control. Adjusted payroll to more accurately reflect work. In other words a few pay decreases were warranted.
  4. Cut costs of goods sold. We compiled a computerized list of all of the parts we sell and use (still a work-in-progress) to track who we purchase them from and have started shopping around for the best combination of price and quality for the parts we sell.
  5. Acquired another business to leverage economies of scale. The business was acquired cheaply with non-standard financing in a territory that had been underutilized and never marketed for a long time. We converted the Payables, Receivables, and Customer-service into our current location with minimal increases in overhead compared to a separate office and staff just for that small business.
  6. Cut personnel to only what’s necessary to be profitable. This will also be on my lists of things I would change. By nature I’m a “nice” guy so letting someone go is tough. However when it’s necessary it needs to be done quickly and decisively. The easy way to know if it’s being done is if you provide benchmarks, procedures, and responsibility lists and a team member isn’t holding up his or her end of the bargain it’s time to move on. This is also paramount if you want your business to run on its own.
  7. Created processes, procedures, responsibility lists and checklists. You can’t increase productivity and you can’t determine if your paycheck-for-work trade is worthwhile if you and your team members don’t have exactly what’s expected of each team member in writing. It seems sad that the team members who just go the extra mile without prompting are few and far between.
  8. Sold more to existing customers. We simply increased our marketing to current customers for upgrades and recurring service.
  9. Tracked marketing and started cutting out the bad. The cuts, yellow pages for instance, have just started since it takes some time to gather that data so in 2009 we should be leveraging our marketing even more. We also started using lead-tracking software to make sure no leads were getting forgotten or missed.
  10. Integrated real-time GPS units into service vehicles. “Inspect what you expect” is how one business owner phrases it. If you expect people to work 8 hours per day and not stop off for multiple lunch breaks or go home, it’s best not to temp them with “no one will ever know” opportunities.

Obviously a lot more things have been done – like integrating weekly team meetings and simply having management at the business every day – however those were the 10 that most quickly came to mind as I started reviewing the last year.

Beyond that, the absolute most important part of buying a business you’re going to grow rapidly is to wait for the business that needs a similar list of things to fix. If you buy a business that’s already “perfect”, which mine certainly is not and we’ll address that in the next blog, what choices do you have for growth? Your only options then become to increase prices, sell to more customers, or sell more products to current customers. And that stuff is hard work! ๐Ÿ˜›

In summary, if you’ve read through my blogs for the last year, you realize that last year has probably been the most educational year of my life. The nice part about that, compared with my years getting an engineering degree, is that I learned a lot and got paid to do it. ๐Ÿ˜€

To your success, Bryan