Article 09: Valuation — Part One
The absurd world of valuations
A successful marketeer, Seth Godin says, “When smart, committed people disagree about the answer to a question, you’ve found a question worth pursuing and a discussion worth having.”
This statement does justice to arguably the biggest question on Shark Tank:
“What is the company’s worth?
The Sharks respond very differently to each company’s value proposition and hence have different viewpoint on its valuation. It is the bone of contention, the number that raises eyebrows, spikes blood pressures, the primary point of disagreement in most pitches, the thing that entrepreneurs always feel right about and the investors feel wrong about, the thing that invokes responses unlike all other things about a business is its valuation. However in reality, the company valuation is a term used as a proxy to the value of the DEAL!
For someone who may not know how actually a company/business is valued, it might very well be something like,
Valuation = (Twitter followers ✕ Facebook fans) + {(#Employees ✕ 1000) ✕ (Total likes + Daily page views)} + (Monthly burn rate ✕ Tesla Stock price)²
LOL! Did you take that seriously!? Coz that’s obviously not how it is done! At times valuation is absurd, abstract, and some seemingly irrelevant factors do make it to the math. Valuation of a stable listed company is easy to achieve because its books are available to all but same is not true for startups. In case of listed companies the stock market gives a fair picture of what a company is worth- thousands of very smart people have done the math and put their money behind it. However 2020 was different, the unprecedented times took the stock market by storm. “The stock market is a strange thing,” the new richest guy on the planet — Mr. Musk said in an interview “It’s like having a manic depressive who’s constantly telling you how much your company’s worth. And sometimes they have a good day, and sometimes they have a bad day, but the company is basically the same. The public markets are crazy!”
Getting back to the matter on the show - Let’s look at an oddball product: SwipenSnap presented in S12E11. The journey of the entrepreneur was not an easy one; she studied the patent process and earned a patent for the product which otherwise costs anywhere between $40–50K in the USA. With ~$15K in Sales; Ms. Kravchenko was seeking $120K for 10%; which means $1.2M in valuation and that essentially means a multiple of 1200/15=80; that kind of multiple doesn’t exist (outside of the tech industry 🙄 ) however Kevin took the deal at 50% equity which still means a multiple of 240/15=16; again that kind of multiple doesn’t exist (Again.. outside the tech industry 😛). However the deal was made on the assumption that the patent would find other takers and the royalty would help recoup the investment and generate profits. You see, valuation is not math; it’s the art of the possible!
We all have heard about so many companies going bust overnight because of irrational erratic valuations; hence we believe it is important to know why they fail. Dr. Aswath Damodaran, a seasoned professor of finance at the NYU claims that there are three big reasons why valuations fail - it’s not about the numbers; it’s not about the models; and neither is it about the metrics. There are some pitfalls or loopholes in the process of valuation and they hold sway over the process (even though it is unwanted). He calls it the Bermuda Triangle of valuation (erroneous assumptions), let’s expand on the three one by one.
- Valuation is unbiased: Valuation of a company involves numbers and assumptions however before looking into the details, the most important thing to know is — Who did the valuation? And Who paid them to do the Valuation? Because the biases are going to be preset by what the mission is. If it’s an investment banker and the agenda of valuation is a takeover (acquisition) of a target company then the banker will find a way to justify a value; not surprisingly the valuation will deliver exactly the result that this company is a good bargain- FYI the pockets of bankers get warm when the deal reaches closure.
- Valuation is science: While valuing a company one thinks they are not being objective- everything looks like a number in the air. The numbers are estimates, and those estimates are going to come with a great deal of uncertainty and uncertainty scares people and makes one uncomfortable. The thought that the numbers could be wrong could be scary — Well guess what, they’re always going to be wrong because, making estimates is like forecasting the future.
- A bigger valuation model is better: If one makes a model bigger (remember the crazy ass formula that appeared in the beginning of the article?), it’s going to get better and it’s so easy to build big models (just like it was done in the case of that formula). As these models get really complex, two things happen : One, these models become black boxes. Two, after a while it’s difficult to gauge who who’s running the house i.e., it becomes difficult to understand whether you are running the business according to the formula or the formula is being deduced from the business.
Now that we have scratched the surface with what’s wrong to assume, we shall discuss the valuation approaches in depth in Part II of this article.
This is our ninth in a series of articles on Shark Tank, where we try to deconstruct the pitches, business fundamentals, and the Sharks.
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