You're Buying Next Year's Company
Valuation of a business is as much art as it is science. Still, in the classrooms that teach corporate finance, there is a general method to this madness. First, we calculate a business’s annual profits1, then we apply some multiple. Typically, this is a function of the industry, the type of product, and how quickly those profits are growing/decaying with each passing year. Businesses in the world of technology often fetch higher multiples than those in industries where scaling means the purchase of large quantities of labor and equipment.
But of course, it’s never quite this simple.
An Example
Imagine a business with $10M of annual profit in an industry where multiples are ~20. So, were this business to have its IPO or be acquired, it would probably be valued at around $200M. Easy enough.
But what is embedded in that $200M estimation? What implications lurk in that figure?
A buyer willing to purchase this business isn’t predicting twenty years of $10M cashflows2 followed by the business’ immediate disappearance. More likely, one of three things happens over the next few years:
- The business is a unicorn of sorts, $10M of profit explodes into $1B+ of profit, and this is actually a business worth billions, not millions! Maybe this business is worth $10B+.
- The business fizzles, a competitor outcompetes it, the market loses interest, and those $10M cashflows peter out over the ensuing years until the spare parts are sold off at a discount rate and the business is shuddered. It ain’t worth much when all is said and done.
- The business rolls along, growing slowly with the market. It won’t be worth $200M in this case, but it’s probably still worth $100M, just because it has the ability to keep generating some profits.
These three outcomes are hardly equally likely, but imagine, for the sake of argument, that the first scenario (unicorn) occurs about 2% of the time, the second (failure) about 8% of the time, and the third (slow and steady) occurs in the other 90% of circumstances.
Back-of-the-envelope suggests:
0.02($10B) + 0.08(~$0) + 0.90*($100M) = $290M
This exceeds the $200M valuation, shareholders are willing to plunk down some of their hard-earned capital for an IPO, some bean-counter thinks the acquisition might be worthwhile, and paying a multiple of 25+ ($250M+ valuation) might actually be justified. But look again… of that $290M above, $200M lives in the first term, the one that describes the possibility of boarding the rocket ship while it sits on the ground.
Waiting
But perhaps when the offers arrive, the board balks. They think their nascent unicorn is worth more than the market does - they tell the barbarians at the gate to go pound sand and to try again later.
And two years pass.
Now, this business that once made $10M of profit now generates $13M. The board sees this as an accomplishment, as growing 30% over two years is certainly no small feat. So they present the business to the market once again. And the offers are lower. Why?
The three scenarios still exist, but their odds have changed. Unicorns, two years after earning $10M in profits don’t earn $13M… they earn $100M+. And to be fair, the businesses that fizzle into nothing are also less likely to experience that growth. So...
- Odds of a unicorn fall from, let’s say 2% to 1%
- Odds of a failure fall from, let’s say 8% to 4%
- Odds of just chugging along become 95%
0.01($10B) + 0.04(~$0) + 0.95*($100M) = $195M
This back-of-the-envelope removed almost $100M from the value of this business, simply by removing 1% from the probability of an extraordinary outcome.
It’s not what the business has demonstrated that it is… it is what it has demonstrated that it probably is not.3 The longer it lingers without explosive growth, the more certain the outside world becomes that it has achieved all that it ever will, give or take a little year-over-year growth.4
Next Year’s Company
In some sense, we never buy a current business. We’re actually looking to own shares of next year’s business, and the business the year after that. In a capitalist economy, profits emerge from the recognition of need and an offer to address it.5 The more time that passes, the more likely it is that either the market “need” is smaller than imagined, or someone else devises a better method for meeting it.
And while we’re on the subject of “next year’s company,” consider that when you hire, you’re actually hiring “next year’s employee.”
If you’re looking to buy a company that might be worth 10x the current market valuation, you purchase equity in comparatively young, cheap ventures. If you’re looking to hire an employee that might be worth 10x their annual salary, should you choose the Harvard MBA or the college dropout with an atypical social manner?
Who is more likely to be worth 10x more than they’ll command?
We’re not just buying a multiple based upon upside, we’re hiring talent with a similar calculus we ignore to our detriment. Why?
Negative Space
In art, we often examine the negative space, which surrounds the subject of an image. In business, we are asked to imagine the negative space surrounding a product or a market and envision that which might fill it. We are asked to imagine products that do not yet exist, and just maybe, the opportunity cost of pursuing the ones that already do.
With employees, this is even more difficult, as we are asked to imagine the space into which they might grow rather than the space their credentials and prestigious resume bullets have already filled. Perhaps this is why we advocate that young professionals “build career capital.”
Or perhaps there is something more insidious lurking. Human nature leads us to avoid the types of mistakes which will be obvious, and for which we will inevitably be blamed.
In “Mistakes Were Made, But Not By Me” the author presents an example of politicians who cannot relax criminal penalties because they know that if 1,000 people are released from prison sooner than scheduled, it is likely that one of them will commit some heinous crime, and then the politician who advocated for the more lenient policy will be blamed. In the alternate case, wherein the taxpayers shoulder the cost of thousands of years of additional incarceration6, no single mistake is obvious, nor can any specific individual face the blame for the inefficient allocation of resources.
When we hire the Harvard MBA for $300K+ when they’re actually worth $250K, it’s a small, invisible mistake for which no one is held accountable. When a manager hires the person who never completed college and has hustled their entire life for far less, if they fail, that manager pays the price in personal professional capital.
Upside
The greatest challenge of all is recognizing when upside exists, then having the nerve to pursue a lower-probability, higher-potential path.
A company has the largest upside before we know whether it will generate $0, $1M, $10M, $100M, or $1B annually. An employee offers the largest upside before they amass credentials and laurels.
This is why draft picks in professional sports command more value in trades than the players taken with those draft picks only a few weeks into their careers. The unspecified draft pick might become a star and empirical observation begins to erode that possibility.
The disheveled, unpolished dropout might be Steve Jobs or Bill Gates. The nascent venture might be the next FAANG company.
Should you act now, or give time the opportunity to reveal that it is not?
1 This receives an acronym “EBIT,” which is basically earnings minus expenses, which is basically the operating profit of the business. There are hairs to be split, but this ain’t a classroom, so on we go!
2 Let’s assume they grow at precisely whatever hurdle rate reflects the time value of money targeted by the acquiring party, and whatever other assumptions fit this example. Again, not a classroom.
3 Incidentally, this is why young backup quarterbacks with no experience as starters garner more attention than veteran counterparts with a higher level of competence. The young backup just might be Tom Brady, but the veteran has already shown the world that, unquestionably, he ain’t.
4 The fact that startups are assessed this way incentivizes them to hack the test instead of hacking the business. What if the CEO did some strategic analysis revealing that the best path forward is to remain at the current size and revenue for another year or two while investing in some long-term growth strategy? Most startups lack the luxury of planning to maximize their long-term value! (Which is sad because there’s no such thing as short-term value)
5 I wax poetic about this on social media periodically.
6 Which probably could have prevented more crimes by funding additional police, teachers, and other social services.