Planning, Startups, Stories

10 Rules for Valuation

(Note: I posted this on Up and Running yesterday. I'm crossposting it here for reader's convenience. - Tim)

I really don't like the word "valuation"; it sounds too much like an MBA buzzword. But I like even less the general confusion about the concept. We talk about starting businesses, we talk about running businesses, getting investment, getting financed, and we should take discussion of valuation for granted. Valuation is at the same time frequently necessary, obvious and extremely arcane. It is nothing more than what a company is worth. It becomes necessary more often than you'd realize, with buy-sell agreements and tax implications after death and divorce, plus financing and investment. It's obvious because a business is worth what a buyer will pay for it. And then it breaks down into complex formulas and negotiations.

So here are 10 (I hope simple) rules for valuation.

1. Valuation is what a company is worth. It's like what a house or a car is worth--less than the seller says, more than the buyer says.
2. A company's ownership is almost always divided into shares. Let's say your company has 100 shares, 51 yours and 49 your co-owner's.
3. Valuation equals shares outstanding times the price of one share. If the company is worth $500,000 and there are 100 shares, then each share is worth $5,000. (OK, there are exceptions, preferred shares and such, but leave the fine tuning for later.)
4. Tax authorities say the price of a share is whatever it was at the last transaction. (There, too, there are exceptions, but let's keep this simple.)
5. When startups offer shares--equity--to investors, then that, too, is simple math. If you sell 20 percent of the company for $100,000, that means the company is worth $500,000.
6. Investment deals frequently revolve around valuation. When investors question your valuation, they're saying they want more ownership for their money, or want to invest less money for their ownership.
7. Analysts often apply formulas. The most common formula is called "times profits" because it multiplies profits times some number. Another common formula is "times sales." Companies might be worth two times sales or 10 times profits. There's also book value, which is assets less liabilities. And there's the estimated sale value of assets.
8. Privately held companies are worth less than publicly traded companies. They get discounted for the disadvantage of not being able to convert ownership to cash easily.
9. Growing companies are worth more than stable or declining companies.
10. As with real estate, comparable sales matter. Analysts look for recent transactions involving similar businesses.

10 Critical Cash Flow Rules

(This is cross posted from my column on Entrepreneur.Com)

Cash flow problems can kill businesses that might otherwise survive. According to a U.S. Bank study, 82 percent of business failures are due to poor cash management. To prevent this from happening to your business, here are my 10 cash flow rules to remember.   

1. Profits aren't cash; they're accounting. And accounting is a lot more creative than you think. You can't pay bills with profits. Actually profits can lull you to sleep. If you pay your bills and your customers don't, it's suddenly business hell. You can make profits without making any money.    
2. Cash flow isn't intuitive. Don't try to do it in your head. Making the sales doesn't necessarily mean you have the money. Incurring the expense doesn't necessarily mean you paid for it already. Inventory is usually bought and paid for and then stored until it becomes cost of sales.
3. Growth sucks up cash.  It's paradoxical. The best of times can be hiding the worst of times. One of the toughest years my company had was when we doubled sales and almost went broke. We were building things two months in advance and getting the money from sales six months late. Add growth to that and it can be like a Trojan horse, hiding a problem inside a solution. Yes, of course you want to grow; we all want to grow our businesses. But be careful because growth costs cash. It's a matter of working capital. The faster you grow, the more financing you need.      
4. Business-to-business sales suck up your cash. The simple view is that sales mean money, but when you're a business selling to another business, it's rarely that simple. You deliver the goods or services along with an invoice, and they pay the invoice later. Usually that's months later. And businesses are good customers, so you can't just throw them into collections because then they'll never buy from you again. So you wait. When you sell something to a distributor that sells it to a retailer, you typically get the money four or five months later if you're lucky.    
5. Inventory sucks up cash. You have to buy your product or build it before you can sell it. Even if you put the product on your shelves and wait to sell it, your suppliers expect to get paid. Here's a simple rule of thumb: Every dollar you have in inventory is a dollar you don't have in cash.    
6. Working capital is your best survival skill. Technically, working capital is an accounting term for what's left over when you subtract current liabilities from current assets. Practically, it's money in the bank that you use to pay your running costs and expenses and buy inventory while waiting to get paid by your business customers.    
7. "Receivables" is a four-letter word. (See rule 4.) The money your customers owe you is called "accounts receivable." Here's a shortcut to cash planning: Every dollar in accounts receivable is a dollar less cash.    
8. Bankers hate surprises. Plan ahead. You get no extra points for spontaneity when dealing with banks. If you see a growth spurt coming, a new product opportunity or a problem with customers paying, the sooner you get to the bank armed with charts and a realistic plan, the better off you'll be.    
9. Watch these three vital metrics: "Collection days" is a measure of how long you wait to get paid. "Inventory turnover" is a measure of how long your inventory sits on your working capital and clogs your cash flow. "Payment days" is how long you wait to pay your vendors. Always monitor these three vital signs of cash flow. Project them 12 months ahead and compare your plan to what actually happens.    
10. If you're the exception rather than the rule, hooray for you. If all your customers pay you immediately when they buy from you, and you don't buy things before you sell them, then relax. But if you sell to businesses, keep in mind that they usually don't pay immediately.

10 Critical Cash Flow Rules

The Planning Process 10%

Picture yourself in front of a group of 20-30 business owners. They are computer or software resellers, dealers of Progress Software, Autodesk, SolidWorks, or a personal computer manufacturer. They are mostly men in their 40s and 50s. Most of them have been in business for themselves for 10-20 years. Most of them have three or more employees, a few have 25, 50, and one or two 100.

If you ask this group how many of them regularly review their business plans and revise them as needed, roughly 10% of them will raise their hands.

You can explore the details in front of the group. The ones who regularly review their business plans will be the stronger and healthier businesses in the group. If they've been around for a while, they'll be the ones with more employees and more market share. If they're younger and newer companies, they'll be the ones with more growth.

You want actual data, numbers, and better yet, names? Yeah, me too. I wish I'd done that but it was enough to run full-day planning seminars, each one took a lot of energy, and there just wasn't enough bandwidth for me to be managing the seminars and populating a database at the same time.

What I will give you, though, is accumulated experience. When I run one of these seminars I can count on my 10% number enough to take the risk of setting myself up in front of the group, at the beginning of the day, with those people as leaders. Throughout the day I can call on them confidently for comments and details and anecdotes, and they'll have the right kind of useful responses.

These people are my stars. They don't all plan the same way, they don't all have the same process, but they do have process. I can count on them. They get it.

Here's a concrete example: during part of the seminar I want to illustrate the paradoxes of planning, say "business plans are always wrong." I have my two or three stars in the room and I can be sure of getting a useful response from one of them when I deal with this issue for the group. I'll ask, "Ralph, Mabel, Mary ... what do you say? Why do I say that?" And I'll get back a response about how they're wrong because assumptions change, which is why plans need to be kept alive and managed. Or they'll say something like that.

I don't like to blithely take risks when I'm in front of a group. This 10% rule, however, has worked consistently for me for years. Now, I realize having a set of numbers to display would be stronger than my anecdotal evidence, but then, so many sets of numbers are flawed anyhow, and give the wrong impression. My people in the seminar aren't a random sample by any means, so the numbers wouldn't be statistically valid anyhow.

So who are these people? Starting in the 1980s I did some seminars for Apple Computer dealers in Latin America, and then in the 90s in Japan and Singapore, then HP dealers in different places, then Data General, UNISYS, and more recently for dealers of Autodesk, SolidWorks, and Progress Software.

Does this same 10% apply for other industries? I can't be sure that my anecdotal data applies; but I'll bet it does.

-- Tim

This is not a test. This is a real problem.

I just finished answering one of the Ask the Expert questions I do for bplans.com. Here is the question:

"I have [details omitted] that cut consumer's [omitted] bills by up to 25%. But trying to sell them one-on-one is slow going. Local ads have done nothing. Contacting media, local officials has little response. Limited funds prevents an ad blitz. Just starting up. What can I do?"

And here is my answer:

"You're asking the right question but to the wrong people. Ask the buyers, or would-be buyers. Get on the phone, get into meetings, go door-to-door if you have to. Do you have something nobody wants, or not enough people want? That's what the early indicators are saying.

"You can't just guess, you need to find out, and there's no easy way. It doesn't take a degree or years of experience, it takes shoe leather, a phone, and looking the right people right in the eye and asking. Keep asking until you're ready to bet your business on the answer. And with each person you ask who doesn't know, ask them who they can think of who does know. "

The question here illustrates a very common  misunderstanding about business planning and business research. It's particularly bad in the real world of entrepreneurship and small business, where people don't have middle managers and research budgets to hide behind. People treat this problem as if it were a test, with the right answers stored in a teacher's drawer somewhere. It isn't. It's about doing the work yourself. You have to find out. The answer isn't in a database.

Sometimes I get people thinking that they aren't suppose to do this themselves, like it's too specialized, or maybe they don't have the training. You don't prescribe your own medicines and so, you don't try to find out why people buy from you. In truth it's just a matter of talking to people. Be polite, be honest, and be persistent.  I went through this same fear and doubt when I quit business journalism and went to business school and focused on business planning. A lot of what I did after the MBA was the same stuff I did before the MBA -- asking questions and analyzing answers -- just billed at a higher rate.

This particular case is more about market research and marketing planning than straight business planning, but it's the same thing. The core and foundation of a business plan is the questions this person is asking. People think you can buy market research but that's rarely a good match for a small business problem. Business planning is essentially something you do yourself.

In many ways a lot of what's involved in business planning is like physical exercise. It's really no good for you if you don't do it yourself.

-- Tim

My Worst-Ever Business Plan Engagement

It's not for nothing that I always say a business plan has to be your plan and nobody else's. It can't be your consultant's plan. You must know it backwards and forwards and inside out, or it won't work.

I learned this the hard way, sitting in venture capital offices at 300 Sand Hill Drive, the business plan consultant on the tail end of the new venture team. I had done the plan, built the financial model, written the text, shepherded the document through the painful coil binding and the whole thing, but I wasn't part of the team. I didn't want to be. I was still at grad school, getting my MBA, and my part of this venture was writing the plan, period. I needed the money to pay tuition.

In meeting after meeting, at key moments, the VCs would ask critical questions and all heads turned to me. I would answer.  I knew the plan, backwards, forwards, and inside out; but I was the only one who did. It was my plan.

It was a good founders team. It included three Silicon Valley veterans, a marketing guy, a technical guy, and a deal maker guy.  They had about 40 years of computer company experience between them. They had a good idea and, much more important, a market window, differentiation, and experience to make it happen.

The three of them never really got into the plan. It was a hurdle they paid me to jump for them. Every meeting generated new changes, so I would go back to the basement computer at the business school, and re-run the financial model. The team of three didn't include a financial person to learn and manage the model, so it was always me, tweaking. Which meant I was the only one who knew the plan. I'd re-run my financial model, edit the text, and publish a new version of the plan. They read paragraphs here and there, glanced at the numbers, but they stayed with the strategy, and left the details to me.

Details that, in fact, they didn't read. They trusted my faithful recording of their ideas, and my financial modeling. They assumed, I guessed at the time, that these were functions that could always be delegated to somebody with special skills, while they generated high-level strategy.

They did not get financed. I was disappointed. When you develop the plan and revise it dozens of times and support it and defend it through the long series of meetings with supposedly interested investors, you want it to take flight.

And time after time, when questions came, I was the only one with answers. It was my plan, not their plan.

All these years later, memory of that disappointment is still fresh. I did learn my lesson, though, and I changed my strategy as a business plan consultant. From then on I made sure that any plan I worked on belonged -- and I'm talking about intellectual ownership here, conceptual ownership -- to the real plan owners, not the consultant.

If you have the luxury of a budget to pay an outside expert, consultant, or business plan writer, then maybe you should use them. This might be a good use of division of labor, and perhaps you can lever off somebody else's experience and expertise. However, that will not work for you unless you always remember that it has to be your plan, not the consultant's plan. Know everything in it, backwards and forwards, and inside out. 

-- Tim

The Essential 'Why They Buy'

Close your eyes. Step away from the daily routine. Answer these questions. Why does anybody buy what you're selling? What do they get out of it? Do you fill a need? Do you offer identifiable benefits?

Some 30 years ago Harvard marketing professor Theodore Levitt said "People don't want to buy a quarter-inch drill. They want a quarter-inch hole!"

One thing I've learned from 20-some years in business-planning software is that people want the plan, not the software.

It seems obvious but we quickly forget. You think about features, not benefits.

For example, think about affordable luxuries like the latte at Starbucks, the lobster dinner, the fancy mustard. Starbucks sells a lot more than a cup of coffee, and Gray Poupon mustard is a lot more than just mustard. 

Look at hamburgers. McDonald's and Burger King sell fast and easy and reliable. On Saturdays they're full of parents with kids between soccer games. It's not a hamburger, it's a quick solution to a lunch problem. Then there are the gourmet hamburgers. You can pay 4-5 times what the cheapest hamburgers cost. That's another affordable luxury.

With high-tech products we're lured into thinking of features, details, bells and whistles. This is okay for a lot of the market. Some of the market, however, doesn't buy for features but rather status or prestige or peace of mind or some other intangible.

This kind of thinking is essential for better planning. It helps you build your strategic positioning. Some people buy for price, some for location, some for ease of use, fast delivery, or because their annoying neighbor said they should.

Why do people buy expensive beautifully-packaged sweet-smelling bath soaps? Most of the time they don't, but imagine it's February 14. You plan better when you really dig into the buyers' real motivation. 

Whether you're planning for a start-up or to grow an existing business, start with buyer motivation. Why do they buy from you? What do you do better, or at least different, from your competition? How can you build that difference into strategy?

-- Tim

Ideas vs. Opportunities

Ideas are a dime a dozen. Opportunities are much more important. An opportunity is an idea that's passed the test of planning. It has potential. You can implement it. An opportunity has some of the following elements:

• Industry and market potential: look at market structure, industry structure, growth rate, margins, costs, etc.
• Economics: capital requirements, fixed costs, cash flow, return on investment, risk.
• Competitive advantage: degree of control, barriers to entry, availability of sufficient resources.
• Management team: people who know the industry, the market, the operations, the logistics, the road to market.

The business planning process is about filtering the opportunities -- a precious few, requiring focus, and planning -- from the ideas.

Whether you're working on a new start-up business or growing an existing business, you need to encourage lots of ideas and then use your planning to filter them down into the real opportunities.

Remember displacement ... recognize that you can't do everything. You want your plan to help you focus in on the best opportunities among your longer list of ideas.

There is no external meter of good and bad opportunities. What you're looking for is the right mix between business potential and your ability to reach that potential, given your position, core competence, strengths, weaknesses, and resources.

-- Tim

Planning and Paradox

Business planning is full of paradox. Here are some interesting examples.

• Business plans are always wrong, but nonetheless vital. Wrong because they're predicting the future and we're human, we're fallible, so we don't get it right. Vital because we need the plan in order to track where, how, and what direction it was wrong, which becomes planning process, which becomes management. I deal with this a lot, so it just came up at my eBay presentation last Thursday.  I talked about this in this interview with Webpronews, at eBay, right after.


• You have to focus to survive, but you need new markets to grow. So which is it? Have you heard of the corridor principal? It says business strategy is like walking down a long corridor full of doors. Open every door to investigate and you never get anywhere. Ignore all the doors to just keep going and you never get any new opportunities.


• I say in my Hurdle: the Book on Business Planning: "Strategy Needs to be Consistently Applied Over a Long Term to Work. Better to have a mediocre long-term strategy consistently applied for years than a series of brilliant but contradictory strategies that never last long enough to matter." So do you stick to the plan regardless, like running into a brick wall? Or do you revise? When do you revise? How do you know? There's paradox, where the human judgment comes in to override the formulaic.

--Tim

Business Plans are Always Wrong

Seth Godin includes venture competitions to his Pundits are (nearly) always wrong post yesterday.

I say take that a step further: business plans are always wrong. I have to say I like how well this ties into his post on Starbucks from a couple days earlier.

That's because we're human. Business plans predict the future. We humans suck at predicting the future.

Paradox: nonetheless, planning is vital. Planning means starting with the plan and then tracking, reviewing progress, watching plan vs. actual results, correcting the course without losing sight of the long-term destination.

Planning is a process, like walking or steering, that involves constant corrections.

• The plan sets a marker. Without it we can't track how we were wrong, in what direction, and when, and with what assumptions.
• Use this marker to manage the constant conflict between short-term problems and long-term goals. You don't just implement a plan, no matter what. You work that plan. Use it to maintain your vision of progress towards the horizon, while dealing with the everyday problems, putting out fires.
• So the plan may be wrong, but the planning process is vital.

The truth is that forecasting is hard. Nobody likes forecasting. But one thing harder than forecasting is trying to run a business without a forecast.

A business plan is normally full of holes, but you fill them, after the fact, with the management that follows. That's what turns planning into management.

Good planning is nine parts implementation for every one part strategy.

-- Tim 

Digg this

Fundamental Financial Words

You don't have to be an accountant or an MBA to do a business plan, but you will be better off with a basic understanding of some essential financial terms. Otherwise, you're doomed to either having somebody else develop and explain your numbers, or not having your numbers correct.

It isn't that hard, and it's worth knowing.  If you are going to plan your business, you will want to plan your numbers.  So there are some terms to learn.  I'm not going to get into formal business or legal definitions, and I will use examples:

• Assets: cash, accounts receivable, inventory, land, buildings, vehicles, furniture, and other things the company owns are assets. Assets can usually be sold to somebody else. One definition is anything with monetary value that a business owns.
• Liabilities: debts, notes payable, accounts payable, amounts of money owed to be paid back.
• Capital (also called equity):  ownership, stock, investment, retained earnings.  Actually there's an iron-clad and never-broken rule of accounting: Assets = Liabilities + Capital.  That means you can subtract liabilities from assets to calculate capital.
• Sales: exchanging goods or services for money. Most people understand sales already. Technically, the sale happens when the goods or services are delivered, whether or not there is immediate payment.
• Cost of Sales (also called Cost of Goods Sold (COGS), Direct Costs, and Unit Costs): the raw materials and assembly costs, the cost of finished goods that are then resold, the direct cost of delivering the service. This is what the bookstore paid for the book you buy, it's the gasoline and maintenance costs of a taxi ride, it's the cost of printing and binding and royalties when a publisher sells a book to a store for resale.
• Expenses (usually called operating expenses): office rent, administrative and marketing and development payroll, telephone bills, Internet access, all those things a business pays for but doesn't resell.  Tax and interest are also expenses.
• Profits (also called Income): Sales less cost of sales less expenses.