WealthEsteem.org :: Psychology of the Deal

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If you are an entrepreneur of any age and any stage you should be reading Australian Anthill magazine. For 24 issues now,  this bi-monthly magazine has covered entrepreneurs, angels, VC’s  and the startup scene in Australia. They’ve grown readership and circulation and are entrepreneurs themselves.

Business is a crazy rollercoaster ride and there is a huge benefit to connecting with others who’ve trod a similar path.

And if you’ve got some experience, consider contributing an article. Read the style and submission guidelines.

I met Richard Hayes at the Sydney OpenCoffee Meetup and he’s written an excellent article that he’s allowed me to reproduce below.

All people working in the Startup / Early Stage consistently asked the same question,
“How do you value business?”

The correct answer is there is no correct answer

Without trying to be facetious here is a number of models that may help.

Anyone wanting further information can attend Richard’s BEERonomics in a pub near you.

Courses in advance corporate finances cost you 2 beers / hour (Cheaper than a MBA)

• Sales Revenue
  Most businesses are valued based upon revenue.
  This means a business with $1 Million revenue would be valued @ $750,000 to $1,250,000
  or values each dollar sales between $0.75 - $1.25
• Price Earnings Ratio
  This is the number of years of after tax profit it takes to return your investment
  A typical private company sells for a PE of 2-5 where public companies sell for 8-20.
  Google sells with a PE 48Many people use EBIT, Earnings (profits) Before Interest and Tax as a measure of how much extra debt a company can take to help pay for the take over.
• Discounted cash flow (DCF)
  This technique combines all the cash generated from the business and then discount
  (reduces) them to a present value. (IE A dollar today is worth more than a dollar tomorrow)
  This can be a problem if the wrong interest (discount) it used.
  BTW, The interest rate is ALWAYS WRONG
• Replacement Value
  How much would it cost to get similar stuff either new or used?In software, many people use COCOMO which is a formula that count lines of code and examines the complexity of code thereby allocating a amount of developers time it would take to replicate it.slccount Is a free COCOMO tool that supports about 27 different languages.

  For many software startups this is a good starting point.

• Return on Investment (ROI)
  This combines a number of the above techiques to derive a single figure.Many early stage investors Angels / VCs demand +45% ROI as compensation for the higher risk associated with early stage. This is a serious market failure.

Example:
A team of 3 developers have written 13K lines of PHP source code to develop a DIY superannuation management software. It has taken 6 months part time (IE 50 hour/wk)

They are all leaving their “real” jobs to pursue their dream.

Sales: Nil

User: 250

Total Cash Spent: $5,800

What is the company worth?

1. Sale Revenue Nil

Future Sales Revenue 2009 $1,000,000 (FV)
Discounted @ 40% pa $510,000

Company valuation $383,000 - $637,000

2. Price Earnings

2009 Sales $1,000,000
2009 Profit $180,000

PE 2 (180K x 2 x 40%) $183,000
PE 5 (180K x 5 x 40%) $459,000

Company valuation $183,000 - $459,000

Replacement value $413,228

The following output is from a real project

Totals grouped by language (dominant language first):
php: 13409 (99.83%)
sh: 23 (0.17%)

Total Physical Source Lines of Code (SLOC) = 13,432
Development Effort Estimate, Person-Years (Person-Months) = 3.06 (36.71)
(Basic COCOMO model, Person-Months = 2.4 * (KSLOC**1.05))
Schedule Estimate, Years (Months) = 0.82 (9.83)
(Basic COCOMO model, Months = 2.5 * (person-months**0.38))
Estimated Average Number of Developers (Effort/Schedule) = 3.73
Total Estimated Cost to Develop = $ 413,228
(average salary = $56,286/year, overhead = 2.40).

As you can see there is no right answer but valuation is much more about art than science.

© 2007 Richard Hayes RHI Ltd reprinted by permission.