Back in 2000, I was hired to do some analytical work for a search engine company looking to either raise mezzanine financing or sell outright. At the time, the Nasdaq was at 5,000, P/E and P/S ratios were not exactly used to estimate the value of Web firms. In fact, no one really attempted to make sense of valuations of dot com firms, they just accepted it. Looking to make a name for myself at the company, I took a stab at doing just that. It was foolish in some ways, but by the same token, it got the firm’s CEO and CFO to pay attention. In a nutshell, it worked.
Method 1: Multiples of Comparable Publicly Traded Firms
My approach then was really simple. My employer was a privately held search engine with a handful of publicly traded search engines on the market: Ask Jeeves, Looksmart, GoTo being examples of pure-play search engines and Go2Net, Infospace, Yahoo! being more diversified search players.
Each one of these companies was attributed a market capitalization by the stock market. Furthermore, online audience measurement firms like Nielsen NetRatings and comScore Media Metrix published traffic figures for these companies. As public entities, these companies would also disclose search volumes and number of clicks per month. To summarize, I could project a market value per unique user, pageview, search and click. It was nothing revolutionary but at the time, applying it to Internet firms was surprising to some who felt that good old fashion comparable valuation was not right for the Web. That was nonsense of course, a business is a business and valuations are fundamentally similar.
As I built my model, I decided to leave out really diversified players like Yahoo! because these distorted the models too much. Even companies like Go2Net (who owned and operated Dogpile and Metacrawler) was not a good fit because it generated revenues from many other products.
When I ran the numbers in early 2000, our company was worth quite a bit. It had 5M unique users and generated well over $10M in revenues and just shy of $20M in annual revenues. Naturally since the market was pricing Looksmart, Ask Jeeves, GoTo at rich valuations, the value of my employer was rich as well. The actual figure, if my memory serves me right (and it usually does) was $200M. The actual value was $400M but I would apply a 50% liquidity discount because our company was privately-held.
This seemed crazy, and I knew that it was, but at the time Looksmart was valued at $1.5 billion. Today it’s worth $100M.
Times have changed, but valuation methods don’t. All to say, that kind of valuation is the comparable method of finding publicly traded companies and benchmarking one’s metrics to those, and then applying a liquidity discount. I could use that method because my employer had been in operation for 4 years, had an audience base and revenue and there were clear comparable companies.
Method 2: Discounted Cash Flow
Of course, how publicly traded companies are valued boils down to good old fashion discounted cash flow methodologies. Not only did I study finance but I alse served as a teacher’s assistant to both undergraduate and graduate business students at the two top colleges in the city here, so I know my DCF better than the average guy - and this obviously explains why I am such a cool guy. All to say, DCF has its limitations, but when a company is profitable, it is a very plausible method to estimate its value. It has its limitations, trust me, but when you hear an analyst looking at P/E and P/S ratios and projecting a value, it is a form of DCF because they project what a company’s earning power will be and then they discount it back to today.
Methods for Younger Companies: Size of Market
For most entrepreneurs, this is not so obvious. Oftentimes we are asked to estimate the value of our company before we have an audience, clients, revenue let alone profits.
When I joined my second startup company, it was a money-losing men’s online publisher. I really had no way of deriving a valuation on either a comparable or a DCF methodology for the simple reason that it was hard to pinpoint publicly traded competitors and even if I did, we were fairly embryonic.
To estimate that value, I simply asked myself “how big is the men’s market?” It sounds a bit funny to do so, but you start off with 50% of the world’s population is male, then work down to what percentage are online, in our age demographic, speak English, etc. etc. Eventually you realize what the total audience is, what you can achieve in terms of readership and then estimate revenues, a profit margin, potential profits, growth rate etc. It’s almost ridiculous to do so, but going into the company I did some back of the envelope calculations and realized that the company’s value - to me, was $10M. In other words, if we executed really well, we could be a $15M exit, if we did ok we would exit for $7.5M…
This is all relative, a well-known venture capital group - Highland Capital - had invested $17.5M in a competitor called TheMan.com. That did not really make sense to me, but clearly, it is possible to build a more successful and valuable company if you invest more in it. So it was not all that crazy in some ways, and if anything more reflective of the ga-ga mood of 1999.
I was coming on as a tiny shareholder but the timing being September 2000, when the market had crashed, I just wanted something with potential. I also figured the exit would come in less than two years. Never did I think I would be locked down with the same cooks in a kitchen for five years.
All to say, in that case, the $10M figure came to me as a potential exit value. I simply looked around the landscape and asked who would be willing to pay how much for the company if we executed. In the end, some of us really executed well and the company became the largest men’s publisher online, had EBITDA of over $1M on profit margins of 25% and sold for $13.5M. At the time, we were doing $1.2M in EBITDA and the 12-month trailing multiple for new media M&A deals was 16.9. As such, in my eyes the company could have fetched $1.2M x 16.9 = $20.28M.
Bear in mind we were the largest men’s lifestyle magazine, being bought out by the largest video game online publisher (somewhat of a competitor), so we could have easily asked for a premium and notched a $25M price tag. For a few good and bad reasons, we did not do that and accepted a $13.5M buyout figure. Seeing how I was a tiny shareholder, I did not really care about the amount as much as I welcomed the liquidity and freedom. We could have hired an investment bank for a fairness opinion, but we did not.
Today, as the founder, investor, shareholder, President of a digital media company, the table has turned and I need to assess what the company I have started and built in year one is worth. It’s not easy. Valuation is subjective. When I started the company, I had very brief conversations with prospective investors, and it became very clear, very quickly, that it would be a brain-damaging experience to raise money at the onset of the startup adventure. For better or worse, I chose against raising funds then because the idea was embryonic and the model untested.
Today, it’s been one year and two buyout talks later, I have decided to start to look for financing because the model before me is huge and enormous. One buyout talk went nowhere due to the mix of equity and cash and my view of the acquiring company’s stock. The second one ended because in all honesty I don’t want to sell the company outright, at least not yet. I put up with a lot, I mean a lot last year and now that WatchMojo.com is generating revenues and growing, I want to give it a real shot to make it the leader in original video production for the Web. And… trust me, come hell or high water it will be. It helps that we already boast one of the largest libraries of original video programming for the web and wireless markets.
Like many others, if I choose to raise external equity financing, I have to establish a price for the value of the company to exchange capital for a stake in the company.
Seller Beware?
Technically, the CEO of the company needs to maximize the value of the firm. But believe it or not, I think that the caveat there is that a CEO should maximize the value at an exit. In financing rounds, in my humble opinion, the value of the company is strategic: if you bring on an investor who invests $5M for a pre-money valuation of $10M and gets 33% (post-money value of $15M), then you are cornering yourself into not being able to make any exit down the road worthwhile for the investor. In other words, if you can get a buyout offer of $20M in a few months, some investors might be happy but a VC who wants to make high returns might block the deal (independent of the liquidity preferences they have set). In this scenario, had you agreed to a valuation of $10M, for example, then the VC would at least be doubling their money and might be more prone to approve the sale. This is one very basic example of why you cannot be greedy with fund-raising.
At the first Internet firm I joined, a VC had come in at the mid-stage of the company’s timeline and established a value of $40M in 1999. At the time everyone was patting themselves on the back, but what this effectively did was make the VCs block any buyout offers at $25M and $50M the next year when the market sentiment had changed. GoTo, Infospace had both shown an interest to acquire us but the board deemed the amounts too low. One reason was not the price tag in absolute terms, but rather in relative terms to the previous financing round.
Of course, one needs to balance this with valuing the company too low. This is why it made sense for me, but admittedly not possible for everyone, to hold out for a year, build the company and then raise money if I chose to when the company had moved from concept to reality. Incidentally, everything I envisioned and set out to do has materialized, which helps.
In the upcoming Part II of this series, we’ll look at some of the ways I have used to estimate the market value of our company. I’ll try to publish that tomorrow, but tomorrow is a big day, I am presenting our company to a room of 5 or 305 people (I’m not sure which one) in the
next phase of my Private Little American Idol.
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