A long time ago, when I was a young lawyer fresh out of school, I was walking with a friend along a side street in Manhattan, probably in the West 30s. There were brownstones on both sides of the street. We stopped in front of one that had a small shop on the street level.
In the window were two shelves on which were displayed a series of antique dolls, doll clothes and doll carriages and furniture. Many seemed to be from the early 20th Century, if not earlier. The shop was dark and the sign on the door said: Hours by Appt. Only.
“Interesting business” I remarked. My friend responded: “That isn’t a business, it is someone’s dream”.
In some ways, every entrepreneur and small business owner is a dreamer. They try to turn the intangible, an idea, into something tangible, a business. Assigning a value to any business is not an easy task. While the business is still a dream it is virtually impossible.
Valuations
Of all the things that we teach business school students, corporate valuation is given very little time or attention. When a business needs to be valued because it is being bought or sold the task is relegated to accountants. Accountants plug data about earnings and assets into established formulas and come up with a value.
Accountants can determine the “book value” of a business by subtracting the company’s liabilities from its assets. That rarely tells the whole story. What if there is little or no data? What if the business has no earnings or assets?
Assets are placed on a balance sheet at cost and are then depreciated over time. The true value of the asset is not always represented in the financial reports. Some assets, especially real estate can often appreciate over time to greatly exceed their cost.
We teach that real estate should ultimately be valued at its highest and best use. A developer may see a dilapidated old farm as the site of a shopping mall or residential development. Still, the current owner carries the farm on its books at cost minus depreciation. The value of any parcel of real estate can change dramatically in the time it takes to hold a press conference announcing a new development.
Accountants will often add a line item for the company’s “good will” which is more often than not the accountant’s way of capturing the value of the business as a going concern, including the value of its brand and customer base. This, too, is far from perfect.
I have helped many clients buy or sell a business over the years. If they use a business broker to facilitate the transaction, they are likely to hear that a business is “worth” 3 times next year’s projected earnings.
This may not be a proper method of valuing a small business either. It is modeled after the way that many research analysts predict the future price of publicly traded securities. But with privately held companies, the risk is often higher so the price for which it sells, logically should be lower.
Yes, I know that this is the antithesis of the view practiced by venture capital firms who are often dealing with companies that have little more than an idea that they want to bring to market. These companies do not have earnings or assets. The values assigned to portfolio companies by venture capital firms have no basis in reality nor are they entitled to be included in any serious discussion of finance.
IP
Intellectual property like patents, copyrights and trademarks are very hard to value at the time they are first obtained. No author knows that they have a best seller on the day their book is published. Few know that their book will be made into a movie or that anyone will pay to see it. So, what is the “value” of any book on the day before the manuscript goes to the publisher?
As an example, I have a friend who is a noted cartoonist. Her characters were originally published in the US for an American audience but have found a huge following in Japan. Was that in her business plan when she sat down to draw those characters for the first time? Hardly.
One of the interesting things about intellectual property such as copyrighted material, is that it can be segmented in myriad ways. A novelist can sell the right to have his book published in the US to one publisher and the rights to publish the book in a dozen other countries, or a dozen other languages to a dozen other publishers. The theatrical rights and film rights to the same novel can also be segmented and sold. In the right circumstances, the rights to produce and sell merchandise that derives from the novel may be the most valuable rights of all.
The value of intellectual property can vary greatly based upon how it is used and how it is sold. Young Bill Gates might have sold the operating system he purchased from a third party to IBM for a nice profit and gone on to do something else. Instead, he licensed the software and received a royalty every time IBM sold a PC with the operating system in it. The result was the Microsoft Corporation which made Gates the world’s richest man. We use a lot of royalty or revenue sharing arrangements in crowdfunding because they are clean and simple.
1990’s
Back in the 1990s when there was a new and disruptive technology introduced every day, I would ask my students if they could identify the most valuable intellectual property that was in use in the 20th Century. It had been a century of tremendous innovation, much of which had been superseded by even better innovation. Many very valuable patents and other IP had become worthless.
The object of the exercise was for them to identify a simple idea that had been patented, trademarked or copyrighted, that had become very valuable even though no one could have predicted the magnitude of its success on day one. I wanted to demonstrate just how difficult it was to value things that had never been done before. Two pieces of IP stood out.
The first was the copyrighted image that is Mickey Mouse. The media giant that is Disney today started with an animated short film of a mouse whistling. Maybe the most recognizable face on the planet, I do not believe that even Walt Disney would have valued the ownership of the copyright at anything close to its true value.
The second was the patented formula for Coca Cola. I have been in a Jeep in the middle of a jungle where the guide said that there was a village up ahead where we could stop and get a Coke. Pour yourself one and try to imagine how many cans and bottles they have sold. How would you have valued that patent on the day it was filed?
I think that I have made the point that placing a value on any business, especially a start-up, is a waste of time and effort. I will encourage any small business owner to dream big, but you just cannot put a number on it.
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