Demand, threat and opportunity in pricing

One valuation model which is used in determining a possible selling price on the open market is that of comparing a business to similar companies which have been sold. Essentially making a comparison between “their earnings versus selling price” and “my earnings versus what my business is therefore worth”. It is a helpful tool, and one which we use in all valuations as one of our reality checks to moderate our more theoretical calculations against what has actually been achieved out there.

Using it back to front creates many problems for business owners. I have long written about the “braaivleis valuation”, which is essentially the use of this method in isolation of any useful measures.

“But hang on”, says the bloke selling his business. “Instagram just sold for one hundred million US Dollars. Why is my business not worth a similar multiple.
Or as a friend wrote to me last week: But I’ve been wondering if this is for “traditional businesses” only. How else do we explain the stupid amounts of money people pay for online businesses that makes no cash. Consider the buy-out of Instagram… This article is inspired by that email.

So for some background, here are some of the considerations in placing a value on businesses:

  1. What is the exposure to customers? If a business will rely on a small number of customers, it will have a problem. If four of them leaving were to destroy the business, there is a problem. If the business has millions of customers (users, in the case of Instagram), it would take a monumental loss of numbers to change its momentum.
  2. What is the exposure to suppliers? If a business relies on a single ingredient, available from only one supplier, and therefore has no redundancy, it’s value is compromised. If the same ingredient is available from several suppliers, but that ingredient cannot be guaranteed, there is less of a problem, but a problem none the less. Instagram has no such problem.
  3. What exposure is there to a small number of highly trained employees? This particularly, if they are paid at the minimum level required to keep them. Most of these high selling tech companies have a small group of employees; true. But they are all incentivised by stock options. So when the business is sold, they often end up becoming millionaires overnight. That helps.
  4. The exposure to environmental issues, such as emission taxes, filtering of waste water, disposing of dangerous chemicals and even scrapped off cuts. Instagram does not even understand the concept, and instead bans bottled water and non green hand wash in its bathrooms! Puerile, I agree, but it makes the point.
  5. Its exposure to currency fluctuations.
  6. Its exposure to the possibility of war, and as a basis for this, its host country, or more likely countries, in the case of tech companies.
  7. Its ability to reach out globally, and scale itself. Tech companies, once established can scale beautifully, simply by moving some code around the planet, at almost zero cost to themselves, and only a bit of inconvenience to some noughts and ones.
  8. The difficulty with which a similar business will become available – being copied. It may be easy for new start ups to do something similar, but will they ever get the traction in numbers? Literally hundreds of millions of users in the case of some tech companies. Those numbers are across borders, continents and hemispheres.
  9. It is of course that following which the buyer is after. If it can prevent this audience falling into the hands of a competitor, then this alone will persuade it to pay way over the top.
  10. If there are synergies between buyer and seller, even more value is added. For instance in the case of Facebook buying Instagram, it has an immediate easy access to its users posting and modifying social snaps of themselves, via their smartphones. More snaps, more posts, more page impressions, more advertising revenue.
  11. Who are the the customers? Who are the users? If they are young, hip and not tech averse, and they come in their numbers; seemingly born with smart phones in their hands, then gold beckons. You and I are dying out. These youngsters will drive this vehicle soon, and their productivity and therefore earning power will reclaim everything our grandparents and parents lost through two world wars and a bunch of nonsense which followed.
  12. If the business is operating at the cutting edge of its technology, and it is easily able to integrate into the new owner’s existing business, then all the better. For the forward looking tech company, designing its systems with the future integration into a parent in mind, will also establish a higher price, simply because the cost of that integration is already taken care of. That is a high risk strategy, if it turns out that the target parent is not interested, and the alternative parent uses a different technology.

This is by no means an exhaustive list of valuation determinants, but it should give you an idea as to why some businesses sell for “stupid amounts of money”.

How many of those boxes does your business tick? Probably not very many. So here’s a thought for the end of the year: “Which ONE box can we add to the profile of our business in our business plan for the next year? Put that to the strategic planning team.

Right now Google is in the home straight of acquiring a company called Twitch for US$1Bn. To put that in perspective; it equates to something like 44 Nkandlas!

Have you heard of Twitch? Me neither. It is an add on to what Google already does via YouTube, allowing users to broadcast live video of what is happening on their screens. Millions of young gamers use it to show how good they are at killing imaginary things. Imagine now, how useful that would be in demonstrating stuff on your computer to your customer base, using a platform which is already available through YouTube (owned by Google).

Footnotes about Twitch:
It is privately owned, and raised US$35 million in funding from a number of investors who are set to make a huge return on their investments.
It has 130 employees.
It has 45 million regular users.

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