The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.
Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.
Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.
The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.
We have previously mentioned various versions of valuation metrics used in investment or acquisition transactions. They all represent somewhat standardized formulas based on a company’s financial performance or projections, and they are accepted in their basic form by various buyers in various industries. Usually, the metrics are multiplied by certain multipliers to arrive at general valuations that fall into ranges that have meaning to buyers and investors in that particular industry or category—e.g., computers, communications, enterprise software, software-as-a-service, retail, agriculture, medical practices, insurance brokers, and so on.
Each industry has its favorite metrics, and the multiples are usually relevant to the current economic times—how popular that industry is with investors at the moment. In the stock market, a primary metric is the price-earnings ratio for a company. Stock buyers look at those PE ratios, as they are called, and compare companies based on that.
While earnings are an important component of valuation for a going concern, it is much less relevant when the company has no earnings. But why would someone invest in a company with no earnings?
An early-stage company typically has a long-term strategy that focuses on growing the company and increasing the value of the enterprise. In this way, it can provide a return to its shareholders and investors—on paper. For those shareholders to convert the paper gains to cash there must be some type of liquidity. Liquidity for investors comes in three primary forms:
- Distributions: paying out dividends to shareholders in the form of cash
- Acquisition: selling all or part of the company to another firm, and distributing the cash and stock proceeds to the shareholders
- Initial Public Offering (IPO): becoming a publicly traded entity by virtue of listing the company directly on an exchange (OTC, NASDAQ, NYSE, etc.), or merging into or acquiring a shell company that is already publicly traded (whether a reverse merger, or acquisition by a SPAC special purpose acquisition corporation that is already public), which will ultimately allow the shareholders to get liquidity by selling their shares in the market
Companies that have the goal of staying private will eventually begin distributing their profits—after retaining enough in the company to continue to grow. Many firms are founded with the strategy of growing and positioning the organization for an ultimate sale or IPO. When growth—in customers, revenue, and valuation—is the goal, the firm will rarely make a profit because it is re-investing all its revenues back into growing the business. Therefore, particularly in younger, faster-growing concerns, they rarely show a profit. In fact, their strategy will likely even require that they continue to raise additional capital to feed more rapid growth, at the expense of earnings. Not having earnings (profits) therefore, is not necessarily a sign of not having value. In this case, the value is then normally measured on the potential for profits and future growth. What metrics are used for this?
By eliminating earnings (profit) from inclusion in a calculable metric, you are primarily left with revenue, however, there are others. A controversial one is ‘eyeballs’—the number of people accessing the application or platform on a daily, monthly, annual basis, their usage patterns, their churn/retention measures, their number of clicks or downloads—mostly their potential for monetization.
Most frequently when using revenue alone as your metric, it is always a multiple of annual revenue, but it is important whether you are looking back at previous numbers, or forward at projected numbers. Some common approaches are a multiple of:
- The revenue from the previous year, or trailing year.
- The revenue from the latest month x 12, or leading year.
- The revenue projected by the company for the next 12 months or projected annually.
The application of the multiplier to this annual revenue figure will vary widely, as we have noted, by sector, industry, category, business model, geography, and other criteria.
In one case, for example, an insurance agency may be valued at a multiple of one times their total commissions on policies (their revenue) for the past 12 months (trailing year). Yet in the case of a cutting-edge enterprise SaaS (cloud-based software-as-a-service) application, the value could be set at 10 times the revenue they are projecting over the next 12 months (projected year).
Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only. Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.
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About the author:
Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.
A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”
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