“Growth for growth’s sake is bullshit.”
–Brett Sharenow, Broadscope Consulting
Why do you want your business to grow? Do you know? We’re conditioned to think that more is always better—especially when it comes to money. But many people don’t realize that growth, done improperly, can destroy a business faster than anything else. Be careful what you wish for.
I was speaking with my colleague and finance expert, Brett Sharenow, recently, and we stumbled into a conversation that exposed a codependence between many startup CEOs and the venture capitalists (VCs) that fund them. What you’re going to learn will startle you. I captured our conversation on video and we want to share it with you here.
But if you don’t have time to watch us share a eureka moment that could change the entire economy, scroll down and we’ll cut to the chase below, as well as define some terms that you may need for the video.
It’s important to note that although we’re discussing startups, the principle applies to businesses at any stage of development.
If you focus on growing top line sales rather than creating value for your customers in a sustainable, efficient way, you are begging to have your butt kicked. (Click to Tweet)
Brett and I see this happen every day. There are no shortcuts to success, and those that try eventually pay the price.
This is why, as Brett explains in the video, when he creates financial planning models for people, he uses three measures to estimate company valuation: Revenue multiple, EBITDA multiple, and Total Discounted Cash Flow (DCF). This exactly matches how I counsel my clients to manage their money. Many investors and business owners, shockingly, only look at Revenue. Others use EBITDA as well. But very few people look at total cash flow, much less use a DCF as part of a company’s valuation estimate, especially when revenue growth is strong. Why? Because they avoid discomfort like everyone else. To help you understand more, I asked Brett these questions:
Brett, what’s meant by Revenue Multiple when it comes to company valuation?
Let’s say that you want to sell your IT firm called SuperIT, that has annual revenues of $1MM. The sales price of a comparable IT startup that sold last year was $7.5MM and their annual revenues were $2.25MM. You calculate a revenue multiple of 3.33 ($7,500,000 / $2,250,000). You then repeat the calculation with other comparable IT firms that have sold in the last two years, then take an average of the revenue multiples. In this case let’s say that average is 3.1. Then, to calculate SuperIT’s estimated value, take your annualized revenue of $1MM times 3.1 and end up with $3.1MM. Simple, right?
There are numerous problems using a Revenue Multiple, but the biggest one is that you’re not taking into account company expenses or capital requirements. So using a Revenue Multiple, a company could be growing significantly in top-line sales, using large amounts of cash to grow, be wholly unprofitable, and still yield an extraordinary valuation because the top-line revenue is large. This is growing top-line sales only: Growth for growth’s sake.
What is EBITDA, and why is important?
An EBITDA Multiple is calculated and used the same way as a Revenue Multiple, except using the value of EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. The advantage of using an EBITDA Multiple instead of a Revenue Multiple is that the cost of goods or services and the operating expenses are taken into account. In this case, you are using a measure of profitability to estimate company value.
However, EBITDA misses interest expense on debt, tax expense, and all balance sheet items such as working capital (cash) needs, payments on loan principal, etc. Suffice to say, it’s not the whole picture.
Lastly, using either multiple method, you are completely disregarding the future when looking at the comparable companies and your target company. Are these companies really the same today and tomorrow?
What’s the difference between EBITDA and Total or Free Cash Flow?
EBITDA is sometimes used as a proxy for cash flow, because it takes into account revenues, cost of goods sold, and operating expenses, all of which have an effect on cash. However, EBITDA as a cash flow indicator is incomplete. It’s missing taxes and capital expenditures.
Total Cash Flow, also called Free Cash Flow (FCF), takes into account all cash flows into and out of the business. It’s a measure of the cash that the company is able to generate after taking into account required capital investment and is a true measure of the company’s financial performance and health.
What is Discounted Cash Flow (DCF) related to valuation?
A DCF analysis is a valuation method that discounts Free Cash Flows (FCFs) projected into the future to estimate company value. The projected FCFs come from creating a detailed strategic financial planning model for the company, calculating the FCFs over time, then discounting them back to the present using the company’s cost of capital.
The two biggest advantages of using this valuation method are:
- It takes into account the overall financial performance of the company over time, including profitability and capital investment required.
- It gives you an incredibly powerful tool that provides unbiased answers of how changes you make to the business affect company value.
Why do you think people focus so much on revenue and sometimes EBITDA, but usually totally ignore the DCF method?
Revenue and EBITDA multiples are easy to derive, understand, and use to estimate company value. They’ve also been used almost exclusively by Angel and Venture Capital investors over the last thirty years as the methods of choice for estimating value.
The DCF method requires a company to build a detailed strategic financial planning model that forecasts FCF to estimate value. It takes expertise, effort, and costs money: all things often in short supply.
Unfortunately, most founders don’t understand the value of a strategic financial planning model that can project cash needs, value, and dramatically impact business strategy and their path forward. Building a solid financial planning model may be the best money a start-up company ever spends.
So, what do you think?
Do you believe investors share with CEOs that they’re hedged against the company’s failure? (Click to Tweet)
This “good enough” model does not include the most important financial modeling metric, Discounted Cash Flow, because fundamentally most VCs are not interested in creating real value in the world—they just want to make money.
This is the exact same kind of thinking that spurred shrewd Wall Street folks to package toxic assets together and sell them as if they had value. It’s a short-term money-making mentality rather than long-term value creation strategy.
When money doesn’t reflect value accurately, it creates a bubble that eventually must collapse (as it did in 2008), and everyone loses except for the investors who orchestrated the creation of the bubble in the first place. They privatize profit and socialize the risk. It’s not illegal, but you decide if it’s immoral. Did you enjoy the recession? That was the price we all paid for it, and it will happen again.
Executives want to believe that their company is the “Chosen One.” Investors are fine with that belief because their portfolio is diverse and balanced. They only need one or two successes out of ten to succeed. In other words, the failure of seven out of ten startups is acceptable to VCs because their model for selecting investments is good enough.
How do you avoid getting caught up in this codependence? Know why you want to grow, besides making money, watch your three bottom lines (Revenue, EBITDA, and Free Cash Flow), and focus on creating sustainable value and enjoying growth as a by-product.
Are you interested to learn more about responsible financial modeling? Does your CFO need training? Reach out to Brett!
Are you honest enough with yourself to admit you don’t really know why you’re growing your business, or have any other questions? Reach out to me!