Unit Of Value
UNDERSTANDING
Entrepreneurs
Jumping into any valuation exercise, I think it's really important to understand the Unit Of Value of every participant in the ecosystem. If you're an entrepreneur and you're providing products and services, the unit of value is actually the units of those products and services. For example, if you are into hospitality and you run a hotel, you are selling room nights everyday. That is the unit that becomes a value in every transaction where you are providing services against which you are getting paid.
As an entrepreneur, in your company P&L, the revenue is going to flow, or the value is going to flow, from selling those units and providing services to the end customers. Similarly, if you're selling a good, let's say a mobile phone, the unit of value is the actual product that you're selling, and you will get paid for every cell phone that you sell. The margins from those cell phones help you sustain your business, pay salaries, pay rents, and, at the end of the day, create a bottom line, hopefully a positive bottom line, which is called the net profit.
Entrepreneurs also derive value from selling the equity shares of their ventures. In principle, they sell the future ownership of profit and losses to the investors upfront and the remaining share ownership sits with them. Eventually, the shares may become more valuable, and they may be able to sell those shares to other investors and gain from these transactions.
But as we will discuss below, this activity has to be looked at from the point of view of outcomes and not goals. If the goal is only to show some activity and show the levels of revenues in a company, and then sell the shares at a value which is a multiple of revenue, then there is an inherent agency risk in this activity. The valuation, as a principle, should be looked at from the point of view of an outcome of the value that gets created within the ecosystem of your venture.
Venture Capital & Private Equity
Just think for a moment how a venture capital firm or a private equity firm makes money. Their primary business model is investing in company shares eventually selling them at some value. At the end of the day, the unit of value for venture capital firms and private equity firms is actually the shares in any company. Those shares are bought and sold, and the difference between the bought and sold values of shares is actually the value that they create as the economic value.
The venture capital firms and private equity take money from end investors, pool that money, and invest it into multiple companies across a spectrum and take calculated bets on those companies. At the end of the day, they have to return money to the end investors from whom they have taken the money. The return to the end investors also comes from the increase in value of the shares that are bought and sold. At the end of the day, for a pure-play investor, the value of a share becomes the key driver of value, and they will do everything in their capacity to be able to increase the value of shares and earn a living.
Above, we discussed just the pure-play investors. There are also VC and PE funds in the market who actually work with the entrepreneurs to create holistic value. They participate in the product, they participate in the business model, and they participate in supporting the entrepreneurs in multiple ways so that the entrepreneurs can work on their mission and their vision and eventually generate the value. For these kinds of venture capital and private equity firms, the valuation of any company is an outcome of the actual value entrepreneurs create through their actions.
Valuation - Goal vs Outcome
At the end of the day, we have to really understand whether the valuation of a company is an outcome of all the value that is created, or it is a straightforward goal. There is a clear difference between these two.
When the valuation is a goal, there are lots of things one can do to create stories, to create data points, to be able to attain a certain kind of valuation and enable the selling of shares. When the valuation is seen as an outcome, there is a real value that is created in the form of products, services, and business models that actually help people in their lives and help people achieve their goals. They are valuable to society, to the country and to overall economy.
Employees
Employees in any firm or in any entrepreneurial venture work within the boundaries of the business model and give their time to be able to enable all the activities that go on in a business. For them, value is created in two ways: they get their salaries, and also, a lot of times, when the entrepreneurs share the value in terms of shares, they may work slightly harder to be able to create more value so that the shares of the company become valuable.