10. On valuation, craziness of the entrepreneur, and entrepreneur-as-an-investor

Dear Co-creator;

I showed my rough draft to a few people first, as I always do, for your reading pleasure. Their feedback is essentially what I always forget after too many years in finance: entrepreneurs do not really have financial literacy. They really have no clue. So I am going to make this long letter about Valuation for Dummies. My apologies to those who may find things pedantic today.

Imagine our tech startup has an unexploited idea, good tech that works in the lab, a solid business plan and the A+ team to execute.

What’s the value of our company?

To answer this question for us, a startup with no numbers, let’s start at the other side of the spectrum with Google, arguably one of the best technology companies in the history of the world. A company with a lot of financials. The only Yahoo asset I still use gives us all the numbers we want: In 2022, GOOG made $91.37 bn in EBITDA (Earnings before Interest, Depreciation and Amortization - we are not accountants per se and for our exercise, you could take this number as it “almost” represents cash). Yahoo Finance gives us a better number though called Net Income Avi to Common (as in available to common stock shareholders) and that is a $60.95 billion for GOOG. This number, in our Dummies context, represents money that GOOG could theoretically give to its shareholders. Larry Page, for instance, owns 3% and could get $2bn from the income (unfortunately, GOOG does not pay Larry dividends every year, and instead reinvests its income back into the business).

More numbers from Yahoo Finance: GOOG has a profit margin of 21.05%, a market capitalization of $1.65 trillion on a net income of $60.95 billion. Grows its revenue to the tune of 7.1% every quarter.

Think of net income as revenue minus expenses. Simple. And you do know this I am sure, because after all, your market share, your number of users, your whatever else does not buy you food to eat (note to self: imagine a venture capitalist supermarket that gives you bread in exchange for your number of users). And market capitalization as your valuation as decided by the market that buys and sells your shares every day. Called as the MULTIPLE, the ratio of valuation divided by net income is the most generic, most widely used valuation metric in the world because it basically tells the investor HOW MANY YEARS IT WOULD TAKE TO GET THEIR MONEY BACK.

Think about the sheer simplicity of what I just wrote.

Net income is the money that the company can pay back to you any given year. Valuation is really what you invest in the company. Put your money in and get it back in time. For GOOG, this simple MULTIPLE (called Trailing Price to Earnings-P/E Ratio) currently is 27.52. So you put $1.65 trillion as an investor (or $132 per share), and GOOG pays your money back in roughly 28 years in $60 bn installments (or $4.4 per share).

How many years would it take me to get my money back…

The entire universes of finance, investing, money, interest, wars, famines, the human condition, can be summed by this sentence. How many years will it take to get my money back, and then some more while risking its loss.

Would you give money to Google who tells you that you will get your money back in 28 years? Yes you would, like millions of people. You might think it is mass hysteria to trust GOOG with 28 fucking years but GOOG has been growing and growing since 1999. It is making more money every year. So you trust that GOOG will make money every year and you would be right. GOOG stock price has netted its investors 13.49% per annum over the past 10 years. Is that a lot?

I lied to you. Human brain and risk averseness think in terms of YEARS TO GET THE MONEY BACK, but wars, famines, investments, finance, Wall Street, rampant capitalism, consumerism, human condition rely on the notion of RETURN ON INVESTMENT. People give money to Google because GOOG says I have given you 13.49% return every year in the past 10 years despite the fact that you are going to get your money back in 28 years. Contradiction? Welcome to the world of finance.

By now, you get the basic idea of modern capitalism. You sell things. Someone gives you money for those things you sell. There is a cost to those things you sell. You subtract the money you paid (cost) from the money you get (revenue) and that’s the money that you can spend on anything you want (net income to presumably buy bread for your family, and a lambo for yourself). One day, you notice that if you buy your things in advance, say, 3-years of bulk you get a 50% discount. But you don’t have money to in bulk. You come to me and say give me money and I can pay it back in [MONEY divided by NET INCOME] years. I say oh cool your net income will also go up next year because of the discount you receive. So in reality you will pay me back in less time. Unless of course nobody buys your things anymore and you go out of business. And I say how about give me some interest because I don’t want to just get my money back, I want to make more. Or I say give me ownership instead of interest because of the risk.

I cannot write simpler than that and I felt dirty writing it. If it offends your intelligence, I sincerely apologize.

In terms of risk, the government of the United States of America lies on the other side of the spectrum. It has nuclear arms, a global naval footprint, 330 million people, largest GDP, etc. etc. So the chances that it will go bankrupt before paying your money and interest is small enough that its obligation to pay you back is considered riskless. If you give money to the United States for a 10-year loan, it gives you 4% interest per year and your money back in that time. Trust me, the day the United States cannot pay you 4%, you’d have some other horrible things to deal with than your money.

So we have Google that seems to pay you 13.49% per year. And the United States Government, 4%. Kind of starting to make sense, no? Google does not have nuclear arms and IRS to collect revenue, and somebody could do better search than Google at some point. So they pay almost 10% more than the US government for your loan.

Let’s now look at our HYPOTHETICAL tech startup. We are not the US Government, nor Google. What interest per annum would someone charge us for a loan that we need to buy or make things to sell at a higher price?

Let’s say we have some awesome tech in the lab that a few partners want. They say they will pay for it once it is deployed commercially. They send us an official looking email that says they reserved $1m for us for next year IF we sell them stuff next year. Great. And it may grow crazy in the third year. After that the growth might ease up but still AMAZING growth can be projected/expected. And the profits margins are also excellent – 40% at zenith. We can see a trajectory to better margins early on since it is “high value” tech but perhaps after some years competition will creep in so we may expect some compression. Simply, a successful business according to the projected numbers that look something like this (excel file available for download for premier members if you want).

Imagine the following extremely simple 10-year financial projections:

And let’s say we get a venture capital firm to believe in the vision, product, the numbers, and everything. They read our presentation, met with us a few times, did a month-long due diligence, everything checks out so we get $1m from them for our first year, in exchange for 20% of the company (if easier, you can always think about the 20% as the interest rate for a loan that never pays the principal back).

What will this venture capital company’s returns be with these projected numbers? They will make two adjustments:

1. Since they are the first money in, and usually a tech startup would need a couple more financing rounds, they would expect that by exit (eg. Year 10), their ownership would dilute. Let’s say the startup takes two more rounds at Year 3 and 5, and the 20% ownership gets diluted to 5% (50% dilution each time).

2. Survival rate and the Lindy Effect (which essentially states that the longer a non-perishable item has been around, the longer it's likely to persist into the future). A good 95% of startups fail, and one may surmise that the survival rate improves as time goes on.

With these two adjustments reflected as the money VC invests ($1m) and the money it can theoretically get as dividends, 10-year Internal Rate of Return is calculated to be 30% when you add a $10m terminal value for 1% of $1bn company.

(What the heck is a terminal value? Any business that kicks out $30m profits with that much growth and margin would have around $1bn value. You didn’t forget the GOOG example, did you? I am simply multiplying my PROFIT ($30m) with my MULTIPLE (30x). Why 30x? Well because I have decent historical numbers at that time so market trusts me, and I grow much better than GOOG. So GOOG gets 28 years, and I, well 30 years.)

When all is said and done, our startup paid 30% per annum interest for 10 years. US Government 4%, Google 13.49%, and us, 30%.

This 30% paying investment would be good for this venture capital company since the 10-year returns for the US Venture Capital industry is 18.42% per Cambridge Associates Venture Capital Index. US Government 4%, Google 13.49%, Venture Capital As a Whole 18.42%, and us, 30%.

An investor, of course, could spend only 1 minute and buy the stock called QQQ which is the ETF for NASDAQ-100 that houses all the top technology companies. That investor would have made 18.15% on a 10-year return basis. Heck, you can buy the entire US economy (called S&P500) and make 9.48%.

Government 4%, US Economy 9.48%, Tech Economy 18.15%, Google 13.49%, our startup 30%.

Let’s ask ourselves the question, dear entrepreneurs/investors:

If you could spend only 1 minute and buy the best of all of United States technology companies such as Apple, Microsoft, TESLA, etc. (called QQQ stock) and make 18% annually on a risk-adjusted return basis, why would you spend months on a startup that gives you 30% risk-adjusted return in the best-case scenario?

Rationally speaking, you wouldn’t. Rationally speaking, “average” venture capital firm should not exist. Rationally speaking, national lotteries should not exist. Rationally speaking, you should NOT be an entrepreneur.

Yes, you are crazy; the numbers do NOT justify your average existence. The answer why you still do it lies in the Superiority Illusion (Dunning-Kruger Effect) which is truly a miracle that makes the human condition the way it is.

Most human beings are risk averse and that’s also a good thing for our survival. That’s why $23.9 trillion was invested in US Government securities in 2022 vs. $483 billion in global venture capital. That’s only 2% and good enough. Not everybody should be an entrepreneur. More than 2% invested in entrepreneurship would be idiotic. But some of us are wired as gamblers who just don’t give a fuck as to true odds. 98% of us perish, but the 2% inspires epic journeys and heroism (and are used in academia to exemplify Dunning-Kruger). Out of that 2%, I believe there is a further 0.1% that obsess about the true odds (eg. numbers) and use them to increase their survival (and success) rate intentionally and sustainably in a crazy-nevertheless-but-correctly-priced journey.

What does that mean? It means two things:

We cannot just be doing things for money, it just doesn’t make sense. Gotta either be really crazy and passionate about the idea (obviously I am currently not, or else we wouldn’t be searching for it) or that the non-monetary reward should be so large that the return is also quite large on the whole. I’d put another line in the financials above and quantify the public good (CO₂ reduction, longevity, etc) and track that return.

Let’s talk about the other thing later. I am done writing. I feel the burden of the paradox between Entrepreneurial Financial Illiteracy and Offending Your Intelligence. Enough for today which was supposed to be yesterday without the Dummies context.

Update:

I am zeroing in on the cooperative idea. Should be able to create the investment memorandum in a week. Want to make the cooperative based on your doing good and well, take out all impediments to membership (fees, deposits, etc) with an initial focus on AI tools, software, etc. What does that mean? Membership is free but only via a referral from a member. Members are all equal, they get shares in the cooperative. Members bring deals and get a piece of that. Everyone wins through the dividends from the shares. Or we use the income for creating actual stuff.  

Cooperative is a method by which we can do stuff together – I am gonna do this no matter what ie. I will turn Addshortcut into a public benefit corporation. And I will also do an AI product/service as promised as part of the Addshortcut. Somehow. Let’s think some more – it is not that easy.

Today’s picture is the AI interpretation of the Black-Scholes Option Formula:

I was a student of the Nobel Laureate Prof. Dr. Myron Scholes after he lost his shirt with LTCM. It was sad and exhilarating for us at the same time. I used to think that the human condition could be quantified with a version of the options formula. Isn’t everything including the parallel universes an “option” after all? I still kinda do but too old and too rusty with math to pursue.

If you read this far, and don’t hate me, humor me with the valuation of your company:

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