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Economics/Valuation of a Start-up

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QUESTION: I hope this falls under industrial economics.  Hello I have a question related to Economics - it's in Valuation.  I'm trying to help a friend perform a valuation pro bono for a 1 person startup.  So I've discounted the cash flows that this person expects his company to have in the future. The valuation came out to $500M. If you look at what this company has thus far, it's just a website and a prototype probably worth just a couple thousand dollars.

What I learned in economics/finance was the present value of the cash flows that an asset throws off was the value of an asset.  Under that premise, this company is worth $500m. Yet the company can't be worth more than a couple thousand dollars (website and a prototype).Can you help me reconcile this?

ANSWER: This does not "fall under industrial economics." However, since I do valuation of non-public companies for a living, I'll try to help you. Obviously since I've not seen the details of what you did, I can't 'reconcile' anything. But, given the tone and other giveaway signs embedded in what you wrote, I'd like to ask you to respond to the following questions, please:

1. What is the purpose of the valuation?

2. What standard of value did you use?

3. What premise of value did you use?

4. Besides doing a DCF forecast, did you also prepare a balance-sheet forecast and then a pro-forma statement of cash flow ? If so, what were the (a) results where the right side of the balance sheet was concerned, and (b) Cash Flows from Operations ? If not, why not?

5. What discount rate did you use in doing your DCF?

BTW, using "Question" as the Subject of your inquiry provides no help whatsoever to anyone searching the archive of questions in this area. Please be more precise.

---------- FOLLOW-UP ----------

QUESTION: Hi Warren -
The CEO of the startup for whom I was doing the valuation was allowed to enter the values that he deemed appropriate into the data collection spreadsheets for the I/S, B/S and C/F statements.
> Besides doing a DCF forecast, did you also prepare a balance-sheet forecast and then a pro-forma statement of cash flow?
B/S Yes Proforma statement of CF Yes
Cash Flows from Operations?  
Free Cash Flows are as follows: 11,700  9,924,000     34,684,000     41,384,000     49,184,000     58,664,000     70,760,000     82,275,200

5. What discount rate did you use in doing your DCF?
By going to the website and selecting under electronics http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.html.htm,
the cost of capital was 7.81%.  However, because this is a startup company with added risk, 12% was used.  
What was interesting was that the CEO looked at the Income Statement’s: “Revenues” and “COGS” and simply entered those same values into the Cash Flows statement’s: “Cash received from customers” and “Cash paid to suppliers”.  In your opinion, is that acceptable?
1.   What is the purpose of the valuation?
To value the company before a Series A

2. What standard of value did you use?

3. What premise of value did you use?
For 2 and 3, I am uncertain what you mean.

I’m sure you remember how it was when you were starting out in valuation..and perhaps you had someone who was patiently helping you out. I’m hoping for the same!
Regards,
Wing

ANSWER: Wing, as a matter of long-standing practice (it's in my AllExperts.com profileref="http://www.allexperts.com/ep/2301-84697/Economics/Warren-D-Miller-CFA.htm">my AllExperts.com profile </a>), I do not answer questions that are marked 'Private'. The reason is simple: I could end up answering the same question from different people a bazillion times. Inasmuch as I'm an unpaid volunteer, that makes zero economic sense. Also, as a matter of philosophy, I believe in sharing knowledge, not hoarding it.

However, in this case, I think I understand why you marked it Private. I don't think it was necessary because no one could figure out who your client is. . .except your client. I also think that the likelihood that your client tunes in to this conversation on AllExperts.com is somewhere between slim and none. . .and 'Slim' just left town. Nonetheless, I'm not going to do what I usually do when I reply to something marked Private: make it Public.

That said, I think it would be much, much better and easier on both of us for us to do this off-line. I'd like to begin by asking you to send an e-mail to me via cfa2005@gmail.com. I will respond and include my contact information in hopes that we can schedule an initial phone call to discuss.

I want you to hear very clearly that I'm making a gigantic exception here for you. You're in obvious need of help because you are so far out of your league here. I'm willing to lend a hand for a while, but you're going to have to do about 95% of what needs to be done. That, in turn, is going to require a significant investment of time here because, when it comes to the most basic of valuation basics, you don't know what you don't know. We both know that. I can help you fix that, but the responsibility for doing the heavy lifting is going to fall largely on your shoulders. I hope that the significance of the exception that I'm making registers with you. It's huge, Wing, absolutely huge.

I look forward to hearing from you.

Best regards--

Warren Miller

---------- FOLLOW-UP ----------

QUESTION: Before I proceed, I noticed that you didn't answer a single question of mine - usually one does that as a demonstration of one's knowledge. So my questions were:

By going to the website and selecting under electronics http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.html.htm,
the cost of capital was 7.81%.  However, because this is a startup company with added risk, 12% was used. Is this ok?

What was interesting was that the CEO looked at the Income Statement’s: “Revenues” and “COGS” and simply entered those same values into the Cash Flows statement’s: “Cash received from customers” and “Cash paid to suppliers”.  In your opinion, is that acceptable?

Answer
#1. No.

#2. It depends on the type of business.

BTW, you have NOT responded to my reply earlier this morning. So, you better be careful about engaging in the same behavior that you accuse me of engaging in. I didn't answer your questions because I chose not to embarrass you. Now you choose to embarrass yourself. So be it.

The sad fact is this: You don't know what you don't know, Wing. That makes you a menace to clients, and that's a bad thing. In medicine, it's called malpractice.

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Warren D. Miller, CFA, CPA, ASA

Expertise

My expertise in economics is limited to three sub-disciplines: Austrian economics, industrial organization, and evolutionary economics. Questions dealing with macroeconomics and other sub-disciplines of the subject should be submitted to those who have the appropriate expertise. N.B.: I DO NOT ANSWER QUESTIONS MARKED 'PRIVATE' because I believe that knowledge should not be hoarded. I also believe that such questions are likely to come those trying to cheat. Also, as one who was a full-time academic for half a decade, I can recognize test/homework questions several time zones away. Do not demean yourself by submitting such questions to me. Those who do so are cheating; I WILL call you out publicly. I have a zero-tolerance policy for cheating and dishonesty. In addition, please don't emulate the businessman who posted a request for help in August 2008. He expressly denied that he was seeking "investment advice" and said that his query was for, and I quote, "educational and informational purposes." Later, he allowed as how his questions related to the possible purchase of a $500K piece of equipment. I said I thought he had misrepresented himself. Bottom line: high-end business consulting is how I make my living. I am the sole support for my family. Please respect that fact and don't try to get for free what our clients pay for. If your company is big enough to have a sophisticated problem, it can afford to pay for the expert advice we and others provide. Beckmill Research, LLC, is a 95-octane firm. We're small, but we've been at this for nearly 20 years. We know what we're doing. Segue: Early on, some asked me for career advice; I gave it. I now get many such requests. The demand for a valuable good that is free is unlimited, so I now charge for that advice. Email me: cfa2005@gmail.com. Finally, PLEASE DO NOT ASK FOR INVESTMENT ADVICE. I am not licensed to provide such advice. If you want such counsel, talk to your financial planner or other financial adviser.

Experience

I work with Austrian economics (which differs in major respects from the traditional economics), industrial organization (which is about industry structure, conduct, and performance), and evolutionary economics (almost, but not quite, the economic analog of its biological counterpart) every day in my work. I appraise closely-held businesses, provide exit-planning services, and offer high-level strategic analysis, advice, and solutions to CEOs and owners of mid-sized businesses. Understanding, applying, and writing about these disciplines is an essential part of how I have made my living since 1993.

Organizations
CFA Institute, Strategic Management Society, American Society of Appraisers, Academy of Management, Culver Legion, National Association of Scholars.

Publications
CFA Magazine, Strategic Finance, Valuation Strategies, Journal of Advanced Property Economics, Harvard Business Review, American Fly Fisher, CFA Digest, CPA Expert, Business Valuation Review, among others

Education/Credentials
Chartered Financial Analyst designation (2006); Accredited Senior Appraiser in Business Valuation (2006); Certified Public Accountant (1992); MBA - Oklahoma State University (1991); Completed all of my Ph.D. coursework in strategic management - Oklahoma State University (1983-87); BBA in finance and accounting - U. of Oklahoma (1975)

Awards and Honors
Business Valuation Volunteer of the Year (2001) - American Institute of CPAs; Winner - Oklahoma Humorous-Speaking Contest - Toastmasters International (1971)

Past/Present Clients
Names are confidential. However, the "sweet spot" of our target market is companies that are too big to be small and too small to be big. Usually, those are companies with employees in the 15-to-100 range. At the low end of that range is where companies can first take advantage of the specialization of labor. However, having everyone do everything is a tough habit for many--most, I would argue--small enterprises. That is why they not only remain small, but also fail to survive beyond a second generation. Only 5% (one in twenty) companies make it to the third generation of ownership.

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