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This is the question for any startup looking to measure their personal wealth creation, take on additional capital, or sell their business. Unfortunately, the answer is usually, “Somewhere between nothing and a whole lot.” You can do better.
Working Backwards: Step One
Think about what your business is going to look like when it’s big and stable (or stabilizing). For instance, “we’re going to be selling units (or service hours) to about 35% of the market, which will be growing at 3% a year, and increasing our penetration of that market by about 5% a year.” This sets some top-line revenue numbers.
Compare yourself to other businesses in similar roles and apply similar operating margins, R&D budgets, or other ratios to your business. This gets you to the bottom line.
Think in terms of different scenarios (“best case,” “worst case,” dissolution, etc.) and how likely those scenarios are.
Working Backwards, Step Two
For each scenario above, run the forecast from Step One for about seven or ten years, from a period of no earnings (you’re reinvesting everything) to a period of justifiable margins. If you’re going to be the first arrival on the scene, you can justify higher margins; if you’re second or third to market, you’re going to have smaller margins.
Use a discounted cash flow analysis to create a valuation for each scenario as of the start of your “stable” period.
Product-sum the valuations and the probabilities to derive a weighted valuation.
Working Backwards, Step Three
Use your detailed project plan (perhaps using EVMS) to estimate the total capital and amount of time needed to get from where you are to where that future forecast begins. Give yourself lots of margin, because it’s not going to go according to plan.
The time required is the time horizon over which you further discount that valuation from Step Two.
The capital required is how much money you’re going to need, altogether.
For more information
Leave your comments below! Or if you feel like going to the library, see McKinsey & Company, Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, 5th Edition. Hoboken, New Jersey: John Wiley & Sons, Inc., 2010. Print.
What will you do if that old roof floods your top floor apartment, or if a cast iron drain pipe cracks just as you’re paying for bedbug extermination? What if the jobs cost $10,000? Do you call up your regular contractor and cut a check without batting an eyelash, or is this is a crisis necessitating soul searching, an emergency loan, or perhaps even a brave attempt at “deferred maintenance”? If you couldn’t afford a $10,000 emergency repair, you’d be in good company. Most small time property owners have a shortage of operating cash. But you can do better.
For large, established companies, there’s a test used to evaluate their ability to survive a “disaster” scenario. It’s called “the acid test.” The phrase comes from bygone days when gold was authenticated by dropping acid onto it. Gold won’t react, so if it’s “good as gold,” the acid has no effect. For businesses, “passing the acid test” usually means having enough liquid cash to cover more than an entire year’s expenses. That’s a heavy burden for a rental property, but if you manage that way, you can have some measure of peace of mind.
You can calculate the “acid test ratio” for your property by adding all your cash accounts for the business and dividing by all your liabilities for the next year. Your liabilities include the total of all interest, all insurance premiums, all real estate taxes, and all expected repairs. Suppose you have $12,000 set aside in the property’s rainy day fund. Suppose each month you pay $800 in interest, $300 in insurance, $300 in taxes, and $200 in repairs. All those expenses, times 12 months in a year, means you have liabilities of $19,200. Your $12,000 in cash divided by your $19,200 in liabilities means you have an “acid test ratio” of 0.625. A typical publicly traded manufacturing company has an acid test ratio of 1.25 to 1.5, more than double.
Now I’ve spoken with landlords about this, and most express shock and dismay that they should have to keep so much cash set aside. With monthly income guaranteed by leases, you might reasonably use another test, called “the quick ratio,” which lets you count receivables as “cash” because you’ll get them quickly. We can calculate this using the example above. If your tenants are obliged to pay $1,000/mo for the remaining nine months on their lease, you get to add another $9,000 in “cash.” Now $12,000 cash plus $9,000 receivables = $21,000. Divide this by $19,200 and your quick ratio is greater than one, just where you want to be. But be honest and don’t count month-to-month’s at face value. And if you’re dealing with tenants who might be headed for eviction or non-renewal, don’t count a full year of their lease at face value, either.
However much money you choose to set aside, the moral here is that large, established businesses set aside a lot of money for rainy days. As a small business, perhaps with limited credit, it’s important for you to do so, as well, and to keep that money allocated separately as a rainy day fund. You’ll be able to weather any storm if you do.
Imagine that you are the proud manager of the only company that provides food to the people who live in a large area around your plant. Your CFO comes to you for the quarterly update and for the first time in a long time it’s good news. He shows you the graph below:
“We haven’t made money in ten years. If we do nothing, we’ll be on forecast 1, still losing money, but the bleeding is slowing down. We’re going to get through it. We’re lucky that the cost savings and price increases we put in place over the last ten years have set us on that path, because sales and operations are demanding even lower prices and bigger budgets. If we were going to give them what they wanted, we’d be on forecast 2 and still hemorrhaging cash.”
You think about it for a second and ask your CFO, “What does our balance sheet look like?”
He pulls out a copy of the balance sheet and hands it across your desk:
“Oh, hmm, ” you say. “I see our shareholders are in the red by about $15 trillion. God love ’em, they do support us. Let’s give sales and operations what they’re asking for.”
Your CFO should be shocked, but by now he’s totally resigned to your insane management of the company. “Okay,” he says, “I’ll call up our overseas competitors and get additional funds.”
You reassure your CFO, saying, “Don’t worry, they know we’re the only company providing food here. If they need us to pay off the debt, they’ll let us know, and we’ll just raise prices. Our customers will have to pay it. But let’s try to avoid that, okay? Also, call some emergency meetings with sales and operations. Make them work through the holidays to make sure we get onto forecast 2.”
You might think you’d be insane to run a company this way, but oddly enough, this is exactly what we’re doing to ourselves in the United States. See, for instance,