Blair Silverberg
More posts from Blair Silverberg
I’ve always told companies that investors have a much easier job than they do. To be good at their jobs, investors have to know how to do math and make decisions. As a business owner, you have to do both while also running your business.
The math piece can seem cumbersome, but it’s vital for understanding whether your company is creating or destroying value. A few simple metrics can demonstrate to investors the health and viability of your company, and they can show you which levers to pull that will best optimize your company for investor interest (and secure a higher price). But before you can ever hope to communicate your business’ value to an investor, you must understand it yourself.
The numbers are simple; it’s the calculations that are complex
Investment math itself is not complicated. In essence, it’s just about understanding whether your company is creating or destroying value by asking:
- Where is your company investing its financial resources? Most growing companies invest heavily in sales and marketing or research and development.
- What is the return on this investment? For example, how much gross profit (revenue x gross margin percentage) does a given sales and marketing investment produce?
- How does that number compare to your cost of capital? If it’s higher, your company is creating value. If it’s lower, you’re destroying it.
Investors use this information to determine if their return would be higher than their expectation (e.g., 15% hurdle rate), should you continue down your current path of creating or destroying value. Then, they make their decision based on that calculation.
A caveat I’ll add here is that it’s not necessarily a deal-breaker if your company is declining in value. Oil rigs, after all, are considered investment assets, even though they are perpetually declining and will eventually run out (i.e., destroy all of their value). Although this article focuses on calculations that demonstrate value creation, all investment assets can be financed at the right price.
A deep dive into calculating value
One of the best metrics you can use to demonstrate value creation is your cohort-level return on investment. It’s a calculation most investors are familiar with, but it may not be as straightforward to companies who don’t see it as often. Again, while the metrics and concepts of investment math are simple, it’s the process of getting there that requires complex analysis.
Whether you are evaluating these metrics yourself or bringing in outside counsel to assist you, use the process below to show investors you are creating value.
Determine which information to analyze
The first step in calculating value is to understand which information from your income and cash flow statements to analyze as “investments.”
Start by dividing your capital allocation into three main buckets: short-term investments, long-term investments and expenses. In general, short-term investments will be the ones you want to focus on, but it’s helpful to walk through each.
- Short-term investments (pay back within 24 months)
These pay off fairly quickly and can be evaluated period-on-period (e.g., monthly). This includes categories such as sales and marketing or inventory, where you’re spending capital to acquire customers and goods to sell to them, and then those customers buy almost immediately.
It’s important to offset short-term investments and the revenues they generate appropriately. So, if the average sales cycle is three months, the trailing three-month sales and marketing spend should be divided by three and applied to revenue cohorts for three months after the first spend occurred, on a rolling basis. In the same vein, if average inventory on-hand is two months, the same should be done for inventory on a rolling two-month basis. The beauty of short-term investments is that they can be compared. While they are often volatile (e.g., an ecommerce company will almost always have a killer November and December cohort), they show at a very granular level how much value is being created or destroyed — and how that trend is evolving.
- Long-term investments (beyond 24 months)
Because long-term investments pay off over many years, they cannot be evaluated period-on-period. For example, it took Apple five years of R&D to create the iPhone. Coca-Cola spent decades developing its brand, and the average time it takes to bring a new drug to market is 12 years.
Due to these constraints, most investors do not attempt to attribute a return to R&D investments. Instead, they focus their assessment on short-term investments, a better reflection of a brand’s health and quality of product. This means you can generally leave long-term investments out of your analysis when assessing whether you create or destroy value. After all, your short-term investments will perform poorly if your long-term investments are not creating value.
- Expenses
When identifying expenses, you should only include items that are truly 1) non-negotiable and 2) independent of growth. The bar should be items that, if cut off tomorrow, would cause your business to disappear into chaos. Typically, you can get away with only general and administrative (G&A) expenses, but you should review this from first principles for your business.
There are different approaches to modeling expenses. Capital’s view is that “steady-state capex” (i.e., expenses needed to maintain production, such as facilities and equipment) should be included in short-term investments, since those assets produce revenue. This inherits from Warren Buffet’s view on “owner’s earnings,” which he first addressed in his 1986 annual shareholder report.
Dig into short-term investment insights
Once you’ve calculated the profitability of your short-term investments, look for insights that translate well to investor messaging. For instance:
- “I earn a 150% IRR on my sales and marketing spend, which means my top line will grow 60 times over the next 10 years.”
- “When evaluating us, please ignore these four cohorts where we ran pricing tests. Instead, focus on these five cohorts, which are indicative of the improving unit economics in our business.”
- “Our loan portfolio yields a CAC-adjusted return of 45%, which is why it is more profitable to invest equity into our specialty finance company than debt to back our assets.”
These types of measurable insights add credibility to your messaging and demonstrate the depth to which you understand your company’s viability.
Use benchmarks to drive home your messaging
By benchmarking yourself against other companies, you’ll elevate yourself in investors’ eyes. Benchmarking sources, such as those Capital provides for our clients, help you create statements such as:
- “My sales and marketing efficiency puts me in the top 5% of all public companies and the top 3% of all private companies in the U.S..”
- “While my return on inventory is average, I am offering a slightly below-average valuation — which makes this an appropriately risk-adjusted investment opportunity.”
These points lend themselves well to everything from pitch decks to one-on-one investor conversations. Having the numbers to back up your statements is not only impressive, it also gives you the upper-hand with investors, in a way. These types of statements essentially put investors on the spot, which compels them to make more rational decisions. (Check out “Influence: The Power of Persuasion” for more from social scientist Robert Cialdini on that topic.)
Understanding whether you’re creating or destroying value is the first step in communicating to investors why your company is worth their money. The concepts are fairly simple, but the calculations can be complex. This makes it vital that you know what resources are available to help you make these calculations, interpret them and benchmark them against other companies.
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