Dragon’s Den is the reality TV equivalent of asking a private investor for some money to expand or start a business venture. Of course, it’s not identical to the situation that most business owners or entrepreneurs will find themselves in – as they’ll usually be pitching to bank managers or small venture capitalists – but the lessons are the same.
One key lesson involves valuation. It’s also the thing that most visitors to the Den get wrong, and probably the number one reason that they don’t get an offer from the notoriously picky Dragons.
In Dragon’s Den (Canada) in 2009, Kevin O’Leary gave a unique insight into his decision process when he revealed some basic mathematics that enables a canny entrepreneur or would-be business owner to gauge whether their idea is a business, or just a good idea.
A Valuation Example
Assuming that an entrepreneur has a need for an injection of $50,000 USD (or any other currency) and is willing to hand over some equity (share) in the company, they might decide that they should offer 20% against the $50,000.
This means that for every 1 unit of profit, 1/5th is handed over to the new shareholder, as a dividend.
It also means that the value of the company is 5 x $50,000, or $250,000. This is because each 20% shareholding is assumed to be worth the value of the stake being asked for. If the entrepreneur hasn’t put in the other $200,000 dollars, they’re unlikely to get a deal from anyone, on that basis alone.
However, if an investor can be shown that the valuation based on profit after tax is reasonable, then they might just see an opportunity that makes the equity worth holding.
Valuation Based on Profit After Tax
Kevin O’Leary used a figure of 5 times profit after tax to cross check the valuation. To get to the profit after tax, a number of things need to be deducted from the income:
- fixed and variable costs;
- staff costs;
- corporate tax.
The fixed costs are usually rent, and other items that don’t change according to the amount of product being sold. The variable costs are those that change in line with production volumes – input materials, heat, light, and so on.
So, to justify a valuation of $250,000, profit after tax needs to be around $50,000. If it’s not at least that, you’re likely to have a bit of a struggle getting support on Dragon’s Den or anywhere else.