3 – Valuation

Determining the value of a company begins by asking the question of value to whom and for what purpose? A company has values both intangible and tangible value to different people for various reasons. Here for example are some intangible values. A company is of value to its employees, as it provides for their livelihood. A company has suppliers it buys from, who value it as their customer.  A company has customers it sells to because they value their products. And for the entrepreneur, the company is the vehicle for pursuing their passions (Investor Incentives and Motivations and Why Exit?). These are all examples of intangible values the company represents to different parties for different reasons.

“The concept “value” is not a primary; it presupposes an answer to the question: of value to whom and for what?”

Ayn Rand

This essay, however, will discuss the company’s tangible value in financial terms, its valuation. A company’s valuation is usually required when negotiating with investors or selling it. Much has been written elsewhere concerning how to determine a financial valuation of a company; and I will provide a primer on how a business valuation is determined for those who have a limited understanding of this subject.  However, the primary purpose of this essay is to discuss the Objectivist principles that guide making that valuation. Does a company have intrinsic value? Is a company’s value objectively or subjectively defined? Are valuations determined by compromise or negotiation?  How do honesty and integrity build value through trust in negotiations? These are the questions this essay will address.

In the beginning, at the idea stage, before developing a marketable product, before sales and profits, does a company have value? It is not uncommon to hear entrepreneurs claim that their company has a million dollar valuation because they have “a million dollar idea.” Let’s be clear, there is no such thing as a million dollar idea. There are only million dollar businesses based on good ideas. No doubt Bill Gates, with his track record, could sell an idea for a million dollars if not more.  But that would be the exception that proves the rule. Ideas are cheap. Only executing on them produces real value. Claims of million dollar ideas are based on the erroneous concept a company has intrinsic value.  But there is no such thing as intrinsic value because there is no such thing as value without a valuer. An entrepreneur may claim their company is worth a million dollars. But if no one else values it for that amount, then it is a value that is base less, a value “hanging in a vacuum”.

“The market value of a product is not an intrinsic value, not a “value in itself” hanging in a vacuum.”

Ayn Rand

What is of value in the beginning is the respective value each of the founding entrepreneurs, if there are more than one, represents to the founding of the company. These are usually granted to them in the form of “founder shares” based on some mutually agreed allocation. Once work begins, with individuals working at a reduced salary or perhaps no salary at all, as is often the case, the equivalent value of that invested effort, called “sweat equity” may also be paid to them in shares.  Also, if the founders invest their own money to begin operations, it is usually recognized as an investment in the company in the form of additional shares. The same applies to family and friends who invest “love money”, or Angel investors who sometimes invest “seed money” in the beginning.

However, beyond the liquidation value of the company, all these share allocations only have potential value, not any actual value. They only become a real value when the company is acquired or sold.  Still, when various investors are involved, it is necessary to determine a company’s potential value if for no other reason than to determine what percentage of ownership their respective investments will represent in the company. However, hand in hand with the error of declaring a company has intrinsic value, it is an error to attempt to establish that value by a subjective assessment.   

“The subjectivist theory holds that the good bears no relation to the facts of reality”

Ayn Rand

Establishing a subjective value is an attempt to determine a company’s value through “positional negotiation” and compromise (Compromise vs Negotiation); and thus a value that is detached from reality (See essay: Sales).  A subjective valuation is achieved when one party declares a high value, the other party a low value, and the correct value being determined through compromise perhaps by “splitting the difference.” This is more descriptive of an arm wrestling contest based on subjective assertions. In contrast to intrinsic and subjective valuations an Objectivist entrepreneur needs be able to provide objective facts and rational arguments to determine an objective valuation. A company’s valuation is not a struggle of wills based on arbitrary assertions or wishful thinking. It is an objective valuation based on reason.

“The intrinsic theory holds that the good resides in some sort of reality, independent of man’s consciousness; the subjectivist theory holds that the good resides in man’s consciousness, independent of reality.”

Ayn Rand

With intrinsic and subjective valuations discarded as means for valuing a company we can now start to discuss how an objective valuation is made. To begin, a business that never achieves a profit has no value beyond the liquidation value of its tangible assets. I am not saying a business that is not profitable in the beginning has no value, as many businesses in there early growth years are not profitable. Amazon is a prime example, no pun intended. Amazon was not profitable when it was sold as a public offering in 1997 for $438M and didn’t make its first profit until 2001. After that it took Amazon 6 more years to make as much profit as its first $1 billion plus quarter in 2017. My point is, a business that NEVER achieves a profit has no value beyond the liquidation value of its tangible assets. Valuation in this context is referred to as “good will” value, defined as the financial value of a company beyond the liquidation value of its tangible assets as a going concern. With this understanding here is a primer on how an entrepreneur determines an objective valuation of their company during all stages of its development.

A company, at least financially, can be viewed essentially as a money-producing-machine. To understand what I mean, imagine you could literally create a machine that legally produced money. You would have to invest time and money to build it. You would have to purchase supplies for it and hire employees to run and maintain it. But once operational let’s say it could produce a given amount of money in excess of the cost of running it, a profit each month. The valuation of this money-producing-machine is determined by how much and for how long it can produce that money. How much someone is willing to pay today to purchase such a money-making-machine represents its current objective valuation, nothing more, nothing less.

The simplest way to calculate that amount is called a “net present value” (NPV) calculation. This is essentially the reverse of compound interest, which everyone should have some understanding of if they have a bank savings account. Compound interest is where someone deposits a given amount of money, every month, at a given interest rate, for a period of time to produce a compounded future value. Determining the value our money-producing-machine is simply the reverse of that. NPV determines how much you should pay today for our machine that is projected to produce a given amount of money each month for a period of time into the future. The risk associated with that projection is similar to the “interest” rate, called a discount rate, used in that calculation. The lower the risk, the lower is the discount rate and the higher the valuation. For an entrepreneur’s company, the money it projects to produce monthly is its projected profits. It is these profits projected into the future that objectively determines its valuation through an NPV calculation.

This is why I said, a business has no financial value beyond the liquidation value of it assets, if it never generates a profit. Even if the company has established a strong reputation or brand name, these are of limited value if they do not result in directly producing a profit. This means the company has no “good will” value. Inevitably such businesses are liquidated to recover their tangible asset value in cash.  This always represents an absolute minimum valuation for that company, albeit usually a marginal one.

The justification and rational support for these projected profits comes from the entrepreneur executing on their vision, building an organization to produce products or services, initiating marketing and sales to customers; and then gathering metrics which allow them to project profits into the future with credibility. The ability to execute on a plan and project future revenues and profits with some confidence is ultimately the way of determining the discount rate as the risk and the company’s valuation. It is an objective valuation based on facts.

“Since each of these elements is based on the facts of reality, the conclusions reached by a process of reason are objective.”

Ayn Rand

But, of course, projections are only as credible as the facts they are built on that one can trust. When negotiating with investors establishing trust between the parties is not just the most important point for successful negotiations, it is the only point. Doing an NPV calculation based on projections is simple math.  Building trust in the projections between the parties is hard. Projections of future profits and associated risks must be credible. Defending them requires honesty and integrity (Honesty and Integrity) if trust is to be achieved. An entrepreneur will undermine their credibility and thus negotiations and the valuation of their company by making unrealistic projections that cannot be objectively defended.  Being dishonest is an attempt to evade the truth, which is a breach of integrity and puts them in conflict with them self and those they are negotiating with. Attempting to overvalue a company based on exaggerated and dubious projections is an attempt to gain the unearned.  Presenting projected profits with honesty and integrity builds trust. With trust established conflict is eliminated and rational discussions of the facts underpinning an objective valuation can proceed between the negotiating parties..

“there is no conflict of interests among men who do not desire the unearned.”

Ayn Rand

While a NPV calculation is an objective way of determining the financial value of a company, it is none the less only a potential value based on projections. Only when a company is sold, either by being acquired or through an initial public offering (IPO), is an actual value determined. However, the value to the entrepreneur of determining an objective NPV valuation is that it can used to rationally evaluate offers for acquisition of sale of their company and either reject or accept those that don’t meet or exceed that value. The Objectivist “trader principle” of value given for value received requires the entrepreneur to know the value they have to offer in order to know the value they expect to receive in return. A NPV valuation provides them with an objective assessment of that value and a rational means for assessing offers.

“The objective theory holds that the good is….. an evaluation of the facts of reality by man’s consciousness according to a rational standard of value.”

Ayn Rand 


Although an NPV valuation provides an objective valuation of a company It may be possible to negotiate a valuation higher than it when the company is being acquired by another company. This certainly is the hope of many investors in startup ventures. The acquiring company, through their efforts, may project higher profits once they acquire the company and thus be willing to pay a premium for acquiring it.  One reason is, an acquisition for most companies is a “make/buy” decision.  It is often less risky and less expensive to “buy” an existing company, even at a premium, than having to “make” it over from scratch.  Another is, they may believe they are better able to expand growth and/or produce higher projected profits once they acquire the company. Both are good reasons for paying a premium to acquire the company. But if the offer to acquire is lower than the NPV valuation, at least the entrepreneur has an objective and rational reason for walking away from the acquisition. Either way a NPV valuation is an objective way for an Objectivist entrepreneur to assess the value of an offer to acquire their company. 

However, an Objectivist entrepreneur needs to acknowledge, if the acquirer by their efforts can expand growth and/or improve profitability; these are values they bring to the table in negotiations. This limits the premium if any they may be willing to pay. An Objectivist entrepreneur does not seek the unearned. They acknowledge the value to the acquirer of acquiring their company is a value of the acquirers.  Yet knowing their NPV value, as well as what that value is to the acquirer, for both parties, determines the lower and upper limits of an objective valuation for the acquisition. This is an objective assessment of the respective values each company brings to the negotiations, discussed with honesty and integrity, acknowledging the associated risks and benefits for both parties, hopefully concluding in successful negotiations with value given for value received.

“…. one must never seek or grant the unearned and undeserved, neither in matter nor in spirit”

Ayn Rand

Next, when a company is offered for sale through an initial public offering (IPO), the investors in the company certainly hope the shares will sell for at least the NPV valuation of the company if not more.  The value being decided by the public may appear to be a highly subjective one. But it is not. From the perspective of the entrepreneur it is the most objective of all. Just as profits are determined by the value customers place on purchasing the company’s products (Profit) the valuation resulting from an IPO is determined by the value the public places on purchasing the company’s shares. As stated, a value is a value of what and to whom.  The “whom” are those buying the shares, the public.  The “what” is based on their individual assessments of the future prospects of the company. A public assessment is an assessment in reality, and thus an objective one.  However, for the public to determine that value, requires applying the same principles of honesty and integrity to build trust that apply when dealing with investors or an acquirer. This applies not only during an IPO but thereafter as well.  A loss of trust through misrepresentation or failure to meet expectations will result in an inevitable loss of value in the company’s shares that is difficult to recover from if ever.

“Trust takes years to build, seconds to break, and forever to repair.”

Unknown

An Objectivist entrepreneur understands that their company has no intrinsic value. That, beyond the liquidation value of its assets, in fact it has no value at all if it is never profitable. They understand its value is also not determined by an arm wrestling contest of wills based on subjective assessments concluded through compromise. Only through profits projected into the future with confidence can their company be objectively valued. The more the Objectivist entrepreneur can defend those projections rationally, the higher the trust, the lower the risk assessment and the higher the valuation. But even that value is only a potential value until the company is sold by one means or another. Only then does it become a real value. That value may be higher or lower than expected; but it is an objective value, based on objective facts, supported with rational arguments presented with honesty and integrity.

“It is in regard to a free market that the distinction between an intrinsic, subjective, and objective view of values is particularly important to understand.”

Ayn Rand

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