Valuation Insights – FOMO, Investment Psychology & Market Dynamics

A while ago, I was having dinner with a friend and decided to ask how much profit his company made.  He gave me an answer which I still dine out on.

He said “Clearly you understand nothing about business.  If I made any profits, investors would be able to value my company, and so far, I have managed to raise over $100m”.

The business was founded in 1999 and today has a market cap of $20m.  Its turnover is around $5m, it is still not profitable and has accumulated losses of A$120m.

This lack of understanding reminds me of another example. 

Several years ago, I invested in a private equity firm in the USA called Elevation. Most of Elevation’s investments didn’t work out. They invested in Palm Pilot, Forbes Magazines, and the list goes on.

Then they put US$200m into a company at a valuation of $10 billion. I arrived at work the next day, complaining about this investment and their investment strategy, and I told one of my young colleagues about it. He asked for the name of the investment, and I said “Facebook – who has ever heard of Facebook?”. To which he responded, “it’s a good company”. Elevation turned the US$200m into US$2 billion, and it became one of my better investments.

So clearly, my friend was right, I understand nothing about business.

So how are unlisted companies valued. Most startups are bootstrapped by the founders, and then they are funded by FFF.  FFF = Fools, Families and Friends.

This is a great way of getting funds, but when the company seeks professional investors, the valuation that the FFF invested in, is difficult to jump over because, at that time, the founders managed to persuade mom and pop that their company was worth $10m and was the next best thing.

The professional investor now must break it to the founder that his valuation is not their valuation and if they want the investor’s money, this is the value.

Startup Fund Managers are skilled on working on the FOMO principle amongst their investor base – The Fear of Missing Out.  

With this fear, they manage to raise huge sums for start-ups. Some of these managers have hit the ball out of the park.

Rick Baker’s Blackbird were early investors in Canva, and that is the success story of the century. I was one of the early investors in Airtasker, and we reversed Vocus into a small wine fund a colleague and I started, which went from a market cap of $25m to over $5 billion at its peak.

If one looks at what all successful startups have in common, it is the founders – people with vision and drive.  When we invested in Vocus, James Spenceley enunciated his vision on a whiteboard, and he delivered!

When I invest in start-ups, there is the  age-old principle: Can I afford to invest,  and can I afford not to invest, as I don’t want to miss out on the next big thing?. 

Is the idea sound, clever and is there a niche for the product? Is there already lots of competition? As for the valuation, what are people smarter than me valuing the business at, and are they investing their own money. 

When I was at Investec, I was an investor (I still am) in a number of offshore syndicates which invested mostly in Asia. My ability to do due diligence was limited to reading the due diligence material the fund manager sent me.

My criteria were simple: How much are the individuals of the Fund investing of their own money.

I remember one opportunity where I was told they didn’t have any spare money for this particular investment, so I passed on it as well. While that may mean I miss out on some good investments, I don’t have enough money to invest in everything.

I always try to invest in syndicates where there are a number of investors so that if things go wrong, there is a pool of money available to try and fix the problem and I try to invest in a portfolio of investments, so if one really succeeds and a couple do a little more than okay, even if I have a few losses,  I still come out on top.

Valuing acquisitions also have their challenges. When looking at acquisitions, one has to decide what it can add to the existing business or what can the existing business add to the business being acquired. Being earnings accretive is not a good reason, for there are always cheaper businesses that will be earning accretive but will do nothing for the existing business.

Then there is the syndrome know as ‘wallet amnesia’. One of the hardest businesses to buy are anything related to services, such as medical practices etc. The doctors get paid a fortune for their business, but then have to reduce their salaries to the going rate for those services.

After a year or so, the doctors resent working for a fraction of what they were taking out previously, which was all the profits, as they now they have to leave some profits for the buyer so that the buyer can get a return on their money. This is ‘wallet amnesia’ – they forget how much money is now in their wallet, having bought a new home, car etc., and now feel underpaid. 

Where one needs the sellers to still work in the business, this can create problems as these sellers start to work out if, where, and when they can start again in their own business and perhaps have a second go at doing this all again.

There are employment contracts and restraint of trade agreements, but these can only go so far.  Many of these professionals do, however, love the new arrangement as they become freed from all the administrative burden and can concentrate on their own skills.

So, coming back to the original question as to how do these businesses get valued?

Normally it is a negotiation between a willing investor/seller and a founder/owner, desperate to raise funds or sell, and trying to get as much competitive tension amongst possible investors or buyers as possible.  

When a valuation is impossible because there is no agreement between the parties, there is always the Safe Note: a financial instrument used in startup investing that allows investors to provide capital in exchange for a promise of future equity.

Provided a minimum amount of new capital is raised at a future date, there is a discount to this raising, and a valuation cap, providing a safeguard for early investors.

Author: Jon Brett

Jon Brett is Non-Executive Director of Corporate Travel Management (CTM) and Chair of the Audit and Risk Committee. Jon is also a Non-Executive director of Raiz Invest (RZI), the NASDAQ  listed Mobilicom, and the Chair-elect of Infomedia (IFM).

Jon is the author of the very successful podcast series “The Taking of Vocus” which chronicles the extraordinary rise of Vocus, what went wrong with the M2 merger and concludes with the privatisation of Vocus. The podcast is accessible on his LinkedIn profile: https://www.linkedin.com/in/jon-brett-95734732/