Business evaluation (Dragon's den)

Factual Questions
1

I’ve watched some episodes of a series called Dragon’s den. Basically the premise is that people come to present their business ideas to a group of business people, and try to get them to invest in the ideas. I’m not all that familiar with economics myself, and something about the business evaluations in the series seems odd to me.

Someone might ask for 200k money for 20% of the company, and according to the series this puts the evaluation of the company at 1 million. Then the dragons might counter that they only think the company is worth 400k, so they offer 200k for 50%.

However doesn’t investing money into a company already increase it’s value? The money isn’t going to the pocket of the person they’re negotatiating with. It’s going to the company, that the dragons would own a part of.

If you have a company worth 400k, putting 200k more into it will make it 600k just from the money being on the company’s accounts, wouldn’t it? So you are getting 50% of a 600k company for 33% of it’s worth.

If the company is worth only 200k, then wouldn’t adding another 200k make it worth 400k? So if someone ask for a 200k investment for 50% of their company, shouldn’t that mean that they value their company at 200k and not 400k like the series would say?

2

I viewed it as the opposite. Anything is worth only what a purchaser will pay for it. So your 1,000,000 dollar company is really only worth 400,000 if somebody is willing to invest 200,000 for a 50% stake. You can always try to grow the company to have a net worth that’s higher, but what’s really going to matter is how much will you get for it if you sell.

A lot of times, the money isn’t the primary reason for asking those guys on Dragons Den. They also have a bunch of contacts and experience, so you get money AND expertise.

3

I see that people overvalue their companies, and the investors can also provide other services. That wasn’t my point however, but rather that the investor’s evaluation is different from what the investor says his evaluation is. Investing in a company isn’t the same thing as buying a part of the company, as you end up owning a part of your investment.

If someone tells me they want to invest 400k in my company for 100% of the ownership, I’d be mad to accept it. I would effectively get nothing, as I wouldn’t own any part of the company the investment went to anymore.

Let’s say everyone including the owner, potential investors, the Bank of England and the Pope all agree that the company in question is worth 400k now, and no one is disputing that. Why is it then the right deal to offer 200k for 50% of the company? I would understand if they were offering to buy half the company for that amount but they are not.

After the investment is signed, the investor now owns:
50% of a company that he agreed was worth 400k pre-investment
50% of the 200k he invested. The company owns the money and he owns 50% of the company, so he owns 50% of the money.

4

Imagine there was a magic box that periodically spits out money. How much would you pay to own this box? Well, it depends on how often and how reliably money comes out of it. Does the money output increase over time? If you stick some money in, by how much does the output increase?

Well, imagine this box was something called a “company”. It would behave somewhat differently than another magic box called a “checking account”.

5

It’s not the risk factor I’m talking about either, but the evaluation itself. If the business is risky, then your evaluation of the business’ worth is lower as well. If we agree that a company is worth a certain amount, the risk of it being unsuccesful is already calculated into that, isn’t it?

To push the box analogy a bit further, buying part or all of the box would be saying “I’ll give you some money, give me x% of the box”.

Investing in the box would the equivalent of saying "I’ll put some money on top of the box to make it a better box, but in exchange I want x% of the box and x% of everything that’s on top of the box.

If we agree that the box is worth a certain amount of money, why do I get to invest in it at the same rate as I would buy a part of it? If I told you I’d put 100 trillion dollars on top of the box if you give me 100% of the box and everything on top of it, that would be a really dumb deal to accept.

So we agree that the box is worth let’s say 10.000 dollars. I offer to buy half of it for 5000 dollars. My second offer is to put 5000 dollars on top of it, and own half of everything in the pile. There’s a huge difference between the two deals. In the first case the owner gets the money. In the second case the box or “the company” gets the money.

6

Simply put - the Dragon Den investors’ evaluation of the company is what the company would be worth AFTER that infusion of capital, based on their guess of how it would perform with the new money.

Presumably there’s more than just the dog-and-pony show, the applicants/contestants have a business plan that says “with $200,00 I can built this production facility and be churning out this much, which generates this much in sales and profit… etc.” The worth of the company is calculated from a guestimate of the medium term earnings and a standard PoE (if profits are pretty certain to be $100,000/yr and using a 20 PoE the company should be $2M.) Then the risk has to be accounted for. If it’s 50-50 that the company can make that profit, the value falls to $1M. etc.

The Dragons make this guesstimate baed on experience and gut feel for the marketplace for what’s being pitched. The contestants are looking for a free handout in return, rather than putting up their house for a loan and paying the bank interest. What share of their dream do they want to give away to make the whole thing happen?

7

You don’t really know the value of anything until you try and sell it.
What others are willing to pay for it is its value.

You can try and guess, of course. But it’s still just a guess which is why the dragons can have a much different opinion of a company’s value. Investing x amount of dollars in a company does not automatically increase it’s value by that amount.

If I gave you a million dollars for a pencil, is that pencil’s value now 1 million dollars?
I’d find out the answer when I went to sell it.

8

That makes a lot of sense. Thank you.

9

Nothing to add except the show has been ‘Yankified’ and is called Shark Tank over here.

10

I think what you’re missing is that companies have an internal value an an external value.

Internal value (literally, Shareholder Equity in accounting terms) is set by the actual assets of the company, less liabilities. In the case of most Dragon’s Den investments, that’s $0 (the company usually has no money at the beginning), plus whatever they get from investors. Thus, someone who pays $200k for 50% brings the internal value up to $200k. And they only own half of that. From an internal value standpoint, then, they have to double their money just to break even.

External value is set by the market price of the company stock. Since 50% of the stock just sold for $200k, it’s common practice to assume that this is a “market price” and that the other 50% is therefore also worth $200k You need to understand that this is just an approximation. Accountants want numbers that are verifiable and reliable. The $200k purchase of 50% is the only number that fits the bill.

Now… what about the $400k for 100% of the company idea? Well, the first thing to understand is that there’s a difference between authorizing new shares and selling existing shares. The owner coming into Dragon’s Den currently owns 100% of the company. Let’s say that is 10,000 shares. The owner is offering to issue new shares in exchange for money that will go into the company. If the offer is $200k for 50% ownership, then 10,000 new shares are issued and $200k is given to the company. If the deal was $200k for 90%, he’d issue 90,000 new shares. As long as the owner retains his 10,000 shares, he will always own some part of the company.

So, an investor on the show would have to buy some shares directly from the owner in order to acquire 100%. That purchase price would NOT go into the company - it would go to the owner of the shares. If we assume $400k is the price to own 100% of the company, that would be $200k paid to the corporation for 10,000 shares of new stock, plus $200k paid to the old owner for 10,000 shares of existing stock.

Finally… it’s also important to understand that Dragon’s Den is to real venture capital as People’s Court is to the real practice of law. They’re both just crude simulations of the real thing meant as entertainment. If Dragon’s Den was real, they’d be talking about convertible preferred stock, guaranteed cumulative dividends, debt covenants, stock dilution limitations, etc. Nobody but accountants would understand any of it.

11

Indeed. In fact a lot of the successful deals actually never happen once the dragon’s and their people get a real look at the numbers.

12

And both programs (Shark Tank and Dragons’ Den) were based on a Japanese program called Manê no Tora (Money Tigers).

13

You cannot add up ‘worth’ and ‘value’ the way you would add up apples or oranges. A company, like anything else, is ‘worth’ whatever someone is willing to pay for it. You may have an idea or a company that you think is ‘worth’ a huge amount, but if you search for buyers, and the best offer you get is $10, then its worth is precisely $10.

The contestants come to the Dragon’s Den with their guesstimate of the ‘worth’ of whatever they have dreamed up and its commercial potential. The Dragons are entitled to respond with their guesstimate, backed by their actual money. So that’s all that the two numbers are: two different guesstimates as to what the company or idea could be sold for on the open market at a later stage. You can’t add a $100k guess to another $100k guess and say that you have something worth $200k.

(As an aside… the idea that something is only worth what a buyer is willing to pay is usually presented as something that works against the seller. The typical scenario is that the seller thinks what he is selling is worth a lot, but if he can’t find a buyer willing to offer more than a dollar, well, tough cookies. It is worth mentioning that it can happen the other way around. Sometimes, the market offers more than the seller expected. This has happened to me a few times, usually in the context of selling original creative work and ideas. On a handful of occasions, I’ve had customers willing to pay quite large sums for consultancy, writing, creative contributions and so on that, quite frankly, I’d have been willing to provide for far less.)