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The Internet of Things – An end-to-end solution to disrupt the fashion industry

For the longest time now, fashion consulting has been specific to the wealthy and celebrities. I strongly believe that it is now time to bring personalized fashion design and consultation to the mass market at little or no cost. I have been entertaining an idea, a use case of the IoT for the fashion industry for over one year now. I believe the end-to-end ecosystem is now ready for the implementation of the solution, which could disrupt the fashion industry and globalize it even further.

It is well known to fashion consultants that if you have short neck, you should not wear polos or high round necklines, and if you have long neck, you may wear turtleneck or high collar jackets… and many more hints and tips. All fashion tips and hints are provided based on body proportions, and of course excellently-tailored when combined with the demographic (age, social status, profession, culture) and the personality of the person. So far, this luxury service of fashion consultation and tailored design has been available to the upper-class and elite. Well, not any longer with an end-to-end IOT solution.

Imagine entering a digital booth, equipped with sensors, in form of mirrors, sensor tapes, light, waves or other, where a digital profile of you (your exact 3D avatar twin) will be generated. Now imagine a world of fashion and clothing retailers where the fashion designers are sitting on the top layer, designing styles for different body proportions, and an algorithm that (based on entries from professional fashion designers) matches the best style across all clothing items (including the best underwear, corset, girdle, bra, or other, as well as the shoe, accessories and even the best color of lipstick or rouge) for the avatar of the customer, all in one shot, and within the price range that the customer selects. Also if the customer choses to share their age, profession and family income level (or even better, share their LinkedIn, Facebook or other social media profiles), the style would be more tailored to them, apt to their social status and personal taste. I bet that shopping for a bathing suits will be much easier and less arduous through this solution, especially for ladies with lots of curves in their bodies, and so many different swimsuit styles.

In this new world of fashion, competition and value creation will shift towards who has the best fashion advice for the shoppers. Cost saving will be huge for retailers, as people will not need to line up in front of the fitting rooms and less salespeople will be required in the stores. Returns, refunds and exchanges will decrease as items are better tailored to customers.

Globalization will be possible at much less cost and in much more efficient ways. No store will be required in the area. People will just shop using their avatars, and will receive the clothes that are recommended to them by top-level professional fashion consultants regardless of where on the planet they live.

On the other hand, fashion designers, clothing manufacturers and retailers will gather more and more information in their databases to gain much better understanding of their customers’ profiles, improve their designs, focus their marketing strategies more effectively, and cater to their customers’ needs in a more personalized fashion.

People in general will be much more fashionable and good looking, while they spend less time and money on their shopping. Imagine a working mom of two kids; the gift of time and fashion would be invaluable to her! Add to it the impartial advice from a professional fashion designer, instead of a retail salesperson thinking of their sales percentage more than anything else. Shoppers will trust the advice, brand and their manufacturer more, which will in turn add to the reputation of the brand.

Other excellent use cases will be shopping for families, friends and seniors. Their avatars will be generated once (may be once every two to three years), shared with friends and families (if they wish), and always available if people go shopping for them. This will be useful if you are visiting someone (parents, grandparents, children or friends) in a different city and would like to purchase clothes as gifts.

Another opportunity is offering the service in the Middle East, where people are rich but for cultural or religious reasons, women do not feel comfortable going out for shopping or changing frequently in fitting rooms, especially for undergarments.

This is not the end; 3D avatars can be uploaded for fitness and medical advice. Notification can be sent to the individual if their posture is changing over time, or is an indication of a health issue.  Another use case would be in dating, where people’s 3D avatars can be added in their profiles, of course upon their permission and authorization. You may think of dozens of other use cases for different industries, including modelling, sports, and much more.

Let’s go one step further and imagine how convenient the solution would become if the 3D avatar can be generated through an application on a gaming console, digital cameras, or a digital mirror hanging in your bedroom! People may get naked in the privacy of their living room instead of a booth in the shopping mall or a retail store, stand (or turn) in front of their gaming console (or use any other sensor) to generate their 3D avatar, upload it, choose what kind of cloths they are looking for, and wait for the best styles and size to be recommended for them. You might be able to even try the recommended items on in the magic mirror (before holograms become available to mass market) and check how they look on you before you purchase, or ask for alteration if you prefer shorter skirts!! Pair the mirror with 3D printers (already available for making clothes) and make your own clothes at home, based on the recommended designs of professional fashion experts!

In this new dreamland, all you will need to do is to stand in front of a mirror and say “mirror, mirror on the wall, make me the prettiest of all”, and then press a button….genies will take care of you in the blink of an eye.

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IoT Challenges – Part 2

Back to the earliest days of the internet, interoperability was paramount and at the core of the idea. I daresay that is the reason, Internet is now such an extremely powerful tool in connecting everybody, everywhere, thanks to the efforts of the IETF. Imagine how the world would look like if there were twenty different types of internet, each connected internally. Then to talk to all of them, users had to have at least one device of each version, hence twenty devices, or at best the same device but with twenty different protocols and may be an underlying interpreter to communicate with all of them. Same internet solutions could be developed by the twenty providers in twenty different versions! And users of a version were locked with the specific provider for all solutions and could not interoperate with the users of other providers! Now instead of people as users, imagine “things” as users of the internet. This is the interoperability problem with which we are facing for the Internet of Everything: Many providers, each with a different platform, and a fragmented environment of all manufacturers and developers. But how important it is, and where the interoperability, hence standardization should happen, should be studied further.

Issues of a fragmented IoT ecosystem are not limited to ineffective and inefficient implications, or users’ confusion as well as high costs, hence delay in the mass consumerization of the IoT solutions. In such environment with limited supervision on devices, applications and solutions, and no or little certification, the ecosystem is not necessarily secure. Currently the obligation is on the developers and manufacturers, which means that end users are not immune to malicious applications or simply ignorance of the developers. In addition, specific devices may just connect automatically to other devices, which is a threat by itself. Furthermore, the internal networks to which these devices are connected may not be well secured, which means that all devices on that network will be exposed to the risk if any element in the system is flawed or defected.

However, efforts to build interoperability will not be well-received by all parties and players despite the undeniable values. The main reason is, many parties are interested in building their own ecosystem to lock their users and prevent them from using their competitors’ solutions. So, the user will not only be locked in, but also should they chose to switch to another provider/manufacturer, their cost would be potentially high. Even worse, if any data is collected already, it could potentially be useless if the format of the data is proprietary and cannot be used by other parties. The magnitude of the effect will increase exponentially for the IOT solutions and data mining for industries, enterprises and governments, and consequences will be totally or partially burdened by the people and the end-receivers of those services and products. Imagine the historical health information of a patient being unavailable for further analysis and health services due to proprietary format of the data.

The interesting piece of information for providers and manufacturers is that unless if interoperability and interaction among solutions materializes, $4 trillion of annual economic value in 2025 will not be fulfilled. This is 40% of a total $11.1 trillion as stated in a 2015 report from McKinsey Institute. So, even though specific parties may benefit in the short run, but there is absolutely no winner in the long run.

Even the standardization of the IoT seems to be adding to the confusion. Different standardization organizations are developing specifications and guidelines for the IoT across different layers, which sometimes do not agree, and are even conflicting in cases.

But another question also needs to be answered: how important are standards? Are standards required across all different layers and for all four communication models?

In the first two parts of these series of articles, I covered a summary of why interoperability is important in general. In the next parts, I will add a review of the communication models, how important interoperability is for each communication model and why, as well as whether and to what extent standardization is required for each model and on different layers.

References:

https://www.internetsociety.org/sites/default/files/ISOC-IoT-Overview-20151221-en.pdf

http://www.mckinsey.com/business-functions/business-technology/our-insights/the-internet-of-things-the-value-of-digitizing-the-physical-world

http://www.greenpeak.com/Press/PressKit/2015GreenPeakWhitePaperIoT&CommStandards.pdf

http://internetofthingsagenda.techtarget.com/news/4500251013/Healthcare-IOT-standards-will-be-key-for-scalability

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What are cost objects and cost drivers, and how cost impacts pricing.

Cost may be defined as a resource foregone to accomplish an objective, which, for the purpose of this article may be redefined as dollars and cents spent to offer a service or build, manufacture and offer a product to the market. Cost is spent in hopes of return on investment, and therefore, the pricing of the service and product should be right to cover the cost and return profits. This is all much easier said than done.

Major Pricing Strategies

Before further discussion about costs and how they affect pricing, let’s just list the three major pricing strategies: 1) cost-based, 2) competition-based, and 3) value-based. In cost-based pricing, price is determined based on the incurred costs and required markup. In competition-based pricing, the price of the similar products determine the end-price, and in value-based pricing, the value of the service or product to the customer determines the end-price, regardless of the cost. Usually a combination of the three strategies would be required for the best estimate. For example, with all the free cloud storage and email services available through Yahoo and Google, no provider can ask for even a cent to offer email and cloud storage services to individuals, regardless of the cost to build the solution or their value to customer. Babysitting services on the other hand, may not cost at all to the babysitter, yet the babysitter will charge parents for his or her service. And, we know of many different instances when purchasing the same product at a specific store could cost much more than purchasing the same product from a store of a different brand or in a different neighborhood. Now, we may return to the initial topic and discuss how cost of a product should be determined, and how it would affect the pricing strategy.

Cost Object, Cost Pool, Cost Accumulation, Cost Assignment

Anything, including product, service, process, activity or other for which costs should be determined and measured is a cost object. Therefore, the first step to determine the cost is to identify the cost object.

Costs may be direct or indirect. Direct costs can be easily traced to the object. For example in a furniture manufacturing plant, labor cost for the hours spent on a specific piece of furniture as well as cost of wood to make the furniture set are direct costs. However the glue or the coating which may be used for more than one piece of furniture cannot be traced to any one piece of furniture. Costs incurred for the resources that have been shared among diverse cost objects are indirect costs. Indirect costs cannot be easily traced and need to be accumulated and allocated. Other examples of such costs are machinery depreciation for equipment in the manufacturing plant, used for making the furniture set, the lease of the manufacturing plant, or the salary of a supervisor.

Therefore cost object should be identified, costs for the object should be accumulated, direct costs should be traced to the specific job, while indirect costs will be allocated, and both allocated and traced costs will be then assigned to the object. Cost assignment is the process of determining and linking the right amount of the accumulated costs in the cost pool to a distinct cost object. The measure of the benefit for the cost objects that used the shared resources of the indirect cost is the cost allocation base. For example the lease for a plant which is used to manufacture three different lines of furniture may be allocated based on the space of the plant required for each different production line. The cost allocation base in this case would be square meter or required space.

This should be noted that an indirect cost to a specific cost object may be a direct cost to another cost object. This is why being clear on the cost object is critical. It is equally important to differentiate between significant and insignificant indirect costs. Insignificant indirect costs do not need to be allocated and can be easily added to a pool and considered in the end price of all products.

Expert management accountants help the organization understand and select the right costing system to determine its pricing strategy, marketing strategy as well as profitability of different products and make decisions regarding the optimized production volume and even discontinuing a specific non-profitable product.

Fixed Cost, Variable Cost, Cost per Unit

Variable cost changes proportionate to the change in the output within a relevant range. For example in a furniture manufacturing plant, the amount of wood required is directly linked to the volume of output furniture. So, cost of wood would be variable, and the cost per unit will remain unchanged, but as more units are manufactured cost increases. It should be noted that often if larger volume of material is purchased, a volume discount is applicable. This means that the variable cost (per unit) may change if the volume exceeds a specific amount.

Fixed costs, however, do not change as the production volume changes. Cost per unit will change and will decrease as the volume production increases. The best example for fixed costs would be the lease for the manufacturing plant. At $1,000 monthly lease, cost per unit will be $10 if 100 pieces of furniture are manufactured, but will be $100 if only 10 pieces of furniture is produced. Again, the notion of relevant range applies. For example one plant would have the capacity for producing 200 pieces of furniture, but to manufacture piece 201, a second plant is required.

In general costs could be in four different categories: direct/variable, direct/fixed, indirect/variable or indirect/fixed.

Some costs could be semi-variable or semi-fixed, or mixed. The best example would be cellphone plans. Consider cellphone plan as the cost object. Cost to those plans are mixed. For 5 GB of data, the cost is fixed and at $20. But if usage exceeds 5 GB, cost will be variable, and subscriber pays (for example) 1 cent per KB.

Cost of furniture is also mixed and comprises from fixed and variable components; Wood is a variable direct cost, and plant lease is indirect fixed cost.

This explains why for a Software as a Service or Computer games profits will materialize as volume increases. Variable costs are much lower compared to the fixed costs, and as the number of users increases then cost per unit will decrease accordingly.

Breakeven point (BEP) will be reached when enough volume has been sold to cover all fixed costs. After reaching the breakeven point, manufacturer turns profits. For example if direct cost per unit of furniture is $10 and plant is leased at $1000, if every piece of furniture is priced at $20, then manufacturer needs to sell  100 pieces to reach at the breakeven point. Selling the 101st piece will turn $10 of profit. If only 99 pieces are sold, manufacturer will incur a loss of $10.  

Cost Drivers

If cost is a function of a unit of activity or volume, then that activity or volume is the cost driver. This means that a change in the unit of that activity or volume, changes the cost. In the furniture manufacturing plant, cost drivers were the solid wood, where square feet is the cost driver, as well as plant lease, for which space is the cost driver. Now, if you have a tax accountant, for example, the cost driver might be his or her different activities; i.e. $50 for personal tax files, and $500 for business tax files, for example. For a real estate agent, however, the cost driver would be the price of the real estate sold, as their commission is in percentage of the total transaction price.

Summary:

For the best pricing and product strategy, cost objects, costs and their nature and cost drivers should be carefully and clearly identified. Without a close study on the incurred costs, decisions regarding priorities, products, services, resources and customer care will be far from sound, and may cause detrimental issues to the survival of the business.

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Happy IoT Day

To celebrate the global day of IoT on April 9th, I would like to list some of the IoT products and solutions of the top ten high tech companies worldwide. The top ten companies are selected based on this article from Forbes magazine.

  • Apple: Connected homes (Homekit), Wearables (SmartWatch), Automotive (Titan)
  • Hewlett Packard: Platform (HPE IoT Platform), Energy Management Solution (HPE Energy Management Pack)
  • IBM: Cognitive Platform (Watson IoT)
  • Amazon: Platform (AWS IoT)
  • Microsoft: Platform (Azure IoT)
  • Google: Platform (Google Cloud Platform), OS Platform (Brillo), Communications platform (Weave), Connected homes (Nest), Wearable (Google Glasses), Automotive (Connected Driverless Cars),
  • Intel: Platform (Intel IOT Platform), Automotive, Energy, Health Care, Industrial, Homes, Buildings, Retail
  • Cisco: Security (Cisco IoT system security), Manufacturing (Cisco Connected Factory, Cisco Connected Machines), Smart Cities (Government Services, City WiFi, Connected Parking and Traffic), Utility (Connected Utilities), Oil and Gas, Transportation (Cisco Connected Transportation Solution), Mining Solutions
  • Oracle: Cloud (Oracle IoT Cloud Services)
  • Qualcomm: Health Information Platform (2net), Smart Media Platform (AllPlay), Development Platform, IoT Connection Manager

For me, personally, this list is a clear indication of three major characteristics of the IoT:

1) All high tech companies are excited about the IoT.

2) The environment is highly fragmented.

3) The end-to-end ecosystem is complicated and not yet clearly defined.

And of course this is an evidence of the fact that, possibilities are endless, and this is just the beginning.

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Small and Medium Businesses in Canada – Gap and Opportunity

As statistics show, from 2002 to 2011 small businesses generated a GDP of 25~30% per year in Canada. In 2008 for example, 46.3% of the total GDP in retail was generated by small businesses of less than 100 employees. This number is 61.5% for accommodation and food services. [i] More importantly, Small businesses provide employment to almost half of the population in Canada. Also statistics from the government of Canada reveal that:

  • 42% of SMBs introduced one or more type of innovation between 2012 and 2014.
    • 26% introduced a product innovation,
    • 20% had innovations in marketing,
    • 19% offered organizational innovation, and
    • Finally, 18% offered process innovation.[ii]

 

All these facts and numbers show that SMBs’ role in the everyday lives of Canadians, our industry, our economy and the future of the country cannot be overlooked.

In a report, CIBC focuses on the economical environment of small and medium businesses in Canada and counts their barriers to grow and compete. As this report claims, small businesses are more likely to survive and flourish if their model requires lower fixed assets and capital requirements, focuses on specialized products or services, leverages specific set of skills, or benefits from new technology to make economies of scale less relevant. The same report emphasizes that “to varying degrees, most small businesses face the following weaknesses: Unsound or insufficient analysis in choosing an initial field of business, Poor management skills, Lack of economies of scale, and Inadequate capitalization”[iii]

Interestingly but not surprisingly the above-mentioned four weaknesses are interlinked and can cause a vicious cycle. Lack of sound management skills may hinder the small business from taking advantage of new technologies to gain access to economies of scale and reduce capital requirements, and leverage the required skills to benefit from the emerging and specialized needs and trends in the market.

Solid business models that utilize and leverage the technological advancements and offer end-to-end Internet of Things solutions to empower micro businesses and SMBs, and enable them to compete on fair grounds would be very helpful. Such solutions could also help with further analysis of the market and customers’ behaviours and patterns of purchasing in local stores. This is extremely important for the small businesses especially due to the fact that according to another report published by the government of Canada the major part of small businesses’ sales is within their local neighbourhood. [iv]

Rewarding the end-consumers of the micro-businesses and empowering the SMBs through building a strong network of them with focus on local retailers will help them gain access to economies of scale, decrease their cost of marketing and increase customer loyalty. As data accumulates the marketing insight will be of high value to those businesses, and in general.

 

References: 

[i] https://www.ic.gc.ca/eic/site/061.nsf/eng/02812.html

[ii] https://www.ic.gc.ca/eic/site/061.nsf/eng/02998.html

[iii] https://www.cibc.com/ca/pdf/small-business/tal-canadian-small-business-economic-landscape-en.pdf

[iv] http://www.ic.gc.ca/eic/site/061.nsf/eng/02998.html

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IoT – Challenges (Part 1)

Interoperability is an extremely serious issue. Objects are manufactured by many vendors, and support different operating systems of different versions. So the peril is that the users will be limited to connect specific devices of specific manufacturers together, and control different groups of devices via different applications and tools that fail to be universal. Therefore confusion and costs will be high, while the value will be limited. In fact, fragmentation and lack of interoperability defies the very definition of “The Internet of Everything“, or the “Connected Objects”. Unfortunately, more often than none, standards and guidelines are late to the game in such highly fast paced environments. In fact, some standards and guidelines have been introduced by the Internet Society, Internet Architecture Board, and GSMA (see previous posts), but only in 2015, after many IoT solutions were already in the market. Nonetheless, interoperability is still one of the biggest challenges to the mass-consumerization of the IoT. Furthermore, standards and guidelines are often developed and driven by the big players of the industry who usually define the market. Therefore the usual suspects will be giants of technology including Google, Apple and Microsoft, as well as (to some extent) telecom companies and device manufacturers, especially Samsung and LG, especially because of their share in home appliances. Standardization however is contradictory to proprietary walled operating systems and devices and poses a threat to the “differentiation” factors of the major players of the market. This is similar to a crowd talking about some valuable information on the same subject, but each person understands the language of a small groups. Now the point is, if there is someone in the crowd who understands all these languages, he can exploit all the advantages, and, all of a sudden the fragmented pieces of the puzzle will make a big picture. This interpreter will be priceless to the crowd.

Now this should be noted that the challenge of interoperability is not the same for different communication models. This is best outlined in guidelines and documents of Internet Architecture Board and the Internet Society. A summary will be offered in future posts.

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Internet of Things – As I would define

After months of research about my favorite topic, The Internet of Things, I would personally define it as:

A group of objects that have been enabled to generate data, share data and use data with little or no human intervention for the purpose of creating value for a group of individuals, communities or businesses.

The role of the human intelligence becomes valuable in capturing the right and most meaningful data, and conducting the right analysis and process to maximize the value, benefits and effectiveness of any single connection and piece of data.

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Startups Valuation: Techniques and Stakeholders’ Perspectives (Part 2 of 2)

  1. Earnings-based valuation

Definition

In this method, the price of the company is assessed as the economic value that the entity generates, regardless of the amount of its assets.

With this technique, the earnings will be multiplied by industry’s average price to earnings ratio to estimate the total value of the company. Industry average price to earnings ratio shows the price that investors are willing to pay in average for shares relative to the income that is generated by companies in that industry. Therefore, multiplying company’s earnings by this average ratio could be an acceptable method to evaluate the business.

Stakeholders’ Perspective

  1. Investors are willing to receive specific amount of return on their investment over time. So, investors may use this method to know how much the value of the company will be, compare it against their required return on investment, and determine their ownership percentage for their investment.

Illustration:

If earnings are projected to be $10,000 in year 5 and price to earnings multiple is 10, the company is worth $100,000 in 5 years. An investor who is investing $20,000 today and expects10% over the period of 5 years will therefore require [20,000*(1+10%) ^5] or $32,210.20 in the end of year 5. Investors will then need to invest by 20,000 for 32% of the business.

Concerns and Ambiguities

Three questions need to be answered:

  1. a) Earnings of which duration should be used (past or future, or both)? With current management, or under a new management / strategic direction?
  2. b) How to determine the effect of accounting practices and assumptions on the earnings?
  3. c) Which earning (before or after) taxes and interests to be used.

Similar to asset-based evaluation, there is no definite answer to any of the abovementioned questions.

As first step, historical earnings may be used. There will, however, be three matters to consider. First) it should be noted that past performances may not be a truthful indication of future returns (or losses). Nonetheless, past earnings can be used as a guideline and data point. To use future earnings, income and expenses need to be examined, their trends (year over year or percentage of income) may be determined, and projected to calculate the future earnings. Second) accounting practices may affect earnings to a great extent, especially for private companies that may not follow financial reporting standards and disclosures mandatory for public entities.  Third) the impact of one-time or non-recurring accounting events (such as losses of operation as a result of an earthquake or fire, or costs of reorganization or lawsuit settlement) should be determined and isolated.  And finally) either EBIT (earnings before interest and taxes) or final net earnings can be used for calculation. But it should be noted that the right multiplier is to be used. If valuation will be based on EBIT, then the price to EBIT multiplier should be used to determine the price, and if valuation is based on earnings, then price to earnings multiplier should be the benchmark. However, to study the earnings before financing costs (interests of loans), EBIT would be preferred to investors. It is because they can isolate the earnings, as an indicator of how business performs, from effects of financing (interest) and taxation.

Notes:

Earnings-based evaluation would be more appropriate than asset-based evaluation for high-tech or IT companies with substantial intangible assets and products. However, considering that accounting practices and assumptions may have significant impact on the amount of historical earnings, this method should be used with extra care and expertise. In addition, past trends may not continue in the future, especially in a turnaround scenario, when investors plan to change the management team and company’s strategic direction.

3- Cash Flow-based valuation

Definition

In this method, valuation is based on the net present value of future cash flow regardless of company’s earnings or assets.  Cash-based appraisal would be more preferred than earning-based assessment, especially in turnaround cases when investors plan to change the strategic direction and the management team. In addition, cash flow is less prone to wild swings due to changes in accounting practices.

Stakeholders’ Perspective

  1. Similar to earnings-based approach, in this method investors can determine the ownership percentage for their investment by deciding their desired return on investment and benchmarking it against the net present value of forecasted cash flow to reach at their ownership percentage.
  2. This method is especially useful to the entrepreneurs. Regardless of the earnings, they can calculate the projected (direct and indirect) cash flow. Cash flows include
  3. I) Reduction in cash outflow: business-related expenses are tax-free, and would have been taxed otherwise. Therefore, reduced amount of tax, will have an upward impact on the amount of cash to the entrepreneur. (Details of tax benefits to entrepreneurs is out of the scope of this article).
  4. II) Increase in cash inflow: entrepreneurs may collect salary and/or dividends.

III) Capital gain/ Return of capital: which will materialize in an IPO exit, or else when the business is acquired.

Founders will then be able to manage their expectations on how much salary and/or dividend they would like to collect in the end. Like investors, founders may determine how much return they would be willing to have on their investment, which includes their time as well as money.

Illustration:

Mrs. E decides to start a business with prospects to sell it at the end of year 5.

She can now expense her car lease, fuel, and a part of her mortgage and hydro bills on her business, because she has a home office and uses her car for marketing and meetings. Business-related expenses amount to $10,000, and tax on those expenses amounts to $2,500 (assuming 25% of tax), which she shouldn’t pay because they are now expensed on her business. Now she has $2,500 more in her pocket.

IF she expects to receive salaries, she will need to generate earnings through either financing her business (bank loan or investors), through operations (providing services or products), or through investment (purchasing a real estate, land or other assets). Salaries will increase her cash inflow.

In the end of year 5, she may generate income through selling her business, or an IPO exit. This will also increase her cash inflow.

Mrs. E may calculate the net present value of the cash flows to decide how many hours she is willing to spend on the new business, and whether she is willing to invest in the business. But the most important decision would be, whether she is willing to start the business, or prefers to remain employed. Also, if she plans to start the business, what strategic direction she should take to be able to sell the business in the end of year 5.

 

Please note that the above-mentioned example is extremely simplified is merely for further clarification of the three streams of cash flow, and how an entrepreneur may use this approach to assess his risk tolerance. Further details are out of the scope of this article.

Conclusion:

Evaluating a business is not a simple task. Information is not readily available, many assumptions are made, and different perspectives and methods may be used to make an educated guess. However, even the best estimates based on all available information and reasonable assumptions is not reliable enough in many cases.

However, a clear understanding of different techniques, what each means, how the calculations are conducted, and how different stakeholders should use each number as a guideline would definitely help entrepreneurs to a great extent.

Entrepreneurs who understand prospect buyers and investors’ perspectives, will have a more realistic view of the value of their company and will be better prepared to negotiate for a deal that is fair to them and of value to the investors or new partners. In addition, with this knowledge, founders will be able to evaluate the financial returns of their startup and therefore manage their expectations and devise a more efficient and effective operation and strategic plan.

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Startups Valuation: Techniques and Stakeholders’ Perspectives (Part 1 of 2)

Introduction:

Valuation is  important to startups for many reasons and in all stages of their life-cycle, including and most importantly when investors or individuals become interested in partnership with the venture, or when ventures are ready for IPO exit, or otherwise for being acquired.

Valuation is more an art than science due to many different factors involved. In this article, the focus is on the fundamentals and the three main approaches to valuation in very simple terms. Details and secrets of valuation merits many pages, case studies, articles and books.

The ultimate purpose of valuation is to determine the value (price) of a business, regardless of the size, industry, or the age of that business. This is not a challenge for public companies; they can be easily valued by multiplying their stock price by the number of stocks. (Details and why their real value, especially for merger and acquisition scenarios might be different is out of the scope of this article). Assessment will be more complicated and very uncertain for private ventures, for many reasons. Startups are young entities -mainly 3 to 5 years- and their aim is to test a new business model, . Therefore,

    • Startups do not have a long history of revenue, expenses and net earnings as a solid indicator based on which their future economic values can be estimated.
    • Their risk is unknown because they are testing a new business model; new products may or may not be the right fit to the target market.
    • There is no knowledge of their fair market value, because there is usually a handful of owners, hence no high volume transaction activity in a public stock exchange. It is very difficult to know what their stock price would be due to the absence of demand and offer information.

Valuation Techniques:

Current valuation techniques are:

  • Asset based
  • Earning based, [and comparison against the industry (multiple-based)]
  • Cash flow based

 

  1. Asset-based valuation:

Definition

In this method, the value of the company is measured by its net assets value.

Stakeholders’ Perspectives

  1. Investors or creditors will have some leverage for the money they invest or lend. Investors could be exposed to no risk if the market value of assets equals the price of the company minus its liabilities.
  2. Founder(s) will not sell the company for anything less than the liquidation value of its assets.

Illustration:

For a business with $150 worth of assets and $50 of liability, investors will be exposed to NO downward risk if they buy the company for $100.

Concerns and Ambiguities

The two following  questions should be answered:

  1. How can one accurately value the intangible assets such as intellectual property or patents?
  2. Which value (book value, market value, liquidation value or replacement value) would be of mutual consent and fair to both investors and founders for the most truthful assessment of the company?

For example, for a manufacturing business with equipment, plant and land, the fair market value of land could be higher than its book value (initial purchase price) due to appreciation in the price of land, while the market value of plant and equipment could be much less than the book value because of depreciation. Now replacement value would be of interest to the investor, because if they purchase plant and equipment ‘as is’, they will not have to replace them and pay high prices for the new equipment or building a plant.

Notes

This is the main reason why banks or investors would be reluctant to lend to high tech, software or IT companies whose major products and assets are intangible with no inventory or little or no tangible assets to leverage.

Therefore, asset-based valuation could be more apt in manufacturing, real estate, retail or even finance industries, whose assets are mostly tangible.

 

(The other two methods are explained in part 2 of this article.)