“My business is worth $250,000 because that’s how much I have put into it over the years.”
I hear that all the time. If you’ve ever watched Shark Tank, you’ve seen it too. Entrepreneurs who value their business by the amount of time and money they’ve put into it, independent of its value in the market or the value of its products as determined by supply and demand economics.
Classical economists like Adam Smith defined the cost of a good or service in terms of the labor the purchaser must use to buy it. In other words, if you want to buy a pair for jeans for $100 and are paid $10 an hour, that pair of jeans costs you 10 hours of labor.
This way of thinking about pricing is very effective as a consumer because it puts prices in perspective. Often it discourages me from buying things I don’t need. When buying something, especially a luxury item, I stop and ask myself, is that worth all the hours of work I’ll need to put in to pay for it?
Are those jeans worth 10 hours of work to me? Often when put in those terms, the answer is no. Imagine how you’re shopping habits would change if prices were listed as hours you have to work instead of dollars?
When referring to valuation, Warren Buffett said,
“Price is what you pay. Value is what you get.”
In other words, price and value aren’t the same thing. This is why we’re often annoyed when we feel we overpaid for something. If you stay in a hotel that costs $299 per night and it has roaches, fleas and terrible service, you’ll probably feel you didn’t get the value you paid for. If price and value were the same, this would never happen.
Karl Marx Was Wrong
Karl Marx later turn that thought about pricing on its head by separating price and value in his book “Capital,” published in 1867. He said the value of something is the sum of all the social labor required to produce it, rather than the labor required to buy it.
Therefore, if you and your team put in $250,000 worth of labor into your product or company, then it should be worth $250,000 (This includes any labor needed to provide real capital to fund the production.) Even if there is no demand for the product. Even if the company fails. It’s still worth $250,000, according to Marx.
His theory is disconnected from the modern theory or classical economics that price is determined by the intersection of supply and demand. He implied that running a business and creating value is solely dependent on the effort. If that were true, then marketing and selling a product would be easy. Just put in a lot of time and effort to increase the value and you’re guaranteed success.
Marxism in the market
As ridiculous as it sounds, that idea is very rampant among entrepreneurs, even if they don’t realize it’s a Marxist idea. Like Marxism, it sounds good in theory, but doesn’t stand up to scrutiny in the marketplace. No one is going to pay a price for anything just because you say that’s what it’s worth (except maybe in the crazy world of modern art where prices have no relation to talent).
The market decides
When thinking about the value of your business, product or service, keep in mind the principles of classical economics of supply and demand and remember it’s the market that decides what anything is worth. The market may be buyers, customers and investors. Your new product hasn’t been truly tested and valued until you put it out into the world to see if anyone will buy it. Your company has no true value until you have a serious offer from an investor.
In a recent M&A seminar I attended given by an international investment bank, the banker discussed privately held company valuations. The room was full of business owners looking to sell their businesses. He said, “I know you all want to know what your business is worth. You’re going to ask me 10 different ways what multiple of earnings you can expect when you sell your business. I can’t tell you that. I can use several common methods of valuation, but they’ll all be wrong because the market will ultimately decide what your business is worth.”
Why companies buy other companies
He continued to explain that companies buy or invest in other companies for reasons other than financials and cash flow, such as market fit or to buy a technology so their competitors can’t have it. A European company may buy an American company as a way to get into a new market instantly and leapfrog over the years it may take to start new in the U.S. market.
This is why large tech companies are continually buying small companies, often some with no revenue. They want the technology and/or the employees that come with the company. This is sometimes known as an “acqui-hire” because they’re buying the company to get the highly qualified employees.
How you can provide value
The value of anything is determined by many factors: technology, timing, geographic markets, competition, etc., but it all comes down to supply and demand.
Build something people want and you’ll be rewarded for it, no matter how many hours and how much money you put into building it. Work nights and weekends for years or build something in a weekend. The market doesn’t care about your work ethic. The market wants a product that solves a problem and will place a fair value on a helpful solution.