Ready for success?

For entrepreneurs used to being asked if they had a Plan B in case their venture failed, Aswath Damodaran’s approach will stump them. This Professor of Finance at the Stern School of Business, New York University, throws a different question at MBA students who seek his advice before starting their own venture.

What will you do if your venture is successful, he asks them, surprising the students, who may feel that the answer is all too obvious.

Isn’t it good that the venture does well, the students respond. Aswath’s reply to them is — it is both good and bad. When people notice that a venture is doing well, they are going to try and do the same thing. “What I am trying to figure out from them is what have you put in place, if you are successful, to keep the onslaught of competition away. To me, that is what separates successful businesses from unsuccessful businesses,” says Aswath.

Successful businesses, Aswath told mediapersons in Chennai during a recent interaction organised by TVS Capital Funds, start thinking about what they would do if they were successful, rather than wait until they were successful. It may be too late if they plan to get legal protection against competition only after they are successful.

His job with entrepreneurs, says Aswath, is to expose them to the fact that they cannot be successful just because they have a big market. “Tell me what else you have in place to be unique in this market.” From a valuation perspective, that shows up as they have to obey the first rule of economics — demand and supply. There are a number of players catering to that market and if an entrepreneur wants a big share, he or she has to cut prices. Do they have the pieces in place to succeed, is what he would like the entrepreneurs to start thinking about.

He prefers to talk to the entrepreneurs about the parameters of valuing their business, rather than telling them what the value actually is. The entrepreneurs then have to work out how they are going to balance the different elements to deliver the highest value.

According to Aswath, the nature of valuation is such that things change all the time. Balancing out the valuation expectations of an entrepreneur with those of a venture capitalist or private equity player calls for reality checks. “When I run into an entrepreneur who has unrealistic expectations about his business, usually because he feels he is catering to a big market, he says he can make a lot of money. The question I ask, is ‘are you the only one that sees this big market. Don’t you think there are other people looking at the same thing at the same time?’”

Likewise with the investors who talk about the great returns they have made on their investment. Aswath says he asks these investors not about their returns, but about what they have done differently. “You can make money for lots of different reasons. The biggest reason you make money is you got lucky. You were in the right place at the right time. It is very difficult to separate luck from skill in this business. I want to see how they have thought through the investment process,” says Aswath.

How you value any business remains the same, he says. It is all about cash flows, risk and growth. “Those three dimensions don’t change.” With start-ups it is an estimation challenge; it is much more difficult to estimate the cash flows because there is nothing much to go on.

He would also like entrepreneurs, with glowing dreams about the future, to think where they are going to get their revenue from. If they are winners, who are the losers? That forces them to think not just about their competition, but how they are going to compete, whether they will cut prices and the like. That is something that has to be got into the process, says Aswath, who teaches corporate finance and valuation, and who has authored four books on equity valuation.

Valuing a start-up involves making estimates about the future. The only way an investor in a start-up can deal with this uncertainty is by charging a higher return than he would get had he invested in a mature company. What about investment bubbles? Aswath says bubbles are like playing musical chair. When the music stops, only one investor is going to get on to the chair and a whole lot of others will get left out. The music is going on right now for social media companies. When the music stops, the question is are you near a chair. “Everybody is making a lot of money (on social media companies). They are having a lot of fun, but the music will stop. I invest based on cash flows. I am not investing based on mood and momentum. But 90 per cent of investors invest based on mood and momentum,” says Aswath.

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