Last week, as we kicked off our new series in which we imagine ourselves getting on Shark Tank, we considered the valuation of our companies—how to determine what our equity is worth. We saw that the total amount of revenue generated by a creative practice has little bearing on the value of its equity. Unless there are retained earnings—money left over after we pay our expenses and ourselves—we’re not building value into total equity. We’re just sustaining a break-even business. We can do this for decades, and at a massive scale, yet never build up equity.
This week we’ll consider how equity can be built—and it’s not from revenues, but rather the profit margins of our revenues. This is why, in the Tank, after a founder gives their practiced and dramatic presentation, and after they spell out the details of their business, one of the Sharks will inevitably ask about their sales—how much revenue is this company generating? And if their revenues don’t bear some relationship to the valuation they seek, they’ll most certainly walk out of the Tank without a deal.
Revenues Without Profit Margins
On a recent episode, when a founder was asked the sales and revenue question—they boasted that they had $3,000,000 in total sales. What’s even more impressive is that she had done it with an initial investment of only $300. This got the Sharks very excited!
But that didn’t tell the whole story. When pressed further, it turned out that she had needed to continually reinvest almost all of that money back into the business to keep up with inventory. Of that three million, she only was able to keep 5%. That sucked the air out of the room.
A five percent profit margin is abysmal. Remember that when an investor gives a startup money, it’s always in exchange for a percentage of equity. So, for example, if one of the Sharks gave this business $200,000 in exchange for 10%, that would entitle them to 10% of the 5% profit. In this case, 10% of $150,000, or $15,000. No investor in the world is going to invest $200,000 in exchange for $15,000 a year in profit distribution.
Another way that Sharks try to ascertain the value of a company’s equity, particularly for product-based companies, is to ask about production costs. They want to know the “landed” cost for a product—which includes manufacturing, packaging, and any shipping costs involved. This cost is then compared to the sale price, and the difference is the profit margin. Anytime these margins are less than 50% Sharks lose interest.
What Are Your Margins?
So how does this translate for creatives? What are your retained earnings from all your work? What are the margins of your “product?”
The production costs for products are objective and easily calculated. It’s a lot harder for creatives to calculate their costs and margins. But there are a few ways to do it.
First of all, if you use an actual accounting system to run your books, like Quickbooks or Xero, you can always run a balance sheet report and look at your “total equity” line item. That line item keeps track of all your retained earnings, year after year, and reflects what your actual equity is worth. Theoretically, if you were to sell your company, that number would provide the most objective basis for a price. If you want more information about reading a balance sheet check out my article, Is Your Balance Sheet Making You Dizzy?.
Another way to get a handle on your margins would be to simply add up all your expenses, including your own compensation, and subtract that from your total annual revenue. This gives you a simple view of your actual profit, but there are some significant potential distortions when calculating it that way, which we’ll cover later in this series.
Cash Flow Patterns
Lastly, you can get a feel for your profit margin, though not very precisely, by simply watching your cash flow. If you regularly struggle to maintain positive cash flow, if you’re often feeling pressured to sign a new contract in order to get that 50% deposit because you have bills to pay—that is a clear signal that your profit margin is pretty close to zero, and might even be negative.
Investors have no interest in buying equity in companies with thin margins and low retained earnings. And since you are your own investor—investing your tireless efforts—you should make sure that you’re going to get a good return on that investment.
For a little more detail on measuring your margins watch this video on the liabilities of the creative service business model.