Dynamic Return on Equity is a crucial ratio for investors. If I put in a dollar into a business as an equity investor, what do I get back out? Ideally, a dollar in yields more than a dollar of value. But what is value? And how do you know?
From a theoretical point of view, the answer is simple: money! Put in one dollar, get two out. That's a good deal, right? 100% gain. But what if those two dollars are coming out in five years? Then it's a dollar in and two out in five years. So you lose the use of the money for five years. That's still a good deal - a 5-year 15% internal rate of return. But there is an opportunity cost of not putting it into some other investment. If I could put it in a risk-free treasury bond for that period at a 1% yield, we would say the return is a 14% premium.
But this being equity, we should look at risk as well. What is the probability the money comes out? This variance in return on equity is where numbers get harder. If you put a dollar in, and you probably get two out in five years, but maybe it's nothing, then the present value of that investment is just half. The risk that something will go sideways is what juices the returns. I can get the 15% annual return vs. the 1% annual return in the example above because of the risk premium. Risk Premium is the amount the market is paying me for the chance that I won't see my invested dollar ever again.
So one looks at what the return is, discounted for both time and risk. Whence does the return come?
One could look at the return from the point of view of cash out of the company. The company does business, makes profits, and those profits distribute to the shareholders. If there are 100 shares in a company, and you own 10, you claim 10% of the profits. Hooray! In reality, the number of shares in both the numerator and denominator of the above fraction is much higher because of some technical concerns, but the ratio math holds just fine.
So if the company does ten dollars in revenue and makes $2 in profit, you would be entitled to 20 cents. But that's happening each year. How do I value the 20 cents per year coming out of the company?
One way to do that is the dividend discount model. We ask, what's the profit, and what's the cost of money in the future? So if we think the company might last ten years, we can say, well, that means a 90% chance it's alive next year. And then, next year, we can say it's still alive! It's probably alive for another ten years, so let's say the chance of being alive next year is 90%. Except in that second year, the odds are actually (90% * 90%) 81%. And so on. The general form of this is Profit per year/discount rate. Profit per year is two dollars for the company.
The discount rate is three elements added together:
- the risk of the company going under next year (we're calling it the inverse of ten years, or 10%)
- plus the risk-free rate of return (the 1% we discussed above - often trivial in these low-rates times)
- minus the expected growth of the company per year over the long term. (This is a weird one, so let's leave it aside for the moment)
So one can look at the value of that $.20 per year as $.20 / (10% + 1%) = $1.82 in equity value.
These are all known metrics and tools for investing money in established companies. But I and I suspect many of you are looking at investing our time into startup efforts. How do we evaluate that return?
First, let's look at how we convert time to money to figure out our investment inputs. I like to use the Slicing Pie framework for thinking about founder economics. In this, author Mike Moyer suggests two rules for thinking about time investment. First, we price time at 2x market salary. That means if you can command 150k in the market, your direct hourly rate would be 150k / 2000 working hours per year = $75/hour. Double that is $150. So investing an hour in your company would be $150. Investing a working day would be 8 x 150 = $1,200. Investing a working week would be 40 x 150 = $6,000. And so on.
Second, we band the market salary for a founder between $100k and $150k. The theory is that in a startup, there is no job for which you would pay more than $150k in cash, so even if you are a super-valuable $500k/year consultant, your contributions are priced as they would be if you hired for the job. And if you have the skills to be a founder, you can probably command six figures in the market. Using the math above, that bands the value of your contribution at $100-$150 per hour. Let's calculate the time cost of working on the weekend. Five hours on a Saturday you are not spending with your children add up to 5 x 150 = $750. What is your return on that?
For this, we should look at the impact of adding MRR to a company. The goal is to build a SaaS with automatic customers to generate recurring revenue. On the assumption that after onboarding, the MRR (monthly recurring revenue) is almost pure profit. (This assumption is far from certain, but that's a topic for another day.) The market will value your company based on MRR on an increasing multiple with scale. So a micro-company with under a hundred thousand in top line might be able to command 1x ARR in an asset sale. A mini-company with half a million in top-line might get 5x in an asset sale. A larger company with a few million might get 12x. Even larger would be 18x. These numbers shift, but the going rates are findable through a bit of googling.
These multiples are like the "10-year" number in the math above - they rate how stable one believes the future revenues to be and what tools are available to realize those returns. For example, at the high end, one can borrow against the cash flows for a "highly leveraged transaction." The company is more valuable to an acquirer who can use more debt than equity to purchase. There is more demand for such a transaction by private equity buyers, which increases the price it can fetch in the market.
What does this mean for time investment? Adding marginal MRR through your time spent in sales and onboarding will drive more equity in the business. So let's say you put in an unpaid hour (valued at $150) to get one more $19/month customer. Good deal or bad deal? Let's pretend this is a very early customer. First, congratulations on the customer! Second, let's ask what the return is.
The annual value of that customer is $19 x 12 = $228. That $228 is assumed to be all profit after your time investment. We multiply that $228 by the multiplier above to figure out its contribution to market equity. An early customer means we have a small base of revenue. The additional equity value of that revenue is 1x 228 = 228. You spent 150 of your time and now have 228 more in equity wealth in your company.
Hooray - if you are a solo founder. If you have an equal partner, you contributed $150, and the company generated $228, but your share of that is $114. Your $150 investment should increase your percentage of the company (according to Slicing Pie), which makes the calculation a little more complicated than the above. Still, in the end, the numbers usually stay pretty close.
But what happens after you grind out some early customers? The valuation goes up. The 1001st customer costs you the same to onboard - one hour. But now, the company can command a higher multiple. 5x 228 = 1140. That's more exciting! You have taken that hour (which you can never get back) and turned it into almost 8x the investment. Again if there is a split, your share of that is still a 4x return.
All this means that the drivers for equity return on your time are:
- The value of your time, usually banded between $100-150/hour
- The amount of time you are investing in a given initiative
- The amount of MRR you are adding to the company through that effort
- The size of the company (to determine the multiple on that MRR)
- Your stake in the company as a percentage of the total shares outstanding.
Understand these five factors to see how your time can feed the engine of wealth creation. Once you start thinking in these terms, it is almost impossible not to start running scenarios of alternative ways to create wealth with higher returns. Thinking about these issues and implementing experiments to support them will let you generate more wealth with less investment.
Photo by Visual Stories || Micheile on Unsplash