Admittedly this has been a challenging post to write. Please do read Valuing a Company – Part 1 [Basics] as the following discussion assumes you are familiar with traditional valuation techniques. Here goes…
A Business with Better Ethics and Higher Costs
Tradeoff of Profit for Positive Impact
There may be circumstances where a social venture’s profit is lower than that for its conventional counterpart. If a social venture is incurring higher costs throughout its supply chain and it strives to keep its products and services affordable and competitively priced (therefore, is unable or unwilling to pass the costs onto its customers), then its profit margin is going to be lower compared to its conventional counterpart. Examples are businesses that pay a living wage to its employees, procure sustainably and ethically sourced products, materials, and ingredients, or use non-fossil fuel-dependent energy sources that presently cost more.
A social venture may employ processes that are less time-efficient than its counterpart, such as management and operational time spent putting their supply chain through a sustainability and ethical screening process, spending more time on training, education, and advocacy, or using low-energy-dependent transportation methods such as bikes, shared travel, or walking. These approaches may eat into profit margin because the social venture produces fewer units in a given time period compared to a conventional business.
These are examples of situations where there may be a tradeoff of profit for positive impact. How can you assess whether the profit for impact tradeoff is present in the business you are evaluating? Take a look at the components of its business model (using the Business Model Canvas is a useful tool) and ask yourself what impact the business is having in each of the components.
Social Venture Risk
There has been a lot of debate about whether this kind of social venture is inherently riskier than a conventional one. It depends. Some people take the view that they are higher risk because they are unfamiliar and are potentially less competitive than their conventional counterparts. I would argue that social ventures, if planned right and operated well, are potentially more resilient, mitigate against risks that are otherwise ignored by conventional businesses, and have long-term sustainability built into their business model. On this basis, we could argue that social ventures mitigate risk. Depending upon your stance on risk level, it can affect your view on the discount rate or required rate of return associated with a social venture investment. Riskier and you would adjust your required rate of return upwards. Less risky and you would adjust your required rate of return downwards.
Effect on Valuation
To estimate the valuation of a social venture, apply the traditional methods described in Part 1 of this series. All things remaining equal, the valuation of a social venture would be lower than that of its conventional counterpart because its profit margins and cashflow are comparatively lower, as described above. Depending upon your perception of the risk of a social venture and your commensurate required rate of return, the valuation of a social venture may be higher, lower or similar to that of a comparable conventional venture.
Disruptive Social Ventures
New ventures that have a social mission embedded within a business model, that could disrupt existing models have the potential of generating significant positive social impact and financial returns. In this circumstance, the potential financial returns are high and commensurate for the high risk, disruptive nature of the venture. Ebay and PayPal are examples of such disruptive platforms that have an element of social change within their business models. Ebay began as an enterprising and efficient way for people to repurpose and sell things they would have otherwise thrown away. It also helped propel home-based and internet-based businesses. PayPal has also enabled many smaller, independent businesses to handle payments and online credit card transactions with ease and efficiency. Both increased access to marketplaces and customers for independent businesspeople and entrepreneurs. Ebay and PayPal might not typically be the social ventures that comes to people’s minds, but their initial vision certainly aimed to be disruptive and improve access to resources to more people.
For disruptive social ventures, the traditional methods of valuation apply just as validly as they would for a conventional business – based on revenue generation or the ability of the venture team to acquire customers.
What does the valuation of a social venture look like when we tap into our emotions and intuition, as well as make use of the analytical tools of traditional valuation methods? Take for instance, the story of an entrepreneurial team that has a hunch about the potential positive social impact and change their new venture could deliver and achieve. They suggest to their investors that their venture is worth more than a more conventional venture that has a single bottom line of maximizing profit. In the absence of revenues in the start-up stage and the lack of evidence of social impact or change, can we even quantity the hunch in terms of valuation? How can we tell the difference between a hunch and deep emotional attachment and involvement in a venture’s development?
Assessing positive impact and social change relies, to a certain extent, upon how we feel about the outcomes, whether they increase levels of happiness, satisfaction, and well-being for ourselves and others. We are looking for transformative change in addition to quantifiable change. These are things that many professionals in the impact investing space try to measure and assess. You might not be able to count them, but you can rate them or place them on a scale. Making a decision about investing in a social venture may also require a leap of faith and tapping into our intuition. Analysis and emotions alone cannot guide our decision-making when it comes to the valuation of an unfamiliar venture filled with unknown potential.
As we transition towards impact investing, I believe valuation decisions will depend upon the social venture and the individual investor, that it is a personal decision that requires candid reflection and a high degree of awareness of our emotions and our values alongside financial analysis.
Valuing a company that has a social mission embedded within its business model can still be done using traditional valuation techniques, but we have to be prepared to adjust our calculations and our expectations if positive social impact is important to us. There is a lot of uncharted territory in impact investing , so it will be interesting to see, how much and how often hunches play a part in valuation decisions.