We were talking to a guy about his web site and he claimed it was worth millions of dollars. Since his site has zero profits on very little revenue and low traffic (and is declining in traffic), we thought it was a joke. But he proudly showed us a “YouNoodle”:http://younoodle.com/ valuation certificate. They really give a printable certificate complete with a gold seal, suitable for framing, I suppose.

Sure enough, YouNoodle says his site is worth millions. I’d never heard of YouNoodle (for good reason, I guess). It’s a site for early stage startups to get in contact with investors and people who can help the startup. They ask you a few questions about your startup, presumably so that would-be investors can take a look at your startup to see if they’re interested. But they go a step further (too far) and determine your valuation, a real dollar value, in 3 years.

As if the concept for determining future value wasn’t ridiculous enough, the questions they ask are “How do the founders know each other?” and “How much money do you expect to make in the future?”. Those are good questions for potential investors to ask, but you’d have to have absolutely no understanding of business or economics or reality, for that matter, to conclude that those questions actually determine value.

Incidentally, YouNoodle values this blog, which makes no money at all, at $7 million! Is it 1999 all over again?!?

Note the fine print:

bq. YouNoodle’s model is based on rigorous quantitative analysis of historical data and the application of the latest relevant theory.

“Rigorous quantitative analysis” means they asked a few questions and did no analysis at all and “the application of the latest relevant theory” means they used whatever theory they like best at the moment.

And note the even finer print:

bq. You should not rely on Startup Predictor for any financial decision and should always seek the assistance of a professional for any tax, legal, accounting or investment advice.

In other words, this number is completely fictitious so don’t blame us if you’re stupid enough to believe it and make financial decisions based on it.

The value of a business (even internet businesses!) is determined by two things: profits (not revenue) and the growth of those profits projected into the future. Intangibles like “brand value”, patents, “eyeballs”, reputation, etc. either contribute to the profits today, which makes them valuable, or they don’t, which makes them worthless. Some simple math using those numbers, adding in any tangible assets, tells the owner of the business how much the business is worth to them, i.e., if they had the same amount of money today versus owning the business and earning profits in the future, they’d come out even. A dollar more today and they’re better-off with the cash now; a dollar less and they’re better-off with the business over the years. The projections of future profits and growth rates are guesses, but they should at least be based on realistic numbers.

Of course, the price of everything in a free market is determined by what a buyer is willing to pay. How does a buyer come up with a value? They do the same math assuming they owned the business and were earning the profits over the years. If the buyer’s value is higher (they believe they can do better than the current owner) than the seller’s value, they both should be happy and the buyer should buy it and the seller should sell it. If the buyer’s value is lower than the seller’s value, the buyer should not buy it and the seller should not sell it. That’s how businesses are bought and sold, at least by intelligent and rational people.

While on the topic, the value of a business has absolutely nothing to do with the cost it took to build it. As an example, I was talking to another guy about buying an iPhone app that he made which was an electronic version of the Washington State Ferry schedules. He was selling it but I figured he wasn’t making any money on it because the price was outrageous. His insistence on selling it was depriving everyone of a useful iPhone app for no good reason. My intention was to buy it and give it away for free, so I wasn’t going to pay much for it. After days of beating around the bush about price he claimed that he spent $130,000 building the app (yeah, sure he did) and he needs at least that much back to sell it. That was the end of our conversation. By his logic, I could spend $1 million building a lemonade stand and expect to be paid at least $1 million for my business without selling a single glass of lemonade, as if there were no such thing as “wasted effort”. Fortunately, this story had a happy ending: he decided to stop charging for the app and give it away for free. :)