What is the value?
There is a myriad of books on valuation methods that include (very legitimate) techniques for the issue. The value of an entrepreneur’s company is a crucial issue to address as it determines the amount of equity she’ll lose if an investor invests in the business.
What exactly is value? The most straightforward answer is the amount someone will pay. The amount you’d like to receive is clearly significant; however, if you believe your vehicle is worth $10,000, and the maximum price someone will accept is $8,000, your opinion on the value of your car is not relevant in the context of selling the car as you won’t get it.
The same idea applies to shares of the company, and in particular those that are listed in which the market decides a price. The value investor seeks shares trading at a price that is lower than their intrinsic value, hoping that the market will eventually adjust the shares in order to reflect this. What happens if the market doesn’t re-price the shares? It doesn’t matter what value the investor believes the value of the shares is, and it doesn’t matter that markets are “wrong”; if the market doesn’t agree with him, he won’t earn any profit.
What impact does this have on the entrepreneur?
Entrepreneurs will be able to bring an investor in with an agreed value. All the research of the world is nothing if the investor is unable to accept an amount.
So, how do you calculate value?
It is essential that the business owner is prepared with the following prior to any discussion regarding valuation in front of an investor (never discuss a ballpark number when you’re guessing, it could linger in your discussions for a lifetime):
A concise, coherent strategy that outlines where the business owner would like his company to be in five years’ time, with the resources needed to reach that goal.
Comprehensive forecasts (income statement as well as the balance sheet and the cash flow statement) for five years, supported by reliable assumptions built on an in-depth study of the company’s operations and the market it is targeting. Don’t underestimate how important this is!
A plan for funding that outlines when the business requires money, why, and in what amount
Together, these data can be combined to calculate an estimation of the company’s value. The primary method to do this is by using the model of a Discounted cash flow that basically discounts all cash flows that are forecast to flow (5 years and beyond) and then compares them to the current date. It isn’t so simple as there are many variables to be considered in the creation of a DCF model, and that’s why it is essential to consult an expert to assist you since even a minor error could cause a significant impact on the value. Remember that point 2 above A DCF modelling is as accurate as of the forecasts that are included in it.
However, it is true that a DCF model isn’t the only way to determine the value. In some cases, it’s not the best choice. But it’s a good starting point and basis for comparisons in the following areas:
Comparative companies’ trading metrics
Comparable companies are typically listed, and the information you’re using is the market’s perception of the value of companies similar that are comparable to what you have. There are a variety of terms like P: E, Book and EBITDA multiples. These and others are utilized as comparative statistics to aid in determining a more similar valuation for your business. They’re not always appropriate, however, if the company in question is facing similar marketplace forces as yours and is able to use them as a reference.
Similar to similar companies, what’s being done is to review recent transactions as well as their pricing parameters to determine the prices similar companies are purchased and sold for. The same cautionary tale about application applies. However, this tool can give a direction.
That’s it, right?
Sadly, no. In theory, if the DCF models and similar data show a generally similar value for your business, then you must have a valuation for investments. In reality, it’s not as simple as that:
It is possible that you have an accurate value calculation, but that’s just the beginning of discussions.
The risk of forecasting, especially for early-stage and start-up companies, will mean that the investor will be looking to lower the value.
Your company isn’t included in the list, and therefore the discount will be added to your valuation to reflect the higher difficulty for investors to sell their share (referred to as “illiquidity discount”). It typically ranges between 30% and 50%.
In contrast, if an investor would like to control your business, you may ask for an increase in control.
The bottom line is that in the end, the highest value will be the highest price that an investor is willing to pay.
Be cautious prior to selling equity.
The last one is the most crucial one to keep in mind when selling shares in your business. If the price you are offered is lower than the valuation of your business, that means you’re giving away shares of your company today and could be valuable to come in the near future. Equity is a costly method of financing your company, so be cautious when negotiating your valuation. Hire a professional, and the expense is worth it.
Ernest Matthewson advises entrepreneurs on the value of their business and on how to raise capital to finance their business. He relies on the network of his investor’s source the most appropriate and targeted financing for a specific business. Only investors that are looking to become long-term partners. He only recommends entrepreneurs are a part of his belief system.