How are businesses valued?
There are many ways of valuing your business, but all basically try to estimate its ability to make money in the future – the more it will make, the more it is worth.
But those who have been through investment negotiations advise not to get too hung up on the valuation. Your business is only worth what someone will pay for it.
Focus on the end result, such as when you eventually sell out, and less on the current offer or current valuation. Think long term.
The most reliable (though still tricky) valuation method is to try to predict how much a business will make each year for the next three to five years.
Opportunity cost
Another method of valuing your business is to assess what return the purchaser expects to receive, and then divide this by the opportunity cost of what the investor requires as a return.
For example, if the investor wants a 25 percent, or greater, annual return on their capital, and the business is currently making a clear net profit of $500,000, then they will value the company at $2000,000 ($500,000 divided by 25 percent). In this example the valuation is from the investors point of view, which is often the case in reality, as it is they who are offering the money.
To get your valuation right, whatever method you use, you need professional advice from a firm that has experience in your industry.
Valuation issues to consider include:
- operating history - if it’s short, this may mean difficulties in forecasting
- variables - these include the economic outlook, prices for similar businesses, team experience, length of leases and pending legislation that may affect your business
- goodwill - your business is worth more than just assets and liabilities. Factors in assessing goodwill (your potential to make above average profits in the future) include management quality, your vision, secure contracts, products or services, marketing strategies, brands and competitive advantage. Fully document your goodwill and justify your numbers
- risk - risky businesses are usually worth less than a safe one. It’s the same for businesses that overly rely on one person or product
- growth adds value - be aware of growth opportunities and ho to exploit them as they add value by increasing potential rewards and future income.
- control - an investor will pay more for control
- liquidity - an ability to speedily sell or quit an investment adds value
- size - larger businesses are usually worth more because they are seen as lower risk and are more attractive as takeover and merger targets
- intangible assets - brands, special processes and trademarks can add significant value
- reliance on key people reduces value - if key people leave it may affect profits or viability of business and increases risk for the investor.
The problem with valuing your business
The main problem is that there are so many variables. As people who have sold part of their business to investors frequently comment, your business value is based on demand and supply.
If you have a company that has $1 million in assets, yet no one wants to buy it, then technically it is worth nothing. Some people have businesses with very few fixed assets, with the main value instead residing in the IP such as software. Such businesses could be worth millions.
There are other variables (which may be outside your control).
- The general economic outlook for your industry. This could be based on overseas trends.
- The market price being paid at the moment for similar companies.
- The experience and profile of your team.
- Leases that may expire.
- Legislation that may be passed, which might affect your business.
The main problem for investors valuing businesses is that business may only have a few years of operating history. Many high-growth businesses have only been around for a few years, which means that:
- the business possibly has only a few years of information to show
- it may have made operating losses whilst building and developing the business
- it’s almost impossible to forecast what sales might be, because of this lack of information
- sometimes the main asset is IP – the physical cost has been legal fees, which might only be in the thousands. But the market value may be hundreds of thousands
- if the industry is new, then there are no other companies to compare with – you’re breaking new ground.
Other factors that influence value
- What value can the investor bring to your business other than money? Experience? networks?
- don’t push for a complicated deal structure. This can be another deal killer
- research the investor. Talk to other businesses they have invested in
- when valuing intangible assets, be prepared to back up your numbers
- don’t make outrageous claims. They will probably be checked
- you and your investor must get along. If the relationship doesn’t feel right, then it probably isn’t
- you don’t have to accept the first offer.
One of the most common deal killers is a lack of flexibility. You need to be realistic about what your business is worth.
Be prepared to be offered less than you thought and to accept far less than you expected.
