What methods can a business owner or seller use to create a company valuation before entering the M&A or VC pitch process?
In this guide, we’ll go over seven methods of creating a company valuation, how they work, and how each approach may (or may not) be favorable to your business. While you don’t necessarily need to be familiar with every one of them, knowing at least one or two of them will strengthen your negotiating position.
Keep in mind that, because of how complicated this process can be, many investors and business owners choose to hire a professional to get an accurate representation of what a business is worth. That being said, even if you plan to hire a professional, it’s still essential to understand how business appraisal works.
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Q&A with investment banker and company valuation specialist Kyle Asman.
Let’s kick off with a Q&A with our investment banking partner, Kyle Asman. Kyle is currently a managing partner of Backswing Ventures and helps numerous businesses with their business valuations, and capital transaction planning. You can learn more about Kyle at asmancon.com.
Leslie Morales – What is a company valuation? What kinds of businesses need one?
Kyle Asman – A company valuation is an impartial view of what the value of a company is worth, this is completed by someone who is totally independent of the business, and has no benefit from the value of the company being higher or lower. Businesses that are preparing for sale or a capital transaction such as a fundraise need a valuation completed.
LM – What if a company is a seed-stage startup and it’s pre-revenue? Is it possible to create a meaningful valuation report in that instance?
KA – If a company is seed stage and pre-revenue this is one of the most important times to know your companies value, because there are so many unknowns at this stage in a companies lifecycle. You derive the value of pre-revenue seed stage companies by using the market approach which values the business based on other similar companies who have raised funding.
LM – What are some of the things that can be assigned value beyond just revenue? Intellectual property? Patents? Other material or non-material assets?
KA – There are three main valuation approaches: 1) income, which is valuing the business based on its cash flows; 2) market approach, which values a business based on the funding other companies in the market have received; and 3) the asset approach, which would value a company based on its assets such as equipment or IP.
LM – Why do you need a company valuation if you’re pitching to VCs?
KA – You never want to let a VC tell you what your company is worth as you are always going to end up on the wrong side of that conversation. They don’t need to give you money but you need capital so you are totally at their mercy.
LM – What about asset management firms? How would it be different to do a valuation for a business like that? Is it based just on AUM?
KA – Valuing asset management firms has to do with cash flows. The AUM isn’t that crucial to the valuation number – you can have a high AUM and a low value if the business isn’t revenue generating.
LM – Is there a difference between a company looking for venture capital and a company seeking to be acquired when it comes to a valuation report?
KA – There’s no difference between a valuation report for an acquisition or fundraise, typically valuations for acquisitions will be a bit longer, and contain more information because the company is further along in its lifecycle and has much more to value.
LM – Would you pitch a tech startup to VCs without first doing a company valuation?
KA – I would never encourage a company to pitch without having an independent analysis done of its worth. I see people most of the times value their companies too high, and it completely turns off VCs.
LM – How often is money left on the table during the acquisition process in general? What are some of the reasons for that?
KA – Money is always left on the table in M&A transactions, and that’s usually because people don’t know their companies’ values and just see a number and take it. I have seen millions of dollars left on the table by companies because they don’t do their homework prior to a sale.
LM – You’ve done a lot of media about crypto and the Blockchain. How do you do valuations for businesses in that space?
KA – Since companies in the Blockchain space are so new, most of them are market valuations, but ones that have assets and income are valued the same as companies in any other industry.
LM – Is there any correlation between the 5-year projections you see in a pitch deck and a valuation report? It seems the projection should be aspirational to a degree. What about the valuation?
KA – I typically do not include projections in any valuation reports, projections aren’t based on fact or usually any substance other than someones opinion of what the company might do, so they are never really utilized in valuation reports.
LM – What have we missed? Can you riff a bit about why you do valuations and why you think they are important?
KA – Valuations are important so money doesn’t get left on the table. I ask people all the time, Would you sell your house without getting an appraisal or having a knowledgeable realtor do an analysis on what it’s worth? It is no different when it comes to valuations.
7 Methods for Creating a Company Valuation
Market capitalization is probably the most straightforward method for creating a company valuation. This method essentially extrapolates what the market thinks a company is worth and can be used with publicly traded companies. Generally, market capitalization involves multiplying the number of available shares with the share price.
For instance, if a company is trading at $86.35 and has five billion shares, all you need to do to get the company’s market capitalization is multiply the share price of $86.35 by five billion. One of the advantages of using market capitalization to show the size of a company is that it’s quite easy to calculate.
Apart from that, it’s also a good representation of the scale of operations. Knowing a company’s market capitalization enables you to determine other characteristics that investors are interested in, including risk.
Usually, a company’s market capitalization is first determined via an initial public offering. Before an IPO, a company that intends to go public can consult an investment bank to determine the number of shares that they can offer to the public and at what price.
Once the company starts trading publicly, the share price will then be determined by the supply and demand for its shares on the market. If, for some reason, there is a high demand for the company’s shares, the share price will increase.
On the other hand, if the market isn’t that interested in the shares, this can drive down the price. Therefore, it’s easy to understand why market capitalization can be a trustworthy representation of the estimated value of a company.
Given how simple it is to calculate the market capitalization of a business, this metric can be quite helpful for investors. It can be used to determine which stocks one should be interested in. Companies that have been around for a while, also known as Large-cap companies, usually have a market capitalization value of more than $10 billion.
Such companies are generally the major players in well-established industries, and they tend to have share prices that grow steadily over time. Apart from Large-cap companies, you also have Mid-cap companies with a market capitalization value between $2 billion and $10 billion. These include businesses that are in the process of expanding and are usually in industries expected to experience rapid growth.
Liquidation value is another metric that can be used to calculate the value of a company. Basically, the liquidation value of a company is the net value of its physical assets if it were to close and sell off everything it owns. This includes the value of its real estate, fixtures, equipment, and inventory. Liquidation value is usually used during bankruptcies and workouts.
It’s important to note that a company’s intangible assets are typically not included when calculating its liquidation value. Intangible assets of a company include its intellectual property, goodwill, and brand recognition. However, suppose the liquidation value is being used to determine the price of a company for the purposes of selling it. In that case, you will also have to take into account the value of the intangible assets.
The sum of the two (physical assets + intangible assets) is known as the company’s going-concern value. Investors usually use the difference between a company’s market capitalization and its going-concern to determine if it would be a good idea to buy its stocks.
When calculating the liquidation value, you also have to take into account the liabilities of a company. For instance, if Company A has liabilities worth $500,000 and assets worth $1.5 million, you have to subtract the liabilities from the asset value to obtain the liquidation value. So, in this instance, the liquidation value will be $1.5 million – $500 000, which is $1 million.
The Times-Revenue Method
This method of company valuation is employed when you want to find out the maximum value of a company. When using the times-revenue method, current revenues are multiplied to determine the “ceiling” value for a particular business.
It is important to note that the times-revenue method does not represent what the company will be worth at that particular time. Depending on various factors, including the industry, and business environment, the multiplied revenues may be about one to two times more than the actual revenues.
Instead of giving a single figure as the value of a business, the times-revenue business appraisal method is used to come up with a range of values for a business. It’s advisable to use this method in combination with other methods since it’s not always a reliable indicator of the value of a company. This is because revenue is not an indicator of profit. As such, an increase in revenue does not always represent an increase in profit.
Understanding the Times-Revenue Method
The times-revenue method is ideal when working with small businesses. This is because without considering the value of potential future sales, it can be challenging to decide whether it’s a good idea to acquire or invest in a small business.
To calculate the range of values of a business, you use actual revenues over a certain period of time. For instance, you can base your calculation on revenues for the previous fiscal year. The value that you obtain can then be used as a starting point for negotiations and to show investors the company’s value based on its stream of sales cash flows.
The basic idea behind getting this range of values is to come up with a forecast of what future sales will be. It’s important to note that different multipliers are used when working with different industries.
When one wishes to buy a business, the times-revenue business appraisal method must be used to obtain a ceiling value that will be used together with the floor value.
The floor value is similar to the liquidation value of the business. With the floor and ceiling value, a business owner can get a good idea of what someone might be willing to pay to acquire the whole enterprise.
As mentioned, the times-revenue method is ideal for small businesses that have very small earnings but are poised to have a speedy growth stage. It’s usually employed when working with technology firms that are expected to have a high growth phase. Some of these companies may be valued in the three to four times revenue range, making them a lucrative purchase.
The comparable analysis method of company valuation is a relative method that seeks to obtain the value of a company by looking at similar businesses. The idea is that looking at what similar companies are currently worth can give you an estimate of what a younger company will likely be worth. This is a widely used approach, and it’s quite easy to come up with a workable figure.
However, it’s important to note that this method can only provide an accurate estimate when working with companies that are assumed to have similar attributes. For example, based on the assumption that an equity’s value should bear some resemblance to equities in the same industry and class, you can compare a company to its rivals and determine whether it would be a good idea to invest in or acquire that company.
If there are any discrepancies in the value between the different companies, you might view it as an opportunity for investment. The general idea would be to acquire the lower valued firm or equity and hold it until it reaches the current value of its rivals.
There are two basic methods of comparable approaches. The first one utilizes comparisons of a firm and its peers. This method can use market multiples, including enterprise-value-to-sales (EV/S), price-to-earnings, and price-to-book, among others.
Analysts can also look at how the margin levels of different firms compare. For instance, an investor can argue that a smaller business with a lower value could experience significant growth should improvements occur. This would be a reasonably accurate assumption if the company’s more established peers have previously experienced growth spurts when market conditions were good.
The other method for comparable approaches considers the market transactions where rivals or investors have acquired similar companies or at least companies in the same industry. This allows investors to get an idea of the value of the company. Using these two approaches, you can arrive at a reasonable estimate of the value of most companies.
The Discounted Cashflow Method
The discounted cash flow (DCF) method is a business appraisal technique used to come up with an estimated value of a company based on projected cash flows. In essence, this method calculates a company’s value based on how much money it’s expected to make in the future.
Investors use this method of company valuation to make decisions such as acquiring a company or buying stock. Business owners can also use this method to make capital budgeting or operating expenditure decisions.
The discounted cash flow method is appropriate when a company’s profits are not expected to remain consistent in the future. While this method is not as easy as other methods, it can be quite helpful when trying to figure out which businesses are worth investing in or acquiring. The method requires significant detail and careful calculations.
As an investor, you can use the DCF to estimate the amount of money you may receive from an investment. This amount is adjusted for the time value of money, which assumes that the value of money keeps increasing since it can be invested.
Therefore, this method only works when a person is trying to pay money today and receive it sometime in the future. If the discounted cash flow value of a company is greater than the company’s current value, then investing in the company is an opportunity that should be considered.
Earning Value Approach
You can calculate business valuation based on the company’s ability to generate money in the future. By using the current and past earnings of a company, you can come up with estimates of its future earnings. However, when using this method, you have to normalize these earnings for unusual revenue or expenses.
If you choose to use the earning value during a company valuation, you must first obtain the average annual income of the company. When you obtain this value, you will need to divide it with a capitalization rate.
For instance, if you are trying to calculate the value of a business with an average annual income of $5 million, and the capitalization rate in the industry is 5%, you can divide the $5 million by 5%. The resulting value for such a company would be $100 million.
When working with this method, you can also choose to factor in discounted future earnings instead of using the current and past earnings of the company. To take this route, you would first need to come up with the company’s cash flow projections for the next five to 10 years.
After obtaining those values, you must then calculate the “terminal value” of the company. This would be the value of the business beyond the forecasted period of earnings. This business appraisal method works well with most businesses but might not be ideal for sole proprietorships.
That’s because the past and current earnings of such businesses might be directly tied to the business owner’s identity. Therefore, it might be difficult to make projections because existing customers might not react well to a new owner. It’s also hard for them to trust whether the new owner will deliver the exact quality of service and professionalism.
If you choose to use this method with sole proprietorships, you will need to factor in the amount of business that might be lost due to a change of ownership. However, this can make the company valuation process quite complicated.
The Cost Valuation Method
The logic behind this business valuation method is that investors will likely not pay more for a business than they would pay for a similar business of equivalent utility. Therefore, this method basically operates on the principle of substitution.
There are two main approaches to this method. Investors usually consider the reproduction cost and the replacement cost. The reproduction cost is the estimated amount of money it would take to come up with the same business from scratch.
For instance, if an investor wishes to acquire a power plant, they would not pay more for an existing plant than it would take to build an entirely new plant from scratch. The cost of the existing power plant would be determined by calculating the cost of materials and the cost to build a new plant.
Which Business Appraisal Approach Is Best?
The most popular approach when it comes to business appraisal is the earning value approach. However, this doesn’t necessarily mean that it would work best alone or for every business.
Instead of taking one approach, it’s advisable to utilize a combination of business valuation methods. This will give more insight if you are trying to identify or set a reasonable selling price.
As you might imagine, business valuation is not an easy and many factors come into play during this activity. Therefore, when coming up with a value for a company, it’s also advisable to hire a professional business valuator.
Because of their level of experience, they will be able to advise you on the method or methods that work best for your particular business. It’s also not advisable to do your own valuation because you won’t have the necessary distance to be objective.
The Bottom Line
Coming up with a precise value of a business is one of the essential components of getting the maximum value from a transaction. Successful investors have refined the craft of valuing assets to avoid the pitfalls of paying too much.
On the other hand, a company valuation gives sellers a fairly accurate snapshot of the business’s worth and provides a starting point for price. Overall, whether you are on the buy-side or sell-side, using several or more of the seven company valuation methods outlined above ensures you get a fair deal in high-stake transactions.
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About the author
Leslie Morales is the CEO of Launch Module and a Certified High Performance Coach. Learn more about Leslie and her team on our About page.