Here’s a great article by Martin Zwilling for Forbes.com on valuing young companies. Though some may argue that some of the methodology is not as relevant in this current economy, I think there are some key nuggets of information that would be of use for business owners. To see the original article, click here.
Say you’re lucky enough to find a willing investor in your young company. At some point (sooner rather than later), the guy will want to know: “How much do I have to pay for a slice of the pie–and how big a slice can I get?”
Placing a valuation on young companies is a tricky, subjective game, but it’s one small-business owners have to know how to play, especially when investment capital remains stubbornly scarce. Quote too low a figure, and you’ll give away the store; shoot too high, and the investor may blanch at your grasp of the underlying economics of the business.
Here are three techniques, some broken into parts, to help you put a value on your company. Your best bet is an amalgam of all of them. When it comes to impressing investors, the more ways you can speak their language, the better.
Technique No. 1: Asset Valuation
Of all valuation approaches, the asset approach–placing dollar values on all the assets on a company’s balance sheet and adding them up–is the most concrete.
Start with physical assets, including machinery, office furniture, computers, inventory, prototypes (and the cost to develop them). Young companies tend not to have much in the way of physical assets, but add up what you do have.
Placing a valuation on young companies is a tricky, subjective game, but it’s one small-business owners have to know how to play, especially when investment capital remains stubbornly scarce.
Then move on to intellectual property. This includes patents, trademarks and even incorporation papers (because the company’s name is protected). This approach may seem squishy, but the dollar amounts are real. A (rough) rule of thumb often used by investors is that each patent filed might justify $1 million increase in valuation.
Next up are all principals and employees. The value of most companies is in their people. In the dot-com boom of the late 1990s, it was not uncommon to see valuations rise by $1 million for every paid full-time programmer, engineer or designer. Don’t forget to include the value of sweat equity–as in the theoretical salaries that would have been paid to founders and executives who didn’t take them.
Also, don’t forget the customer relationships. Every customer contract is worth something, even those still in negotiation. Assign probabilities to active customer sales efforts, just as sales managers do in quantifying their teams’ forecasts. Particularly valuable are recurring revenues, like subscriptions, that don’t have to be resold every period.
Technique No. 2: The Market Approach
Another way to look at valuation is by estimating a company’s earning potential based on theoretical demand in the market.
Start by estimating the size and growth of your addressable market. The bigger the market, and the higher the growth projections (ginned up by independent analysts), the more your start-up is potentially worth. For a young, asset-light company looking to attract deep-pocketed investors, the target market should be at least $500 million in potential sales; if your business requires plenty of property, plants and equipment, the addressable market should be at least $1 billion.
There are also professional valuation consultants who can pitch in
Next, assess the competition and determine the barriers to entry. The stiffer the competition, the lower your valuation. On the flip side, the more fortified your company against new challengers (based on factors such as location, contracts with key customers, first-mover advantage, etc.), the more it’s worth. These intangibles translate into what’s known as goodwill–the amount a buyer might pay for your company above the value of the assets on your balance sheet. Goodwill can well bump up a valuation by a few million dollars.
Third, look at other similar companies that have managed to raise money–an exercise not unlike appraising the value of your house by comparing it to similar homes recently sold in your area. A thorough news search on Google might get you pretty far when looking for comparable deals. There are also professional valuation consultants who can pitch in–for a price, of course.
Technique No. 3: Income Valuation
The method, used extensively by financial analysts, involves projecting a company’s future cash flows and discounting them, at some rate, to arrive at their value in present dollars. The discount rate applied to start-ups is typically steep–from 30% to 60%. The younger the company, and the greater the uncertainty of its future earning power, the larger the discount rate should be. (Note: In the case of very young, pre-revenue companies, this technique may not prove very useful.)
A variation on this approach involves tallying your company’s earnings before interest, taxes, depreciation and amortization (EBITDA, to finance types) and multiplying that figure by some reasonable factor. Calculating typical EBITDA multiples for publicly traded companies in your industry is easy: Just take their market capitalizations (easily found online) and divide by EBITDA.
If running all these numbers sounds like a bit of work, well, that’s true. But, then, would you rather give away the store?