Business valuations in start-ups
Where to begin and who to listen to
We’ve talked a lot about the importance of valuing your business. By knowing your value today, you can decide tomorrow’s value. But, most valuation models are based on historical revenue figures and hard facts – something that is quite hard to come by in a startup. With mature companies, a common valuation is done by looking at earnings before interest, taxes, depreciation and amortization (EBITDA). But startup businesses are usually in a pretty unstable stage when it comes to revenue. So how do you go about valuing a startup?
Quick recap of the basics
There a few different factors to take into consideration when valuing a startup. A couple factors that will raise the valuation are balance in supply and demand, well-functioning distribution channels and a positive reputation of the founder. On the other hand, a few factors that could lower a valuation are low margins, high competition and a management team without experience. Pre-revenue valuation models are of significant importance when it comes to startups, since most startups don’t have revenue in the beginning – let alone profit. More times than not, valuation comes into the picture when business owners are looking to bring in capital through an investment. What’s worth keeping in mind is that business owners will generally want to value their company is high as possible, while investors are looking for the lowest valuation possible in order to maximize their return on investment (ROI).
Look at the company you keep
The most common valuation framework is actually combining several different models and finding a sensible average. Since startups usually don’t have historical numbers to go on, the models are based on well-founded predictions. The first useful model is the Comparable Transactions Method. Find out how much similar companies in your industry and region are worth.
Peek into the future
A second common valuation model for startups is the Berkus method. Designed by angel investor Dave Berkus, you start by asking yourself if you believe that your company can reach $20M in revenue by the fifth year of business. If your answer is yes, then you start looking into the following factors; sound idea, prototype, quality management, strategic relationships and product rollout. The model clearly shows how valuations of startups are built on the prognosis of future development.
Keep track of your scoreboard
A more elaborate approach to startup valuation is the Scorecard Valuation Model. Determine an initial value for your company and then adjust in accordance to 12 risk factors. These factors include, among others; stage of the business, manufacturing risk, technology risk and potential lucrative exit. These factors are modified and weighed up depending on their impact on the overall success of your company.
A valuation is always a good starting point when looking to bring in capital. It helps you to look objectively at the company and enables you to base your argument on numbers. To sum it up; a valuation is never permanent. You can always influence your valuation, especially as a startup!
The importance of business valuations in small companies
Know your value today – decide your value tomorrow
A common misconception among entrepreneurs is the notion that you only need to know the value of your business once you are ready to sell. But ask yourself this: do you own all or a part of a business? Do you want to retire some day? Are you planning to grow? If you answered “yes” to any of these questions then you are definitely going to appreciate knowing the value of your business.
In many cases, however, business owners are too late in realizing the importance of valuing their business. This is especially common among small and medium-sized businesses. The impression that a valuation is complex, costly and very time consuming are some of the reasons why business owners tend to procrastinate completing a valuation. But, in starting too late, you will have little to no chance to increase the value of your company before a defining moment. Defining moments can be anything from seeking investment, to adding a new owner, to selling your company.
Where are you now, and which direction are you headed?
A business valuation will give you a pretty solid idea of how your company is doing today, but also an insight as to where you are headed. Knowing which areas need to be improved in order to increase value is an extremely valuable part of business valuation, but it’s often forgotten. Since many business owners conduct a business valuation at the exact time they need it, it leaves them with little to no room to actually improve the results. A valuation of your company could show which areas need to be improved, and can thus serve as the foundation for strategic decisions aiming to develop and improve your business.
Getting down to business
Traditionally, valuations are made in connection to a sale and/or purchase of a company. Nevertheless, there are other scenarios where a valuation is needed. If we put personal matters like divorce and retirement to one side, it still leaves us with several business situations where a valuation is essential. If your company is big enough, a listing on a stock exchange could be an option, meaning that it is of the utmost importance to set a price that the market believes is fair and thus accepts. If you need to report estate tax, or gift tax, a business valuation provides the value of your ownership and determines the amount of future payments.
Do you want a good price or a great price?
A valuation of your company can mean the difference between a good price and a great price. It could help set the floor and/or ceiling values for negotiating. By giving yourself enough time to improve your valuation results, the price tag during a sales process could significantly change. It is also worth mentioning that a business valuation is an incredible help during a negotiation, but it does not replace the negotiation itself. In an ideal situation, you are able to value your business each year to continuously track the development of your company’s value. This will enable you to see the effects of your value-creating actions. If you value your business, then you should know the value of your business!
Long-term business value in small companies
Serving the market or society? Can you do both?
It’s pretty safe to say that the economy today is caught up on delivering on short-term goals. This phenomenon is known as short-termism. Short-termism is usually focused around the earnings per share (EPS) ratio. One reason behind this phenomena is the fact that most shareholders today are not individuals, but rather institutions. Even though individuals are still active, they aren’t organized and they usually remain passive. The power instead lies with pension, hedge and mutual funds, giving them almost all of the influence and power. Having a diverse set of financial players generally means that there’s healthy competition and is therefore, usually, a strength of a capital market. But when the most frequent question that managers ask is if an acquisition will dilute EPS over the first couple of years – there’s a problem.
Performance against short-term measures
By always focusing on short-term EPS, many companies pass up the opportunity to create value. It has been shown that discretionary spending is reduced on areas like marketing, R&D and human capital in favor of meeting short-term financial goals. Managers are often inclined to give discounts to boost sales activation this quarter, as opposed to next. As most of the power lies with different fund managers, the goal will ultimately be short-term gains. With that focus, these investors are unlikely to show an interest in building the company’s policies or tackling issues regarding environmental and social risks. This approach, in the end, actually shortchanges all stakeholders. The result is a situation where companies are being discouraged from developing sustainable products and policies that would benefit society.
“Easy” doesn’t always cut it
The publication McKinsey Quarterly stated that there is no empirical evidence linking increased EPS with the value created by a transaction. So, even though many experts, bankers and investors vividly agree that short-term EPS results are not important in regards to value, it is still a common yardstick when evaluating a company. Why? The answer seems to be: because it’s easy. Everyone understands the concept of EPS so it simplifies trying to proving a point in the board room meeting or in various reports. Pressure for short-term results seem to especially arise when a company is in a more mature stage and preferably when companies grow by acquisitions. Investors are always on the look-out for high-growth companies, which is where the clash occurs.
Moving on from catch 22
So, what can be done about this catch 22? Suggestions on leverage points could be market incentives and transparency. A market incentive would be to encourage more patient, long-term capital through taxes that discourage exaggerated trading or introducing a minimum share-holding period. Internally, boards need to encourage managers who make smart decisions about trade-offs between short-term earnings and long-term value creation. This is not to say that short-termism isn’t sometimes effective, and that value creating actions sometimes do take a lot of time. They are not created equal, and shouldn’t always be held against each other. A balance between the two will lead to a healthier, more stable organization. Ultimately, a company should serve society in order to create value. The shareholders will benefit from this mindset, just maybe not right away. Valuing long-term value is the way to go!
Long-term value creating strategies in small companies
How a correct valuation could prevent the next financial crisis
Short-termism is a phrase used to describe the behavior of focusing excessively on short-term results, at the expense of long-term interests and value creation. History has shown us several examples of what happens when you only aim for short-term results. In 2008, with inexhaustible faith in the market and the continuous rise of house prices, banks lent money to people at tempting rates. Since the belief was that the house market rates would only continue to increase, the banks thought their loans were secure. But by tying in high-risk debt with long-term securities and selling them to investors who in turn purchased them with borrowed money, a long-term risk was created for the initial moneylender – the bank. When people who had purchased a home then started to fail their payments, the U.S. real estate market crashed. Loans became worthless since the values of the homes dropped below the value of the loan. See what a lack of an accurate valuation did here?
History repeats itself…
Still, history has a habit of repeating itself. This lesson of short-termism should have been learned during the late -90’s, or even at the very beginning of the new millennium. The dot-com bubble was also a result of short-termism. Banks and investors forgot the crucial principle of value creation. A key ratio that was abandoned was return on invested capital (ROIC) and what drove this ratio. ROIC aims to conclude how much a company earns on the capital invested in its core business. The heavy investments in Internet-based companies during the second half of the 1990’s created a sense of “winner takes all”, making investors make even riskier and more speculative moves. Investors wanted to be in on all the fast-growing new tech companies so badly, that little-to-no research or proper valuation was made. It eventually became obvious that these Internet companies didn’t have the sensational competitive advantage that the market assigned them. The companies were struggling to earn even a modest ROIC, and the result was the dot-com bubble.
… and repeats itself
Other examples of when short-termism has completely failed an entire market are the East-Asian debt crisis in the mid-1990s and the U.S. savings and loan catastrophe in the 1980s. Both were a result of high-risk investments, aiming to turn a profit in a short-term perspective. Short-termism can be destructive for a market, as history has shown several times. When the focus on short-term results gets in the way of long-term value creating actions, the balance is tipped. The consequences will eventually undermine the market’s credibility, leading to fewer investments, and, worst-case-scenario – another financial crash.
Long-termism is a winner
Researchers disagree on why short-termism occurs. Some call upon our human nature for instant gratification, others assign the blame to greed. Whatever the reason, most analysts agree that short-termism is irrational and expensive for the economy. The rules of economics will always prevail, which is why a sound and accurate valuation will prevent you from getting too caught up in market trends and group thinking. Long-term value creating strategies will end up serving both your company and the market! You need to create generate cash and profits to create value. Growth first with hopes of generating cash and profits is much more risky than the other way round. You have to envision the long-term in a credible way.
How to increase the business value of your small company
Make sure your business stands out
There are a ton of different valuation models and most of them have different advantages and disadvantages in regards to assessing a fair and trustworthy value of your company. However, they all have one thing in common: growth and profitability are the key drivers to creating value. Whether the valuation model directly or indirectly focuses on growth and profitability as key drivers, they always play a big role in the valuation process. Why? When your company consistently delivers higher returns than what your investors require – your company creates value far beyond the recorded values on your balance sheet. So how do you actually increase the value of your company? It’s an important question, and one we hope to answer here!
A valuable list
In 2017, smallbiztrends.com published an article showing 10 things that make your business more valuable than your industry peers. Two main points were clear: predictability and uniqueness. Here’s the list with the rest of their findings:
- Recurring revenue
- A unique product or service that is difficult to replicate
- Growth, especially if it’s above industry average
- Cachet: old-fashion companies acquiring younger, trendier companies
- Clean books
- A second-in-command for after sales activities
- Happy customers
Tracking your results
All of these statements are very important and, even though some of them might be overlapping, they are all worth mentioning. Another interesting observation is that they are all closely related to growth and profitability. Like we’ve mentioned before, the longer you have to prepare your valuation, the more control you have over its results. This is a pretty good reason to conduct a valuation annually, in order to track your improvements. See your conversion rates go up, your costs go down and your productivity increase! So, to be able to see the results over time, you need to make strategic decisions. Even though this list mentions valuable strategies, there are other actions you can take in order to increase the value of your company. A few suggestions are proven scalability, financial foresight and a strong competitive advantage. Keeping key employees on board is also a good strategy as they bring stability and invaluable knowledge.
Understanding a valuation
From a pure valuation perspective, the most important topics are recurring revenue, predictability, clean books and growth. The other activities mentioned in this list will generate those key drivers. This list gives you a pretty good understanding of which actions our valuation model takes into consideration in order to emphasize growth and profitability. It’s pretty much common sense that a buyer is willing to pay more if they see profits increasing, as it shows a more stable future. Make sure to align your actions with your value-creating-goals, to assign the task to the best person for the job and to always have a back-up plan! These lists will help you build a stronger and more valuable company! The key elements to improving value are 1) return above the cost of capital; 2) beat expectations implied in earlier valuation; 3) grow only if your returns are above cost of capital, i.e. focus on profitability first and growth thereafter. Earn your right to grow! Continuous valuations serve the purpose of helping you keep track of your results.
Business valuations in small companies prior to a sale
Worlds apart – or more similar than we think?
Previous posts have shown that there are tons of different strategies and models you can choose from when it comes to valuating your company. Some tend to look backwards, some tend to look forward, some will dial down your numbers, and others will make them look good. Maybe sometimes even too good. There is a danger with dressing up your numbers too much, especially if you are in negotiations to sell your company.
Comparing yourself to others and getting caught up
Most of the discussions regarding showing off good numbers revolve around the use of relative benchmark valuation. The use of the benchmark valuation model can vary a lot from year to year. The model is based on finding an average in an industry by comparing companies to each other, and then using that average to determine a relative value. If a certain industry has experienced a year with unusual circumstances, the relative valuation will be off. If you then move on to applying a price/earnings ratio or an EBIT-multiple without any adjustments, it is inevitable that a higher ratio number will ultimately give your firm a higher value. It is easy to get caught up in wanting to push positive trends in a time of divestment. The buyer naturally wants to see a fundamentally sound company. These factors will push the sales value up, benefitting the seller. But does dressing up your numbers come at a price?
The cost of pretty numbers
First and foremost, there might be legal consequences following the dressing up of your numbers. If your previous annual numbers were inflated by aggressive revenues or expenses, it could skew the accuracy of the valuation. Besides legal action, it could lead to industry discussions and an overall distrust.
Secondly, we are all familiar with accounting 101 – the numbers eventually have to match up. The revenues and expenses should be equal to the cash flow in the long run. Any differences would be because of accruals and the adjustments made to balance out the revenues that have been earned, or any expenses that have been incurred but not yet recorded. These effects happen at different times, and will balance out the numbers in the long run. On that account, hyped up earnings today will inevitably lead to downplayed earnings tomorrow. Furthermore, many acquisitions include clauses in their contracts. One of these clauses could link additional payments with future performance. If the numbers are too dressed up, and thus promising more than can be delivered, it can end up being a costly deal for the seller.
Moving on, the third reason for not trying to manage your numbers too much is that in a short-term view, it may not even make that much of a difference. If the buyer conducts his research on a more in-depth level and takes the history of the business into account, then short-term number improvements only play a modest role in the valuation. If serious, both buyers and sellers will want to have the most accurate valuation available.
Pretty from the inside out
That being said, a valuation should be higher than your tangible assets. The appeal to a buyer is also the intangible assets: the knowledgeable employees, customer lists and business processes. Assets that are needed to maintain daily operations, but that are difficult to monetize. Without doing a proper valuation through an appraiser, you risk either setting your price too high and scaring off potential buyers, or setting it too low and essentially leaving money on the table. Both situations are less than desirable, right? An outside expert also adds credibility to your numbers, since the buyer will be able to see how you’ve arrived at your asking price. Our valuations are based on research, your own expectations about the future, as well as medium and long-term assumptions. It is vital that you focus on real business developments in your forecasts in order to make the valuation as accurate and true as possible. Good looks and dressing up is all fun and games but when the makeup and fancy clothes come off, it is what is left on the inside that counts!
Risk affecting business value in small companies
A simple question with a surprising answer
Surprisingly, we don’t know much about risk. The first sophisticated theories of economic risk were developed during the 1950s, and even though they have been refined since then, there is no universal truth regarding risk. The definition of risk will vary depending on who the risk is pertained towards. Buyers, sellers, investors and customers will all have a different definition of risk, as well as a varying level of risk aversion. But most people can agree on the general definition of risk being uncertainty of what lies ahead. Basically, the future itself conveys a risk since there are so many variable factors that will determine the outcome of a situation. If we look at a business setting, risk is often associated with investment, and more specifically, return on investment.
Is risk an unstable business?
An uncertain economic outcome is the risk in a business situation. Will an investment’s actual return differ from the expected return? This is an important distinction to make, as risk and volatility are not the same thing. An unstable, or volatile, company does not automatically mean it is risky. If you are able to forecast the business’s cash flow or profit, you can plan accordingly and make the necessary preparations. In most investment situations, risk is the uncertainty that is perceived by the investor. Since perception is difficult to concretize and monetize, it is hard to precisely and accurately incorporate into a valuation.
Diving into risk
To deepen our understanding of risk, we need to look into different factors influencing risk. First off, we have industry-specific risk. In general, most businesses within the same industry have similar types of risk. It can be based on daily activities such as the geographical location of a business or the equipment that is used, but risk can also come from the overall industry growth prospects. These risks include barriers to entry, consolidation trends and technological requirements. Then there is the underlying risk of the business itself. In this case we’d be looking at varying supply and demand, at different cost structures that affect bottom line earnings and at the size of the company. Bigger companies tend to show more stability than smaller companies with a niche customer segment.
Moving on, several businesses are financed by debt. This amplifies the risk towards investors since bond holders will always try to ensure that their interest on the loan is being paid in a timely manner and that they will get the principal amount back. Usually, businesses that are very dependent on debt are riskier to the shareholder – all else equal. Furthermore, assets are usually put down as collateral, exposing the investor even more. However, debt holders normally do not lend money to super adventurous businesses.
Cash is king
Investors are also sensitive to the question of liquidity. Will the investor be able to sell its holdings at any preferred time? If not, it might be difficult to obtain cash if and when it is needed. Just look at the real estate market. More times than not, it is difficult to sell property at any given time, compared to, for example, government securities. From an investor’s perspective, the easiness with which an investment in a company can be translated into cash to be used in other situations is thereby of fundamental concern.
Reaching universal truth
As mentioned in the beginning of this post, there is no simple answer to the question of what risk actually is, especially since it differs in so many situations. But by breaking down the concept of risk into various investor-situations, we hope you have gained some insight. One general principle, that we claim is safe to assume, is that as an investor, the more risk you are exposed to, the lower the value of the firm is. Companies can affect their own risk parameters, even though there is usually an industry standard. By thoroughly doing your research on the nature and logic of the business and thereby enabling an estimate of your business value, your risk assessment has a much larger chance of accurately reflecting reality. By doing so, you are coming one step closer to the universal truth of risk!
Three most common small business valuation model categories continued
There is a saying that goes something along the lines of “important things should be repeated, important things should be repeated”, which is why we need to mention the significance of valuating your business again. If you are looking to sell, or bring in more equity, the need for valuation is obvious. But valuation is also a powerful tool when managing your business. Your strategic decisions are more easily tracked in value, and not just in money. Furthermore, it gives you a holistic view over your company, and helps you foresee the consequences of your actions.
Back on track
Now that we have that covered, we can return to the different methods of valuating a business. It can be difficult keeping track of the different limitations and benefits associated with them. In the previous post we discussed two of the models: accounting based valuation and relative valuation models. In this post, we are going to look at the last of the three most common business valuation model categories, which model we like the most and of course – why.
Accounting-based valuation models
Valuation models that are based on accounting usually originate from cash flow models. They’re reworked and adapted so that it is possible to use accounting information directly in the model. So accounting models are based on the book value of assets and liabilities. They are also based on historical cost (or whatever valuation principle is used in the financial statements), which ignores opportunity costs and replacement costs as well as the time value of money. The models rely on the clean surplus relation, i.e. that changes in the equity of the company can solely be explained by net income and the transactions with the shareholders. The true benefit of these models is that they use the balance between the three financial statements; income statement, balance sheet and cash flow statement, to indirectly derive cash flows while having income and balance sheet data directly as inputs to the valuation.
Residual income valuation model – accounting and valuation in a golden mix
This may not be the most well-known valuation model, but it is widely used by analysts. Let us tell you why. The residual income model discounts future excess returns based on available accounting data. Now, residual income is more than excess cash, it is the income that is left after having accounted for the true cost of capital. The income statement includes one’s cost of debt, but usually ignores other equity costs. The residual income model basically looks at the cost of equity as the stakeholder’s opportunity cost, giving a more accurate value to the business.
Compared to many other models, the residual income valuation holds one distinct advantage. It is based on the comparative stability of accounting measures, while the commonly used free cash flow model is based on volatile cash flows. Cash flow figures are considered more uncertain to base future forecasts on, as the numbers tend to vary a lot over time. On the other hand, this is where you have to be a little careful. Since there is potentially a bit of management discretion in accounting numbers, making your forecasts must be done after an analysis of the quality of the accounting data at hand. That being said, the residual income model is growing in popularity as it can give you a pretty clear look at what the actual intrinsic value of your business may be.
Wrapping it up
It might feel overwhelming when you start to research business valuation, and you realize there are numerous models out there. The tools and methods can vary amongst industries and valuators. The most important thing to keep in mind is to look at each company individually. Based on their characteristics, different valuation methods will apply. Decades of experience have shown us what works in different situations, even though the residual income valuation model ranks highly due to its simplicity and intuition. We hope that this mini-series has showed you the same!
Three most common small business valuation model categories
Valuating your business is crucial. Valuating your business before you think you really need to evaluate it is even better. However, many business owners only start to contemplate a valuation process in the midst of a divorce, corporate breakup or a selling process. Unfortunately, this makes you miss the bigger picture. Valuating your business will allow you to see how far you’ve come and benchmark against yourself for future reference, but it will also give you a snapshot of where you are today. After all, most of us are in business in order to create value – makes sense to know your own value then, right?
A masterpiece and a work-in-progress at the same time
Valuation models today are both a science and an art. It is both magnificently accurate and abstract, intriguing and complex at the same time. There are several different types of valuation models. They all come with their own set of advantages, alongside their disadvantages. In textbooks and research papers, it is generally established that all models would give the same results if applied consistently and without any restraints. However, since most models today include a forecast of the future, the models are applied with some limitations. The limitations will decrease the level of accuracy in varying ways, depending on model. We’ve selected the three most common business valuation model categories and will discuss the implications of all of them. Enjoy!
Direct cash flow models
As the name gives away, this model is based on the cash flow that is leaving or coming into the company. They can be both direct and indirect, i.e. the models focus directly on the cash flows to the shareholders or indirectly on the cash flows generated by the company from an operating perspective. Consequently, it includes models based on discounting of dividends to the shareholders of the company, but this only highlights how the funds are being distributed, not the value being created. The target here is on cash flow model’s focus on cash generation. The most commonly known indirect cash flow model is the free cash flow model. It’s useful when you want a view over your current cash generation status from your operations which is the key in value creation. Theoretically, this is the core of most models, but in practice it is tough. Cash flows often vary a lot over time, making them difficult to forecast.
Relative valuation models
Relative valuation models are based on comparisons with other businesses in the same industry. By looking at similar companies and their valuations, these models try to analyze your business in relation to others. Relative methods can then illustrate if a business is over- or undervalued compared to similar enterprises. However, more times than not, it is quite dangerous to assume that the market has it figured out. It can be argued that it was the lack of critical thinking that led us into the 2008 financial crisis, or into the Greek crisis in 2011. Sometimes the market values an entire industry inaccurately, and we find it best to be aware of those risks. Nonetheless, we are here to discuss the model. In order to make a good valuation, the key ratios that are compared should be broadly equal to the other companies. This is why you should be careful of which ratios you choose. Earnings measures that are defined in the same way across companies is a good place to start! But again, the limitation is found in the market itself. Since the economy changes over time, an industry’s key figures from last year can be misleading when analyzing a company today.
The best is yet to come
Stay tuned for more! The next post will contain part two of this mini-series, where we will discuss the third business valuation model category. We will also let you know which explicit model we think is the most applicable, and why!
The difference between price and the company valuation of a small business
The difference between the price and the value of a company is simple, yet crucial. Knowing the distinction can mean having leverage during your next negotiation, the difference between making a bad or a great investment, or just simply making good conversation at your next dinner party. After reading this, you will be able to properly identify the difference between price and value in a negotiation.
Value is value?
Let’s start off with understanding value. Value can be broken down into two major sub-divisions: book value and market value. Book value is, as the name gives away, what is in the books. Accounting will show a company’s value by subtracting liabilities from the assets. What is left if a company were to sell off its assets and settle its debts would be the book value of that company. Book value is accounting value which is shareholders’ equity.
Fundamental value, or intrinsic value, is the estimated value of the firm based on the expectations of future cash flows. These estimates are based on an evaluation of earnings potential, investment needs, financing opportunities, business models etc. These are then adapted and inserted into a valuation model of your choice.
Finally, market value is the value of the company according to the stock market. The easiest way to calculate this is multiplying the number of shares with the current market price. This is also referred to as a company’s market cap. Market value is usually the value that is referred to by newspapers and analysts as it reflects how much you would have to pay in a purchase situation.
Fundamental value in the market
There are a couple of general principles when looking at the relationship between market value and fundamental value. When the fundamental value is larger than the market value, the market is for some reason undervaluing the company compared to its actual value. Many investors seek out these companies as they are viewed as a great investment opportunity. In the scenario where the market value is greater than the book value, the market usually has a firm belief in the potential earnings of a company. When market and fundamental value are equal, the market and your performed fundamental valuation are agreed upon the value.
Knowledge might determine the price
Moving on to price, i.e. the market value. The price of a service, good or business has for a long time been viewed as the compromise between what a buyer is willing to pay and the price a seller is willing to sell for. That logic is beautiful in its simplicity. Practically, there are several different factors that come together to determine the price. These include the number of interested buyers, the sense of urgency of the deal and the negotiation power of the involved parties.
Reaching an agreement
The bottom line is that both value and price will fluctuate during the life span of a business, and maybe especially so in a negotiation. The fundamental value of a business is primarily based on your belief and trust in the company. Do you believe in the company’s ability to grow and stay profitable? It also depends on the industry, and the timing – is there a peak in interest during a specific period in time? This might spike prices. To evaluate the price and decide on your willingness to invest, you have to weigh in all factors and establish a link between the fundamental value of a company, its accounting information and future prospects for the company. Based on that, the buyer and seller can hopefully reach an agreement on price – in all its beautiful simplicity.
The value of business valuation in small companies
The concept of business valuation has been around for more than a century, but many people still find it difficult to grasp. We’re here to tell you that it’s actually surprisingly simple! Business value is created when a company grows, and their earnings from their capital is more than their cost of capital. That’s it!
What’s your business worth?
A valuation of your business was previously known to be costly and very time consuming. It would often involve contacting financial advisors, looking through accounts and analyzing numbers. In general, there are three main areas you could base your business valuation on: assets, market value or fundamental value. Asset-based valuation does not apply to all business types, and a market value really only works when there are enough similar businesses to compare your company to. When looking into fundamental value approaches, the most common method is the discounted cash flow model (DCF). A more modern approach to business valuation is instead to discount future excess returns. This is based on available accounting data, which many perceive to be more stable and readily available than cash flow measures. By finding out what your business is worth today, you will be able to track change from year to year, plan for an increase of value of your business and influence the right actions.
The key? Objectivity!
If history has taught us one thing, it’s that it can be disastrous to neglect the basic concept of business valuation. Both the Internet bubble and the most recent recession of 2008 can both be traced back to misappropriation of valuing a business. To further add to the list of catastrophes, the Japanese economic breakdown in the 1990’s was, in essence, a consequence of incorrect business valuation. Let’s not have that history repeat itself! A major flaw that contributed to these crisis was the lack of an objective valuation. If you try to value your own company, it’s going to be like asking a hardcore fan about their favorite team – it’s difficult for both to take a step back and look at the situation objectively.
Today’s action – tomorrow’s value
Remember that business value is created when the return on capital is more than the cost of capital. Essentially, it’s like a health check for your company. Regardless if you’re planning on adding shareholders, strategizing about growth opportunities or looking to buy out partners, you will want to have an updated business valuation at hand. More times than not, people don’t think about business valuations before they need one. Those situations may be quite stressful, and the extra pressure of uncertainty is unnecessary. By valuing your company today, your future value will be easier to determine, track and benchmark against.
The beauty of a business valuation is that nothing is set in stone. If you don’t like the numbers that you see – change them! Record and trace key numbers, educate management and develop an action plan to reach your goal value. By getting a business valuation, you will clearly see which areas need extra care. Setting goals and knowing where you want to go is half the battle.
Decide tomorrow’s value by knowing today’s value!