What Is Your Business Worth?
Q: How do I place a value on my company?
A: In reality, valuing a business is much more of an art than a science. The most widely accepted value will be defined by how reasonable the figure is relative to the assumptions used in the analysis. I just finished an early round of growth capital bargaining for an emerging enterprise. The deal was put on hold while both sides regrouped (and rethought) each other's valuation positions.
Most financial professionals will admit there's as much qualitative input as there is quantitative number-crunching when it comes to performing valuations. Even when two valuators do agree on the methodology, they may vary on the assumptions used in that model and then arrive at very different values for the firm. So it requires a blend of pro forma cash flows, tangible assets, financial and industry ratios, earnings multiples and a wide range of "comps," all shaded by investor sentiment, personal gut feeling and a healthy dose of reasonableness.
Let's look at two perspectives in the context of one of my recent deals. A newly launched engineering design, manufacturing and distribution company had fewer than 30 employees and had never done more than $825,000 in sales in any of its first three years. However, the business began to book a steady stream of new contracts for OEM custom component parts, and applications systems and devices to keep company operations running strong over the next few years.
Based on the recent flurry of new potential sales, the growth curve was plotted for the next four years, and it was somewhere in the range of 20 percent per quarter. In order to support this ramped-up scale, the facilities, IT capabilities, personnel and communications systems needed significant upgrades of around $2.2 million. A partnership of two angel investors and a smaller venture capital firm were approached, and within two weeks, they showed interest in funding the deal through an equity stake.
The potential investors hired a private firm to do a valuation, and I performed a competing valuation for my client. Later, we met at the negotiating table to talk about the industry prospects, the entrepreneurs and key management team's background, the company's innovative patented new designs, and the overall sales prospects. When we sat down, we were separated by a factor of more than 30 percent. (My value was 30 percent higher than their value.) To further complicate things, my client already thought that my value was less than half of what it should be.
Valuation can be derived from any combination of the following eight models:
Net liquidation at fair market pricing
Replacement costs at existing market levels
Adjusted goodwill on excess earnings
Recent comparable sale price
Comparable public company price
Comparable price-earnings multiple
Present value of after-tax cash flow
I prefer to start with the discounted present value of the after-tax cash flow and compare that to recent sales of similar firms. Then I look at the market capitalization of similar publicly traded firms and similar industry PE multiples. The combination of these three should be reasonable and make sense for both parties. But one of my close business associates has often said, "The correct valuation is the one the capital provider will agree to."
Be sure the valuation passes the critical test of reasonableness. Does the value accurately reflect the company, industry-risks and expected returns for the future? Whatever you come up with determines how much equity you'll relinquish to the funding group and how much stock you'll have left for subsequent rounds of growth capital in the future. Strong sales and profit results in the next few months will strengthen my position on the value of the company described in the example above during future deal talks. Poor performance in the coming months will make my value appear far too optimistic. Concessions on valuation might be necessary to keep forward momentum in your operations, but in the end, make sure the final value truly makes sense.
David Newton is professor of entrepreneurial finance at Westmont College in Santa Barbara, California. He is the contributing editor on growth capital for Industry Week Growing Companies and a moderator on small-cap stocks for eRaider.com. His books include Entrepreneurial Ethics(Kendall-Hunt) and How To Be a Small-Cap Investor(McGraw-Hill), named November 1999 book-of-the-month by Money magazine and a 1999 Top 10 book by Forbes. His latest book is How To Be an Internet-Stock Investor (McGraw-Hill). He has written or contributed to more than 80 articles for publications including Entrepreneur, Your Money, Business Week and Solutions, and has been a consultant to emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.
For reprints and licensing questions, click here.