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5 Tips to Getting an Accurate Valuation

5 Tips to Getting an Accurate Valuation
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This story appears in the July 2015 issue of Entrepreneur. Subscribe »

When Brian Duerring decided last fall to pursue venture capital for StreamSpot, a Cincinnati-based start-up that provides automated streaming services to faith-based organizations, he needed to calculate a valuation for his business to effectively negotiate terms with potential investors.

“I knew there was going to be some sort of cap or ceiling, and I felt it would be smart to have that ammunition in my pocket for when that first term sheet came over,” he explains.

To arrive at a figure, Duerring employed various evaluation models, then incorporated the value he assigned to the company’s physical assets and intellectual property. During negotiations, he was pleased to find he did not get much pushback from investors, and StreamSpot, which was founded in 2011 and operates in 40 states and seven countries, closed its first round of seed financing in March.

“Calculating that valuation was helpful, because while there was a little bit of haggling, they were more than happy to accept that number, and the final deal was pretty much where we wanted it to be,” he says.

If you want to bring in a partner or investor or put your business on the block, you need to know what your company is worth. In the startup stage, that can be hard to do. Some of your assets may be just time and ideas. You may not have significant cash flow or revenue. If you’re a disruptor, it may be hard to get comparative industry benchmarks. And when you try to assign a number to all the blood, sweat and tears you’ve invested—well, there’s no spreadsheet for that.

Insiders agree that in the early stages, calculating valuation is an art form, so there’s no definitive right or wrong way to arrive at a number. But there are formulas that take into account your projects, competitors and sweat equity to come up with an estimate. Consider these factors when calculating what your business is worth.

1. Apply a method to your madness

Nathan Beckord, principal of San Francisco-based startup consultancy VentureArchetypes, has three methods he finds helpful to setting a valuation for early-stage companies. The first, the “cost to re-create” method, entails calculating what it cost to start the business and what it would cost someone else to replicate it, including marketing, buying materials and equipment, leasing space and recruiting staff.

“That usually shakes out in the lower end of the scale because it’s just what you’ve already put into it,” Beckord says.

The “market multiple” method determines a company’s valuation by examining other transactions that have occurred in the sector. If a business in a similar field sold for $2 million and was roughly three times larger than yours, you can back into a valuation based on that.

A variation of that method is to look at multiples of revenue; for example, consider a similar company with revenue of $300,000 that is selling or trading at $900,000.

“You can use that multiple—3x—and apply it to your revenue,” Beckord says. “If your revenue is $50,000, your implied valuation would be $150,000.”

The third approach, the “discounted cash flow” method, forecasts a revenue stream and factors in expenses to arrive at the value of future cash flow.

“If you’re doing $100,000 in revenue this year and earning $10,000 in cash flow on that, and next year you think you’re going to triple to $300,000, your cash flow will increase proportionally to $30,000,” Beckord explains. “You can do that math and then convert it into a present value.”

2. Subtract the personal

Roger Murphy, president and CEO of Clearwater, Fla.-based business brokerage Murphy Business and Financial Corp., says it’s critical to analyze a company’s financial statements to give a truly accurate account of how much value is in the business.

Because most small businesses try to minimize taxes by expensing personal charges to the business (think: supplies, travel, golf membership and charitable donations), one of the most important things Murphy does, he says, is to “recast the financial statements” to find the accurate worth of the company’s operations, assets and liabilities.

“We take a look at the income statement and recast to try to get to what we call ‘owner’s discretionary cash flow.’ That’s very different than what you see when you look at the bottom of the tax return and see net profit or net loss, and that number is the one that’s going to drive the valuation.”

3.Factor in nonfinancials

Non-monetary elements can affect your valuation, from owner and team experience to access to talent, revenue stream and the ecosystem in which you operate.

For example, second-time founders often have higher valuations because they have a track record—either from success or from failure (but with an understanding of why they failed). Conversely, a founder writing a consumer app based on the sharing economy who wants to launch in a small town may not have the density needed for success. That may negatively affect the company’s valuation.

“All of these types of nonfinancial terms can still have a financial impact on the valuation,” says Michael Litt, CEO and co-founder of Kitchener, Ontario-based video marketing and analytics startup Vidyard, which in January closed an $18 million funding round based on a valuation of roughly $100 million.

For Duerring, StreamSpot’s intellectual property factored into its valuation. “Though it wasn’t in our balance sheet, I knew it had a value,” he says. “We took what we felt the average cease and desist would cost a company in the event they tried to mimic us, then assigned a value to that and added it in.”

4. Consider your audience and terms

Blair Garrou, managing director at Houston-based Mercury Fund, notes that all capital is not equal. The better the investor or investment firm, the lower the valuation will likely be.

“But entrepreneurs need to realize that by bringing in the best investors early, their valuations down the road should be higher because of the Rolodex and advice they’re getting,” he says.

Similarly, Murphy points out that the terms of your deal will have an impact on the valuation on which it’s based, specifically as it relates to how payments are made.

“If you want to sell your business for $200,000, and you want it in all cash, you’ll likely only get 70 percent of your asking price, vs. agreeing to sell it for $100,000 down and financing the rest on a note,” he explains. “A lot of buyers are concerned with how much money they have to put out, and they’ll pay a little bit more when the business is actually paying it over time.”

5. Check emotions at the door and enlist a professional

Of course, you’re emotionally invested in your business, so it may help to get an impartial outside opinion. Affordable help is available. While established firms may charge upward of $15,000 for a comprehensive business valuation, a small business that’s going to sell for less than $500,000 can get a valuation report for roughly $1,200 to $1,500, Murphy says.

“It’s not a formal appraisal, but it is a broker’s opinion of value, developed by experts in the market who know what businesses sell for and have access to valuation models and databases of the similar businesses that have sold.”

This can be good for those whose feelings get tangled up in their valuation. “Entrepreneurs have a tendency to place value in the potential,” says Tina Aldatz, who sold her Foot Petals shoe-accessory company for $14 million in 2011. “But this doesn’t work for bankers and bean counters who only want cold, hard facts and figures—and you have to be OK with that. Otherwise, it’s very difficult to become comfortable with any number.”

Finding a Valuation Broker

Even if you’re not looking to sell your company, a business broker can help you calculate how much it’s worth. Roger Murphy, CEO of Murphy Business and Financial Corp. in Florida, says experience and industry credentials, particularly a Certified Business Intermediary designation from the International Business Brokers Association, are meaningful when selecting a broker.

“Credentials are important, but not as important as knowing what types of businesses the broker is used to handling and what types of transactions he has completed,” he says.

That’s because it’s crucial to make sure a broker understands your particular business and how it operates so he or she can evaluate it properly. That includes understanding your specific industry, your customers, your competitors and your future projections.

“The broker needs to have access to information about the industry and your particular marketplace,” Murphy says. “Ask about which databases of information he plans to use to do his research.”

Murphy cautions ’treps to be wary of brokers who immediately try to apply a general rule of thumb to the price of a business, such as saying its value is three times its earnings. “Avoid brokers who give you a market value of the business off the top of their head without first doing some analysis,” he says.

Edition: November 2016

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