Valuations: Understanding The Pieces Of The Puzzle
Brian Perry
30-Oct-06
What is clearly the single most common difference of opinion between entrepreneurs and angel investors? You guessed it; what the value of the company is when making an early stage investment.
Business valuation is truly a combination of both art and science. For those professionals trained in this obscure faculty, even the most established companies that have been in existence and profitable for years can be difficult to place a value on. Of course the old adage strongly applies here; “value is what a willing buyer is willing to pay to a motivated seller and what they are prepared to accept at any given time”.
Let’s take a look at the traditional approaches to valuation first. Using these traditional methods, one can value an existing small business using the three main approaches:
- Asset Based Approach
- Market Approach
- Income Approach
Asset Based Approach
The first approach is known as the Asset Based Approach. This Approach derives an indication of value based on the costs to replace the tangible assets in like kind condition. If the earnings will not support a value greater than the assets, then the best-case scenario is that the value of a business is the value of its tangible assets. This can sometimes be tricky however. A buyer and seller (or entrepreneur and angel) may have conflicting views on what the “real value” or “economic value” of the assets. An appraisal can come in handy in these circumstances.
Market Approach
The Market Approach derives indications of value using data derived from the earnings, sales and/or assets of past transactions of similar businesses. These factors are then applied to the company’s sales, earnings and/or assets to derive an indication of value. Rules of Thumb are also considered to be a Market Approach method. However, Rules of Thumb are best only used as a rough estimate because they are not very specific as to how the conversion factors were derived and at best, Rules of Thumb are based on averages. If the business being valued is not average, then Rules of Thumb will not properly determine value.
Rules of Thumb should never be relied on to value any business. They are only to be used as a very rough guide in the preliminary stages. Many businesses do not fit into the “normal” business class for which they apply and therefore, the estimated value is not considered reliable.
Income Approach
The Income Approach derives indications of value by converting some level of earnings into a value using a capitalisation rate, discount rate or multiple. There are about five Income Approach methods that business valuators frequently use to obtain indications of value. Each of these methods requires some level of earnings and a conversion factor to convert the earnings into a value. Properly matching the selected level of earnings (pre-tax, after-tax, discretionary or some form of cash flow) with the correct conversion factor (cap rate, discount rate or multiplier) is the key to obtaining a reasonable and supportable indication of value. If done correctly, each of these methods should produce similar values.
Here is one Income Approach method frequently used by business brokers and business valuators to derive an indication of value. It is known as the Multiple of Discretionary Earnings method. This method is a two-step process. First, you must determine the discretionary earnings likely to recur in the near future. This can be determined by either averaging the last several years or, if the most recent year is indicative of what you expect to be ongoing, then you can use the past year’s discretionary earnings. Discretionary earnings is defined as reported pre-tax earnings, plus salary, interest expense, depreciation and any personal expenses run through the business. The next step is to pick a multiplier. The entire range of multipliers applicable to this level of earnings is 0 to 3. Most small businesses sell in the range of 1 to 3 times discretionary earnings. The resulting value includes all the tangible assets needed to operate the business. Additional value that you can keep or sell is the net liquid assets (cash, accounts receivable less payables) and non-operating assets owned by the business such as your personal car or property. Thus, if a business generates discretionary earnings of £150,000 and the business is considered average, then 2 times £150,000 = £300,000 plus the value of the net liquid and nonoperating assets.
Business valuation is fairly straightforward for the fairly straightforward business. There are however, many businesses that are complex and much harder to place a value on. Although business value is dictated by what a motivated buyer is willing to pay at any given time, there is certainly value placed on having a professional business valuator or appraiser prepare a detailed and thorough valuation for the more complicated situations.
Pre-money Valuations
Now it gets difficult. We have no revenues in the company yet, we have no historical numbers to attach a multiple to and we don’t even qualify to use industry comparables yet. What do you do? Does it come down to strictly asset value and/or real cash invested in the company thus far?
How many times have we heard an entrepreneur say their company is worth suchand- such and this value has absolutely no basis for them to believe this. Of course the entrepreneur attempts to back this up but more often than not, they are “pie-in-the-sky” justifications.
The reality is, most entrepreneurs will attempt to value their idea or business based on future earnings not yet realised by the company and with no real basis for this. We have all likely had experience with an entrepreneur who is looking for investment capital and without having any understanding of valuations, has completely shattered their chances of raising the much needed capital because they were unrealistic and/or poorly advised about the value of what they have to offer.
It isn’t difficult to realise when something makes little sense. For example, if an entrepreneur is asking for £100,000 for 10% of their company, this obviously means they have placed a value on their company of £1,000,000. Now, if this entrepreneur has no orders, no existing revenues, a small amount invested in the company and no tangible proof of a solid business plan, chances are they have overvalued the company. However, there are the quick “snap shot” views of something and sometimes with a little investigation and due diligence, things might prove to be a little more exciting. Perhaps the product has been granted a patent or there has been extensive market introductions completed and just about to turn into real orders from customers. The point is, you can’t approach every deal the same way and determining a value is not as objective as we would all like.
Getting back to pre-money valuations for the typical angel investment deal, we need to determine the difference between “pre-money” and “post-money”. Determining the amount of pre-money valuation for a company, combined with the amount of capital accepted by the company, determines the amount of equity ownership sold in exchange for capital. The end result of the valuation after the investment is called the “post-money” valuation. For example, in a company with a pre-money valuation of £1 million, a £1 million investment would buy a 50% equity ownership stake in the company.
According to Dow Jones VentureOne, the median pre-money valuation of U.S. venture-backed companies has reached their highest point in more than five years. In the second quarter of 2006, they reached a huge $23 million, the highest since the end of 2000 and up over $7 million from the same period last year. The reason; investors are seeing a strong exit opportunity for these investments as a result of the excellent demand for acquisitions, especially in IT and Healthcare. Second round financing valuations for IT companies was $22.5 million with an acquisition median of $60.4 million.
Valuing companies also generally changes in the approach used by the stage the company is at:
Because of the risk factors of new start-ups or early stage companies, the values tend to be lower and investors must be compensated by placing their capital at such high risk, which is translated in the form of shares/equity. As a company matures, the risk generally decreases and the value goes up. As a result of these various stages of risk and company maturity levels, different valuation approaches must be used to reflect each.
The stages of funding, as outlined in the above chart and below, are typical of deals that grow substantially and require venture capital funding:
Seed Financing
The first round of investment generally comes from personal funds, friends, family and angel investors. The capital investment at this stage is usually used for R&D, salaries for founders or management (although some angels frown on this for founders), product development, testing, etc. The objective of raising investment for this level is to get your concept to the next level and have positive results to attract financing for the next round.
Round 1 Financing
Obviously getting to this stage of financing is dependant upon initial success and positive results from the seed stage. This round is usually the first institutional investor and led by one or more venture groups. Ideally, this round would achieve up to a 50% ownership in the company by the investor. Capital obtained would be used for attracting top talent, furthering product development, begin business development and begin to work towards the next round of financing.
Round 2
Financing This round would likely be even more than round 1 and would be used to further operations, scale-up production, and also prepare once again for the next round of financing. Sales are likely to be coming in at this point and the technology risk has been greatly reduced or removed.
Round 3 Financing
This round of financing is usually obtained when the company is stable but looking to make an acquisition, strengthen the balance sheet or increase working capital. The company has achieved a level of predictive revenue and ownership begins to position the company for an IPO or acquisition. Valuations of the company at this point are generally straight forward using multiples of revenue or EBITDA.
Non-Financial Factors
Of course you must begin with the numbers when placing a value on any business or investment but there are a number of other considerations you must place value on:
Principals of the company (experience, integrity, etc.)
- Quality of the management team
- Market conditions
- Quality of product or service>
- Competition
- Size of the market and how scaleable the business can be
- Track record of entrepreneur
There is no benchmark for the above factors and every entrepreneur and business will factor differently. There is obviously a difference between investing in a company vs. purchasing a company and one must consider this. Obviously the track record of the entrepreneur may not be very important if they will no longer be involved in the business if you purchase it. Likewise with various points about the markets or industry as these generally are reflected in the financial statements of the company (not to be taken fully for granted however and part of the due diligence verification process).
Early Stage Valuations
So, what is an early-stage “typical” angel investment company worth? It is worth what logic, reason, market intelligence, experience, skills, technology, contacts, equity and what a whole slew of other things dictate it is worth. There is no easy answer and every company and investment must weigh all these factors. Unfortunately, the earlier the stage of investment and newer the company, the more difficult it is to come up with an objective valuation approach. Hence the reason for “high risk equals high reward” in angel investing. Many deals will be improperly valued but sometimes no valuation will ever be able to gauge “the next big thing” (who will even be able to forget Ram Shriram’s early stage $100,000 investment in Google that turned into a massive $1.1 billion!).
Common Ground
As you can clearly see, valuing a company, no matter what stage it is at, is not an easy or objective task. It is one thing for an entrepreneur or investor to have been through the process before but chances are the new business is completely different and at a very different stage. It is also one thing for one party to have some understanding of valuations but because this is such an art, it is unlikely the other party can appreciate or see their views like they do.
At the end of the day, entrepreneurs and investors MUST come to a common ground in order for the business to grow and for each to realise a return on their investment. It certainly is a matter of give and take in this game and the higher the risk, the more clouded it can become and there will be more “taking” than “giving” on the part of the investor. Investment in a company can make a good one even better but it will never save a bad investment in the end. Both parties have to be realistic and there is nothing more important than starting the relationship on common ground. In the end, things will hopefully work their way out, the challenge is starting from a point of knowledge and understanding and getting to the end before the competition gets there first!
