This is the second article in a series aimed at would-be venture capitalists and investors or the entrepreneurs looking for them. Previously, we discussed how VCs network for leads and mentioned a few platforms one might use to research matchmaking opportunities. Today, we’ll explore different methods you can use for company valuations and the instances when each technique works best.
Of course, there is always risk involved in investing. No business valuation method or online tool is guaranteed or infallible. And put plainly, business valuations can be difficult. But they’re invaluable for both entrepreneurs and investors. Let’s begin with a clear definition.
What Is Business Valuation?
Business valuations calculate the financial value of a company. Depending on your chosen method, you’ll need access to data like revenue, sales, and losses. You’ll need to be aware of competitive risks an organization may face. The final goal is an estimated intrinsic value, enabling both VCs and entrepreneurs to make investment choices.
It’s easier to evaluate an established corporation with simple multiplication. For example, if a publicly-traded company has 100,000 publicly traded shares valued at $60 each, the valuation is $6 million. This is called market capitalization. But VCs and startups don’t have it that easy.
No matter which method for company valuations you choose — and we’ll get to those in a moment — you’ll need access to some data.
Which Numbers Will You Need?
Think of company valuations as a very educated guess. To guess well, you’ll need to learn about a company’s:
- Financial records, so you can understand a company’s cash on hand, future income, outstanding invoices, liabilities, and planned expenditures
- Information about the company’s size, like business locations and the number of employees
- Tangible assets, which include heavy equipment and machinery or expensive hardware
- Intangible assets, like reputation or branding, trademarks, and patents
- Management experience and industry experience, which startups may or may not have
- Competition, to understand the likelihood of competitive advantage in the future
A common problem for young startups is that they don’t have tremendous assets or lengthy financial records. As a prospective investor, you should do your due diligence and get as much data as possible. Also, it’s important to understand the bookwork. Warren Buffet said, “You’ve got to understand the accounting… It must be like language to you.”
Now let’s talk about various valuation methods.
Which Valuation Methods Are Appropriate in the Early Stages?
The Venture Capital Method
This is the go-to system most venture capital firms use for pre-revenue startups. It’s most appropriate for investors who will likely leave a business within a few years.
You’ll use two formulas:
- Anticipated Return on Investment (ROI) = Terminal Value / Post-Money Valuation
- Post-Money Valuation = Terminal Value / Anticipated ROI
Calculate the company’s terminal value or the expected selling price after the firm has invested. Find this using estimated revenue multiples for your industry or the price-to-earnings ratio.
Determine the anticipated ROI and plug everything in to find your post-money valuation. Next, subtract the investment amount, and you’ll get the pre-money valuation.
The Comparable Transactions Method
The Comparable Transactions Method is easy to understand, so it’s a popular valuation technique among entrepreneurs. Your goal is to ask and answer, “How much did it cost to acquire a business like this one?”
For instance, imagine you’re interested in a cleantech startup with a new environmentally-friendly desalination process that processes seawater into freshwater. You research other desalination companies and learn two new startups sold for $300m this year. You make the assumption, based on precedent, that this company will be worth about the same.
The challenge with this valuation method is that entrepreneurs don’t always compare apples to apples, and they don’t always agree with the valuation of their “baby.” Furthermore, sometimes we cannot compare a truly new technology or idea with anything else on the market.
Remember, no law says you must use only one valuation method. You can try these and others before investing in a pre-revenue company.
Which Business Valuation Methods Work Best During the Deal or as the Company Grows?
Let’s fast forward three years. Your startup now has a financial track record, and the competitive environment is becoming more evident. Which valuation method works for a company during the deal?
The DCF Analysis Method
The discounted cash flow formula (DCF) is probably the most popular valuation method used by VCs. The goal of DCF is to estimate the current value of a business based on its future cash flows. It’s suitable for young startups that are post-revenue — that is, they’re operating, making money, and ready to scale.
Calculating the future cash flows of young startups is a challenge. Many startups hope to scale rapidly, and their cash flow may be nonexistent or limited. Lack of financial information makes any prediction difficult.
Broken down into five steps, it goes like this:
- Understand the business
- Look at historical cash flows
- Project future cash flows
- Calculate terminal value
- Discount the cash flows
The DCF formula is: CFt /( 1 +r)t
Remember that a dollar today has more spending power than a dollar will in five years, thanks to inflation. The limitation of DCF is that no one has a crystal ball. Economic factors like pandemics and trade sanctions do happen!
It’s time to fast forward a few more years and think about valuations for a company that’s now several years old and publicly traded.
Which Valuation Method Works Best for Companies at the End of the Deal?
From an investor’s point of view, things are much clearer at this point. Aside from unforeseen economic crises —like a war, for instance — valuations are more reliable. The company has a financial track record in black and white. Consumer appetite is established, the company is branded, and anyone looking to knock off the product or service has tried it. Expenditures are planned well ahead, and you understand your competitors’ angles.
The Liquidation Value Method (It’s Warren Buffet’s Favorite Tool)
The liquidation value is the net cash a business would generate if all of its liabilities were paid and its assets sold right now. Granted, this method doesn’t represent a company’s or future worth very well. But, to paraphrase Mr. Buffet, it allows you to see the margin of error you have with company valuations.
Think of it more like a fail-safe. The logic is this: if everything goes wrong and the company utterly fails, then we can always fall back on the liquidation value.
The formula is simple: total assets – total liabilities = liquidation value.
This is a great starting point and tool, but what if you’re confident this company will exist forever and continue to scale at about the same rate? The best valuation technique, in that case, is the Gordon Growth Model.
The Gordon Growth Model (GGM)
Investopedia describes it best: “[GGM] is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate.” The GGM method assumes that dividends will continue to grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends.
The formula looks like this:
P = r − gD1
- P = Current stock price
- D1 = Value of next year’s dividends
- g = Constant growth rate expected for future dividends, forever
- r = Constant cost of equity capital for the company (rate of return)
Of course, no valuation technique is infallible. The limitation with GGM is that it assumes growth will continue at about the same rate ad infinitum.
If you’re an algebra buff or a very experienced investor, you noticed a hiccup in the GGM formula, too. When the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the whole thing useless.
Also, if you’re a private investor, you might be wondering if you need to f*&k with all that math, especially when there are so many pitfalls and unknown variables along the way.
Do You Really Need to F*&k With All That Math for Company Valuations?
In a word, yes. The math is complicated, and you should try several valuation methods before making a commitment. This article is merely an introduction to some popular business valuation techniques. There are dozens more out there.
The good news is that there are tools you can use to complete these evaluations and others. When you’re an aspiring VC, you should familiarize yourself with these formulas. Like Mr. Buffet says, they should become like a language to you. Play with various formulas and compare the results. Your final company valuations may be somewhere in the middle.
If you’re an entrepreneur, then try a quick search on your favorite search engine for “business valuation calculator,” and you’ll find matchmaking organizations ready to help you value a business and present it to likely investors.
Then stay tuned for the next piece in this series, which covers what to do within the first 90 days of buying a new company.