Business valuations can be incredibly complex.
Even for large, public companies like Apple, BHP Billiton and others, the pricetag attached to the business can swing around quite substantially over the period of a year. For much smaller companies run by newer entrepreneurs, the process of coming to a valuation for fundraising purposes is quite multifaceted. For that reason, they must think carefully before arriving at a final number, to optimise their chances of receiving funding.
A poor valuation process can actually prevent an entrepreneur from getting funding. If they set the number too high, investors might be scared away and refuse to invest. If the number is too low, investors might assume that there is not much potential or interest for the company. The entrepreneur must find the sweet spot that comes closest to the correct valuation.
The easiest way to come to a valuation is through revenue or profit analysis. Start by finding comparable companies in your industry, ideally, ones that are listed on public markets. Those companies clearly indicate a ratio of their overall value to revenue. For example, a hardware electronics company may be valued at 5 times the revenue it is currently generating. If your revenue is $500,000 and you are also a packaged goods company you may want to value your company at $2.5 million. However, if your company is growing very quickly you can put a more aggressive multiple of 7 or 8 times revenue. If your revenue is stable or declining, you will need to place a discount on the multiple as a smaller company is riskier than a large one. The same analysis can be done with the profit numbers, if any.
The Importance of a Solid Team
The number and experience of co-founders is also a means to get a valuation. Theoretically, more people working on a company should automatically produce a higher valuation, especially if those individuals have hard to find skills. World class software and web engineers with deep experience can generally expect to get up to a $1 million value per person. Meanwhile, excellent sales and marketing professionals with proven results can expect a few hundred thousand dollars of value. Managers with a wealth of experience managing exactly the type of company they are founding can also expect a few hundred thousand in value.
However, the most valuable founder is one that has previously accepted venture capital and run the business to an incredible sale or IPO. Those founders can be worth tens of millions in value. For example, Twitter founder Evan Williams started a new blogging platform called Medium. With his name and reputation, he was able to find millions in funding at a high valuation with a simple business plan and a basic mock up of the site.
Is Your Business Scalable?
Investors are also worried about the scalability of the business. Those businesses that can grow extremely rapidly are granted the highest initial valuations because the potential is much greater. Early investors in China's Didi Chuxing ride hailing service or Uber in the US were able to see their stakes grow by tens of billions of dollars. That was because there was low initial competition and fast growth through technology and the power of the mobile phone.
On the other hand, companies that enter entrenched industries with slow or low growth have a much harder time of seeking a high valuation. A new paper manufacturer for example, would need a large marketing, production and distribution budget just to break into the slowly declining industry. Any investor willing to enter the industry would be taking a large risk and would want a large stake at a low valuation to compensate them. In both cases, entrepreneurs should look to comparable companies in the same industry at similar stages of development to approximate the valuation.
The Value of Intellectual Property
Lastly, a company with deep, sophisticated intellectual property or proprietary technology can expect a higher valuation. Patents, pharmaceutical drugs with government approvals and hard to copy engineering represent potential valuable assets for a company.
Entrepreneurs must seek out comparable sales of the IP to understand how much they are worth. If there is nothing comparable, than the entrepreneur should look at the valuation of similar companies that were based on IP. Those patents are extremely hard to value because nobody can tell when the true commercialization of the technology will be worth. On the other hand, large companies often pay premiums on patents just to prevent lawsuits. Google purchased Motorola for billions of dollars largely to acquire the company's thousands of patents in the mobile phone sector, thus immunizing them from many legal actions.
Pharmaceutical approvals can be even more difficult to value because further clinical tests might make the findings worthless. On the other hand, a final confirmation of the effectiveness of a drug could be worth billions. In any case, the investor must be an expert before getting into such a complex field.
Other assets including commodities, machines, cash on hand, liquid securities and real estate should also be counted into the valuation. While start-ups usually do not have a high level of tangible assets, they of course must be counted in the valuation. Investors that have recourse for a failed venture are more likely to invest or place a higher value on the entity. Most companies at least have a little cash on hand that they can throw into the equation of the company's value.
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