What is Valuation and The Impact on Your Ownership

What is the appropriate valuation of your business? And why does it matter? This typically arises in the context of raising money for your business. When you are raising money, the value of your business will determine the percentage of your business you will give to investors in exchange for their capital. Generally, your business is worth what somebody is willing to pay for it. And the methodologies applied by one buyer in one industry may be different from the methodologies applied by another buyer in another industry. That being said, there are certain considerations and methods that are used rather consistently by the investing community.

“Generally, your business is worth what somebody is willing to pay for it.” 

Valuing early-stage businesses is more of a negotiation art rather than a mathematical equation. Convince investors your business has value and illustrate why they’ll benefit by investing in your business. That being said, there are some common factors and techniques that impact the valuation of a business.

Factors That Impact Valuation

The valuation of an early stage company will be determined by a combination of factors. Below are some of the factors to consider:

• Industry Demand. The industry in which a company operates will be extremely important in determining valuation. If a company operates in a “hot” industry, it is likely that it will be able to achieve a higher valuation compared to another company in a different industry at the same stage of development and current traction. This is because in a “hot” industry there will be a greater demand to make investments and more money ready to be invested resulting in higher industry average entry valuations.
• Market Size. The larger the market in which a company operates, the bigger the potential upside of an investment. Therefore, the bigger the market, the bigger the potential valuation a company can command and vice versa. If your product lies in a high demand industry with low market supply, investors will come knocking with offers aplenty. If you operate in an overly saturated market with numerous competitors, your chances of attracting investors are slim unless you have a distinct competitive advantage. Investors will get a glimpse of your business’ value by assessing your earning capacity based on market demand.
• Stage of Development. If a business is still just an idea then it is very unlikely it will get the same valuation as a company that has a product in the market with customers or user base.
• Traction. If a company has evidence that it is gaining amazing traction with really high growth rates then this will demonstrate to investors that the business is on to something and could result in a higher valuation.
• Talent Potential. In addition to market potential, your company’s talent also plays a role in valuation. The more relevant experience your company’s leadership has, the more likely you’ll achieve product/market fit. Since most investors prefer to see early evidence of market traction, your talent plays a pivotal role in establishing that early traction and in turn attracting investors. An amazing team with high profile or experienced key members will be able to command a higher valuation as the higher the quality of the team, the more likely they will be able to build a successful company (or so their track record would suggest). For many investors the team is the most important factor in determining whether or not to invest.
• Future Financing. Considering how many rounds of finance a business will need to reach an exit point is another important factor. Companies should avoid giving away too much equity too early, so that the founders and the team is incentivized to take the company all the way there. Investors understand this and take it into account.
• Unit Economics: At the early-stage it is highly unlikely the company will be profitable. Being able to demonstrate good unit economics for your product/service is important to show investors that your company will be profitable in the future.
• Comparable Companies. Look at comparable companies and industry exits. Looking at these will enable you to make a judgement on what a potential exit scenario could look like. Once a company has an idea of a potential exit scenario it is possible to work back towards a present valuation.
• General Economy. When the economy is performing badly (i.e. during a recession), it is likely that there will be less appetite to be invested in a high risk asset class such as early stage companies. Consequently, it is likely valuations during these periods will be lower than when the broader economy is performing well.
• Investor Demand. The biggest determinate of the valuation of a company can often be investor demand to get in on the deal.
• Urgency. If a business needs finance urgently then it is likely that their valuation will be lower than a company that does not. This can appear a bit desperate, especially if you’re looking at a significant down round, so we’d suggest not resorting to this.

Common Methods for Valuing Companies

Beyond these general considerations, there are some some specific methods that investors use to value companies:

• Discounted Cash Flow. Discounted cash flow (DCF) measures future intrinsic value. Since DCF looks toward future earnings rather than historical earnings, it’s particularly effective for early-stage businesses. DCF analyzes future free cash flows discounted by the weighted average cost of capital. In order to be useful, DCF should analyze future revenue models, not future revenue projections. Many investors will scoff at revenue projections, especially for early-stage businesses. Although DCF sounds complex, it’s rather straightforward. It simply estimates how investment funds will affect your future cash flows while discounting the time value of money. After running the DCF analysis, if the future price of your company’s shares is higher than the current share price, it’s deemed an attractive investment. If the future price of your company’s shares is lower than the current share price, it’s an unattractive investment.
• Multiple of EBITDA (Earnings). Many early-stage companies are valued as a multiple of their operating income or what is often referred to as EBITDA – which is earnings before interest, taxes, depreciation and amortization. Considerations:
  • Why EBITDA. The notion is that EBITDA represents the normal operating income of the business when non-ordinary and non-operating activities (like depreciation) are removed.
  • Applying a Multiple. Investors apply a “multiple” and multiply that by the EBITDA. to determine the value of the enterprise. For example, if a multiple of 4X is used for a company that has EBITDA of $5 million, the value of the company would be $20 million.
  • What Multiple. These multiple ranges can be very wide, and vary substantially, within and between industries. As a rough ball park, assume EBITDA multiples can range from 3x to 10x, depending on your “story”.
  • Growth is Key. And, forecasted earnings growth is typically the #1 driver of your valuation (e.g., a 25% annual net income grower may see a 25x net income multiple, and a 10% annual net income grower may see a 10x multiple). In other words, the higher the growth projected and the sexiness of the industry, the higher the multiple will be.
• Multiple of Revenue. If there are no earnings yet, with your business plowing profits into long term growth, then revenue multiples or some other metric would be used. Revenue multiples for established businesses are typically in the 0.5x-1x range, but in extreme scenarios, can get as high as 10x for high flying companies with explosive growth (e.g., Groupon). But, that is, by far, the exception to the rule. And, if there are no revenues for your business, unless you are a bio tech business waiting for FDA approval or some new mobile app grabbing immediate market share before others, as examples, raising funds for your business, at any valuation, will be very difficult. Investors need some initial proof of concept to get their attention.
• Comparison to Related Transactions. This method looks at recent valuations of similar businesses in the same industry. If comparable businesses have been recently sold or funded, the valuation of those businesses can serve as your initial negotiation benchmark. This valuation method is particularly useful if you have multiple comparable businesses. The more comparable businesses you have, the stronger your negotiating position will be.

Other Considerations

Additional considerations to take into account:

• Industry Specific Considerations. Each industry typically has its unique valuation methodologies. A next generation biotech or clean energy business, would get priced at a higher valuation than yet another family diner or widget manufacturer. As an example, a new restaurant may get valued at 3-4x EBITDA and a hot dot com business with meteoric traffic growth could get valued at 5-10x revenues. So, before you approach investors with valuation expectations, make sure you have studied the valuations achieved in recent financing or M&A transactions in your industry.
• Perceived Demand. The natural economic principles of supply and demand apply to valuing your business. The more scarce a supply (e.g., your equity in a hot new patented technology business), the higher the demand (e.g., multiple interested investors competing for the deal, and taking up valuation in the process). And, if you cannot create “real demand” from multiple investors, “perceived demand” can often work the same when dealing with one investor. So, never have an investor think they are the only investor pursuing your business, as that will hurt your valuation. And, before you start soliciting investment, make sure your business will be perceived as new and unique to maximize your valuation. A competitive commodity business or “me too” story, will be less demanded, and hence require a lower valuation to close your financing.
• Private vs. Public. Private company valuations typically get a 25%-35% discount to public company valuations. While at the same time, M&A transactions can come at a 25%-35% premium to financing valuations, as the founders are taking all their upside off the table.

Valuation is a complicated concept. Creating a compelling business is the key but understanding the factors that impact valuation and how investors value companies should give you a foundation to better understand the process.