Business Valuation Basics
Entrepreneurs and business owners will generally need to value their business on many occasions during the course of a career. Whether part of a seed investment round, follow-on series investment round, merger or acquisition, partnership or owner dispute, or a partnership or ownership dissolution, you will likely need to fix a value to your business at least once.
Behavioral study indicates that people tend to value that which they are selling higher than they would value the same thing if they were buying. This means that most of the time, and especially when the valuation is forced, the number the buyer proposes and the number the seller will accept are far apart. So you often see business owners and entrepreneurs turning to accountants, consultants, and business lawyers to help them decide who is off the mark. Generally, both parties are.
In most cases, business valuation is a complex and difficult task with many pitfalls for the inexperienced. It is almost always the best advice to consult with a professional for guidance on what your business is worth. But sometimes business owners just need the basics to be able to avoid a dispute or get a deal done, so:
What is Value Anyway?
Value according to most people (including the IRS) is the price a willing buyer would pay a willing seller when not under any compulsion to buy or sell, with both parties having reasonable knowledge of relevant facts. This is also known as “fair market value.” While fair market value (FMV) is not the only type of value, it is often what people associate most closely with the term.
Another common type of value in business transactions is “investment value,” or the value a firm would associate with an asset for which it had a particular attribute that might make it better suited to exploit the asset.
The fair market value is often associated with valuation of a going concern. Whereas investment value is more often associated with a merger or acquisition where one company might have specific synergies (and as part of the merger ceases to be an independent going concern). (See for example, Welltok’s acquisition of Seattle startup Mindbloom.)
Is Business Valuation Art or Science?
There are two general camps when it comes to business valuation methods. The “rationalists” generally conclude that everything can be reliably estimated using math, and that capital market pricing errors are present only in the moment before the market adjusts to correct them. The data in general is accurate, so the math and thus value derived from the math is accurate. Rationalists tend to favor complex calculations for finding a reliable estimate of “intrinsic” value.
The other camp is what I will call the “marketeers” who tend to favor valuations based on relative measures that can be observed in the market, such as comparable businesses or assets. Marketeers generally look to find a recently sold asset that is closely comparable in all attributes to the asset being valued. But because no two businesses are exactly the same, the marketeers will usually apply a multiple to some objectively measurable industry or niche specific standard, such as earnings, EBITDA, users, paid users, etc. to find value.
The Major Business Valuation Methods
If you have the available resources, you are better suited if you analyze your business’ value using as many methods as possible. There are three main approaches: one favored by rationalists, one favored by marketeers, and one hybrid approach:
Income. The income based approach is favored by rationalists because it looks to the intrinsic value of the business by determining value based off the income the asset produces over its useful life. By discounting this future stream of cash flows to a present value using a discount rate that estimates risk, the rationalist can get a good idea of what the current business is worth. Because this approach works best with recurring cash flows, you see this approach used widely in retail, wholesale, manufacturing, subscription, and service businesses.
Market. You guessed it, the marketeers favor the market approach. The market approach looks to objective measurements observable in the market to provide a comparison for value. The market approach is based off the idea that over time with information widely available, the market will adjust so that like assets are priced alike. The market approach seeks to compare objective market data for similar assets. The market approach is often described in terms of multiples, for example, multiples of earnings, cash flow, revenue, users, etc. The business is valued under the market approach by applying an estimate of the appropriate multiple to an appropriate objective measure based on the observed multiples of other comparable companies. The market approach is common across industries.
Net Asset Value. The net asset value (or adjusted net asset value) approach to valuation adjusts book value based on the market. This approach requires the assets of the business to be appraised to determine fair market value. When the estimated fair market value for all assets has been determined, the sum of the value of those assets is adjusted by the value of off balance sheet or contingent assets or liabilities to find the value of the business. This approach is common with investment and real estate companies, and other companies with intensive capital assets.
Adjustments to Value
While you may be able to come up with a reliable measure of value using one of the valuation approaches, this measure will often be discounted (or a premium will attach) if certain other relevant circumstances are considered. Essentially, whatever price you come up with using the valuation method(s) described above will often be adjusted upward or downward based on one or more factors:
- Minority Discount (10-35%)
- Key Person Discount (5-15%)
- Blockage Discount
- Lack of Marketability Discount (10-45%)
- Litigation or Contingency Discount(s)
- Control Premium
- Swing Vote Premium
Assumptions and Manipulation of Measures of Value
Almost everything in business valuation is based on an assumption, and we know what it means to assume. Therefore, you cannot take any measure of valuation as fact. Financial statements can be created using generally accepted accounting principals, and yet hide or divert attention away from key values. Appraisers can be influenced, and they may not always have the best idea of what is comparable. And market values are necessarily a product of the perceptions of the person who decides what is comparable. In essence, valuation is subjective and thus can be manipulated. Make sure you have someone on your side who knows what they are doing, so you don’t overlook something that could cost you real value.
A Note: Pre v. Post Money Valuation
When considering value in the context of raising capital, such as a seed or venture capital investment, make sure you and the other party are talking about the same thing. If you are considering the value of the company prior to any infusion of capital, you are talking about pre-money valuation. If you are talking about value after the capital infusion, you are talking about post-money valuation. The difference is considerable and meaningful. For more information on pre and post money valuation other topics related to raising capital, check out our series on key term sheet provisions.
If you’d like to learn more about business valuation, buy-sell agreements, business purchase and sale agreements, or raising capital for your business, please comment below or contact us.