How to Value your Business to Secure Investment
This article looks at 4 methods of valuation which could be adopted to arrive at a realistic valuation of your early stage start up business to help secure investment.
There were 620,285 company incorporations in the 12 months to March 2018. Some of these new companies will be self sustainable ‘lean’ start-ups, debt free and equity rich with a small working capital requirement that is raised by the founders. The remaining companies may require a larger amount of working capital and the founders could require investment from a variety of sources including crowd-funding, business angels, venture capital firms or incubators, for example.
For these new companies that require a larger amount of working capital, the valuation of the start-up is a critical step in being able to obtain investment. An understanding of the methods of valuation available to you and the most suitable ones to adopt, is vital.
Why it’s important to get the valuation right…
Before an investor begins to consider funding your start-up they will ask a lot of discovery questions, including how much investment you require and how much equity in the company you are willing to give away.
- From the investors perspective, an unrealistic and/or poorly considered valuation of your start-up will invariably lead the investor to immediately dismiss your investment opportunity, without giving proper consideration to your product/service, market or management team.
- In addition, your valuation will often be one of the first points of contention if negotiations with the investor pass the initial stage, it’s important that you can justify your valuation to give you as much leverage as possible in negotiations.
- From your perspective, as the founder(s), the valuation of the company will determine the share of the company that you give away. At this early stage, due to their experience, the investor is likely to view the opportunity as ‘high-risk’ and will be seeking to minimise the value of your start-up to manage their risk profile.
- An ‘under-cooked’ valuation of the company may result in you giving away a larger share of the company than is necessary and could even lead to you being resentful of the investor in later years as you may feel you have been ‘robbed’ of value.
It is therefore, crucial that the valuation of your start-up is realistic, carefully considered, prepared on a basis which the investor can understand and justifies your perception of the businesses current and potential value.
4 methods of valuation that you can adopt:
A sophisticated investor will typically use several methods of valuation to help build a picture of the value of your start-up business. When considering what method should be adopted to help determine the value of your early stage start-up, the two biggest factors that should be taken into consideration are:
- The nature of your start-ups activities; and
- The information available at the date of the valuation.
Your early stage start-up will be unable to demonstrate a stable trading history and it is likely to either be pre-revenue or experiencing volatile levels of income during the early stages. Therefore, well established methods of valuation such as divided yield/cover and earnings multiples (P/E, EBIT and EBITDA) are generally not suitable methods to provide useful valuation information.
As you will appreciate, there are many different valuation methods available today including ‘theory’ based methods which tend to be prevalent in the US (First Chicago, Venture capital, Berkus, Scorecard and Risk factor summation) and ‘established’ methods of valuation which are widely recognised in the UK and have received scrutiny from the UK judiciary.
Summarised below are the advantages and disadvantages of 4 valuation methods which you may wish to consider adopting to help value your start-up to secure investment:
1. Transactions in the start-ups own shares
When, in an arm’s length transaction, a company issues fully paid shares in exchange for capital investment into the business the price paid for the shares could be used to help determine the open market value of the company at the date of the investment.
- In the absence of unusual circumstances, the sale price of the shares in the start-up should at a minimum provide an indication of value.
- Unlike comparable company transactions, the type of transactional information required to carry out this form of assessment is generally available to the valuer.
- We are dealing with the company itself and, therefore, are not reliant on justifying the use of comparison data which may be distorted by a range of factors which are unknown to the valuer due to the lack of transitional information available.
- The reasons for sale, identities and circumstances of the participants, the prevailing market conditions and many other factors cold very easily result in different prices for similar holdings and, therefore, a simple multiplication exercise is not advised.
- Invariably, in most start-ups, there are very few transactions in the company’s own shares and, therefore, it is unlikely there there is a large enough pool of information available which could be used to confidently justify any conclusions reached about the start-ups value.
2. Comparable transactions
Adopting data gathered from transactions of comparable companies is one of the more common methods of valuation adopted. Companies such as FAME and CapitalIQ are useful sources of such information.
- Companies that are broadly similar (product/service, size, market, etc) could be expected to be subject to similar pressures and influence from market forces, therefore, it is not unreasonable to assume that their values may also be broadly similar.
- Useful for providing reference points and supporting conclusion reached by using other methods of valuation.
- Comparable company transaction data is difficult to obtain and it is very rare to find instances where transactions demonstrate identical or even very similar facts.
- Most transactions, whether in early stage start-ups or not, are concluded after negotiations and at a price which is satisfactory to both parties. Therefore, without the full facts of the transaction(s) caution should be exercised.
3. Discounted Cash Flow (DCF)
Discounted Cash Flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity and is typically used in start-up situations where there is a lack of reliable financial information.
- A carefully designed and well considered DCF calculation can provide not only an indication of the value of your start-up but also an indication of whether your start-up is over or undervalued.
- Reliance on ‘free cash flow’ and, therefore, focuses on the actual cash made by the business rather than relying on the reported financial information which includes depreciation, amortisation, etc.
- Heavily reliant on input information and in the case of start-ups, without any reliable trading history, there is little confidence in cash flow projections as generally they are based on educated assumptions, or pure speculation at worst.
- The conclusions reached using the DCF model are subject to discounts applied by the valuer which are subjective and largely based on the valuers experience and guidance from sources such as case law precedent.
- Conclusions can be interpreted and manipulated to suit either the investors position of the position of the company’s shareholders.
4. Market approach
Many start-up businesses involve the exploitation of intangible assets such as brands, patents, trademarks, copyright, design, franchises and customer lists. For start-ups exploiting a form of intellectual property (IP) it would not be uncommon for the value of the business to be broadly similar to the value of the IP.
- Generally, the easiest way to help determine the value of a start-up which exploits IP.
- The market approach is very useful if full transactional information of similar forms of IP can be obtained as it is not unreasonable to assume that broadly similar forms of IP may have broadly similar values.
- In a similar vain to comparable transaction information, it is difficult to obtain detailed information on the sale of comparable IP assets.
- The reasons for sale, identities and circumstances of the participants, the prevailing market conditions and many other factors could very easily result in different prices for similar forms of IP.
There are many different methods of valuation which are available to adopt. In order to ensure that you are adopting the best method(s) in your particular circumstances you need to consider the nature of your start-ups activities and what information is available to you at the time.
Whilst certain methods are more appropriate than others, it is generally considered best practice to adopt more than one method to arrive at a robust valuation of your start-up.