How is a business valuation determined? How does valuation play a role in financing or selling the business? We look at valuation for SMBs.
What does your business have in common with so-called unicorns, start-ups with valuations in excess of a billion dollars?
Ride-sharing company (or is it prefers to be called, “tech company”) Uber was valued at the end of July at $51 billion. That makes it the most valuable privately-held start-up in the world.
CNN reports its valuation increased $10 billion in just seven months. In case you’re wondering, the companies it beat out are Chinese smartphone maker Xiaomi ($46 billion), Airbnb ($25 billion) and Snapchat ($15 billion). To put that in another perspective, Uber’s valuation is more than four times that of publicly traded car rental companies Avis and Hertz combined, according to USA Today.
These companies are even more fantastical than the original unicorn, described in 2013 by Aileen Lee writing in TechCrunch to explain how the scalability of high tech since 2003 helped transform mythical beasts into real giant money-making enterprises. Today, Uber and its peers are called “decacorns,” meaning they exceed $10 billion in valuation.
However, for most start-ups, such valuations might as well be mythological.
But just because you aren’t a billion dollar company doesn’t mean you shouldn’t do a business valuation. It’s a real-life necessity if you’re looking for funding, considering a merger or the sale of your business. But it is a time-consuming process, which is why most small business owners have only a vague idea of the actual market value of their companies, notes Bankrate. Complicating matters is that there is no one “right” way to perform a valuation. These include:
- Asset valuation. In essence, everything the business owns, including cash, inventory and equipment.
- Market valuation. What businesses similar to yours are worth, usually stated in terms of gross sales times a multiplier. For example, a comparable company with gross sales of $1 million might be expected to potentially increase that tenfold, so the multiplier of 10 makes the company worth $10 million. Needless to say, how one determines the multiplier and how it anticipates actual performance is open to interpretation.
- Capitalization. A likely price based on cash flow plus a realistic ROI to the business owner(s) should the company be sold under current market conditions. According to Bankrate, most small businesses can figure a multiple of 3 ½ to 4 times gross annual earnings to determine market worth. Again, though, this is just a rough guideline and multipliers vary among industries and take into account other factors such as market conditions and operational requirements, such as the need to increase staff or obtain additional capital funding.
- Owner benefit. Similar to capitalization, it multiplies one year’s discretionary cash flow times a 2.2727.
Related article: Who is the Next Bill Gates or Steve Jobs?
The valuation of your business is particularly important to attract venture capital. Investors are looking at a combination of factors involving what your company is:
- Currently worth
- Potentially worth
- Worth plus whatever investment funding the VC firm provides
- Potentially worth (exit value) when your company goes public, merges with another company or is sold.
That sound simple enough. But like a lot of simple-sounding things, there are underlying complications. Some of it is mathematical, some of it is guesswork, some of it is negotiable. Most of it is probably beyond the ken of most business owners. Which is why we recommend obtaining the assistance of an independent business valuation advisory service.
Related article: Creating an Employee Survey That's Worth Your Time
Don’t just sit back and leave everything to the “experts.” It is your business, and the way to make sure your business is properly represented between what the valuation advisory service is telling you and what the VC firms are telling you (which may perhaps be different) is to realize investors are trying to get the lowest price for what they perceive as maximum gain.
Your objective is to get the highest price for your maximum gain. The art of negotiation is to meet somewhere in the middle (and maybe a little more towards your side of the discussion, if at all possible).
MaRS innovation hub recommends that to maximize your valuation, you need to:
- Make the best case possible for the value of your company. Don’t accept the first valuation offered. Push back and explain why you think a higher valuation is justified. Of course to do that, you must…
- Do your homework. Know what companies similar to yours are worth. Understand the methodologies used to value your company and why certain alternatives may be more accurate representations of market worth. Identify any perceived gaps in business performance and address how you intend to close them.
- Get additional advice. Other business owners, industry consultants, board members and advisors can help you assess whether you are getting a good deal.
- Find a competing investor. Nothing drives up the price of a deal than a little competition.
- Consider other factors. It could be that an investor with a lower valuation of your company offers more than an investor with higher valuation. That investor might have better industry connections, a better performance record or just better compatibility with your personality, all of which bode better long-term results.