PART #1: EVER WONDERED HOW MUCH YOUR BUSINESS IS ACTUALLY WORTH? (I HAVE)
James Tuckerman, Editor-In-Chief, Anthill Magazine
A couple of days ago, I caught up with an old school friend. When the topic of Anthill came up, he said with obvious but ill-directed admiration, “You must be a millionaire!”
‘If only that were true,’ was all I could think, before delivering a suitably ambiguous Cheshire grin and dropping a generous tip (the service was exceptionally good).
So, why am I not a millionaire? Anthill must be doing OK? (You might think.)
Well, to be frank, a business is only worth how much someone else is willing pay for it. And, until that time, it is worth the amount of profit it delivers to its owner or shareholders.
It’s also worth the pleasure it brings to the entrepreneur, of course (which is why I described my friend’s admiration as ‘ill-directed’, as it reflected his measure of success, not necessarily mine).
However, to get to the point, this harmless and well-meaning comment by my old acquaintance got me thinking. It initiated a ripple of thoughts, culminating in one final question…
How much is Anthill actually worth?
Understanding the value of any given business or opportunity is, of course, vital to its long-term success.
Firstly, because financial valuations are useful as a sanity check. (Am I treading forward or backward?)
Secondly, because knowing the value of a business allows you to reward staff with equity. (How can you allocate options without knowing the company’s fair value?)
And thirdly, because the value of your company is the first thing a potential investor or buyer will ask in the event of a capital raise or trade sale.
Yet, even the most sophisticated investors still describe private company evaluation as a ‘black art’.
So… over the next new few weeks, I plan to review five different aspects of valuing a private company. And, of course, I’ll be seeking your comments and observations along the way (call it learning by teaching).
Therefore, if you are interested in the value of your business, or if you are interested in the potential value of your business opportunity, read on. If you are an expert in this area, please join the conversation and help inform our readers (including yours truly).
To get the ball rolling, I propose that this blog series consider the following five topics:
Terminology (Liquidity Event, Hurdle Rate, Pre-Money Value, Post-Money Value)
Comparable Method of Valuation
Discounted Cashflow Method of Valuation
Profit Multiple Method of Valuation
Strategic Buyer Method of Valuation
If you have any further suggestions, please don’t be shy, as together we attempt to explore the ‘black art’ of business valuation.
Tags: Exit Strategies, finance, trade sale, venture capital
May 22nd, 2008 at 2:28 pm
Great initiative, James.
For those of us who’ve raised angel investment and tried - in great pain - to use projections as inputs into the standard valuation models you list above, it would be great if you could consider businesses at a pre-market or very early stage.
May 22nd, 2008 at 2:30 pm
James,
Good idea! This is the biggest FAQ of all. My clients are always asking for advice on this one.
The business owner wants to get as much as they can for their equity and the investor wants to pay as little as possible.
I often say that I hope for parity between the value of money and the value of innovation.
May 22nd, 2008 at 2:34 pm
I’ll be watching this with interest.
As someone who works in the biotech industry one thing that drives me mad is the DCF valuation method which is used by analysts. Using a DCF valuation for a young biotech really does not make sense at all. It seems to be the case that in order for an analyst to have his/her research taken seriously by the dealing desk/investors its mandatory to have a DCF there no matter how irrelevant it might be.
Placing a valuation on a young biotech is a tricky business but there are other ways to do it.
May 22nd, 2008 at 2:37 pm
I agree with all the reasons listed above for knowing what your business is worth - and to that list I want to add another more salient reason.
Studies have shown that as many as 50% of small business owners are banking on the value of their business to fund retirement. As most SME’s know, very often the profits left over do not provide the return they really deserve. So the mkaing sure they have enough in the “business nest egg” is critical in being prepared for retirement.
To add more weight to what James has already said, a record number of business owners are approaching retirement age (end of the baby boomer business era), there will be a large array of choices for buyers. So having the business prepared for sale is just good business sense - otherwise your retirement plans will have a sudden change when there isn’t the funds you thought there would be.
And whilst I agree there is some “art” to valuation, the educated guesses should always be based on some reasoning or rationale. I don’t think valuation is a “black art” - but it has many shades of grey.
I look forward to an interesting blog.
May 22nd, 2008 at 2:44 pm
I concur with earlier comments - Great initiative James but hurry! We are going through this process at present and would like to see your conclusions tomorrow.
PS: There’s no problem with DCF valuations, there’s just no value in most young biotechs.
May 22nd, 2008 at 2:49 pm
James, looking forward to the articles with great interest. I have raised around 7 mill in VC and grant funding for two different early stage/growth companies over the past few years. One listed, the second is now ramping up fast. I have tried different models: put-a-number-on-exit-event-and-discount-for-risk, discount to future earnings etc.
It is all so subjective. In the end, it is about power. Does the company have the power to walk away? Do either side have good alternatives to the deal on the table?
If entrepreneurs can get a powerful base of clients, tangible product, dominance in their niche, and walk-away alternatives to the deal; they get a better valuation, almost independent of spreadsheets holding dreams about the future. Entrepreneurs also need to see things from the investor’s point of view, stripped of all delusion. They need to see other potential investments as competition, and shape their company to be the best alternative for the investor.
Nontheless, I would love to see you guide us through the formal approaches, so we can understand better how investors think.
May 22nd, 2008 at 3:09 pm
How many start up business owners know my old mate Jack Schitt? They should, because as a start up, he’s exactly what their business is worth. Angels and VC people are banking (betting) on the FUTURE value of the business if they assist in getting it up and running. Established business valuation however, goes along these lines.
Goodwill for leasehold businesses are worth (in general) the previous 9 - 12 months nett, nett profit. This profit is derived when you deduct a reasonable salary for the owner (many owners do not pay themselves) but add back in any depreciation. The salary deduction is necessary to calculate what the business really would earn if the owner were incapacitated and needed to employ a manager.
Then add in any written down value of plant and equipment plus the current value of any freehold property. Take the higher figure and add 10% if the business has a monopoly in the area or if the barriers to entry of a competitor are high. Likewise, take the lower figure and deduct 10% if there is strong competition and any mug with a bankcard can go in opposition to you.
Simplisitc? Yes, but after 35 years hanging around all types of businesses, I’ve found that the back of a beer coaster feasibility is never more than 5% out. Good luck!!
May 22nd, 2008 at 3:10 pm
JUST GET AN OFFER - ANY OFFER & HERE’S WHY…
When pitching for investment, what if the entrepreneur simply stated how much money they were looking to raise without stating the pre-money valuation or the % of equity on sale?
i.e. just simply leave it up to the buyer to make a formal bid. Of course you don’t have to accept the offer, though importantly at least the you have a starting point valuation!
This approach could be particularly useful if there are existing investors with the first right of refusal. For example; if a third party offers $1mil for 20% - then the inside investors have to at least match it to take the round.
Conversely if you put too high of a value on the company yourself and don’t get any offers, then the inside investors have you right where they want you!! ouch! I’m talking from experience on this one.
Steve
May 22nd, 2008 at 3:20 pm
Further to my earlier comment, another area of difficulty is valuing IP. I would be interested to read some comments/experience about this.
May 22nd, 2008 at 4:23 pm
I have just completed a week at the Ballarat Innovation Expo where this topic was touched on and it was a real eye opener. I expect to go into these types of negotiations within the next month as I am in the early stages of taking an innovation product to market.
I look forward to this topic developing and will watch with interest and contribute if I have something pertinent to add.
John
May 22nd, 2008 at 4:47 pm
May I suggest …
a. Forget about putting a value on your business for assessment by traditional VCs
(or pseudo VCs in Angel’s clothing) … or having them do it for you.
b. Replace “investor” with “partner” as the description you have for the person or
company you are seeking
c. Don’t offer ANY prospective investor financial projections as a way of determining the
value of the business.
d. Seek out people or companies that can share your vision and have something to
bring to the project other than dollars… then jointly work out HOW you would make
it successful together.
e. Put down what you would both want to achieve and receive as partners in the venture,
financially, careerwise and in working roles.
Oversimplistic I realise … but maybe a starting point.
PC
May 22nd, 2008 at 4:56 pm
Great idea James. Every business should be built with its sale in mind - to paraphrase Gerber. Mine is a services business, not a technology business. It is four years old - and I am beginning to realise that when I was told it would take seven years to build something worth selling - or at the “ready to sell” stage, that was good advice. My challenge is that in the services sector a few intangibles come into the equation - such as the “stickiness” of customers - and a few conventions operate which have no basis in logic. An example is that accounting practices typically sell for 1 to 1.5 times ebit, where as financial planning practices sell for up to five or six times ebit. Not sure I have this correct, but the difference in their “value” is of this order, and I don’t know why.
I look forward to the development of this discussion
Hugh
May 22nd, 2008 at 4:58 pm
Peter, you are right on the ball. This is exactly what I say to people. Why is the investor- speak so attractive. An angel investor is a business partner so make sure that your personalities are compatible. If I may say so, I was the first person internationally to put the emphasis on personality rather than funds.
May 22nd, 2008 at 6:40 pm
Really looking forwrad to your series, James. For me, I have my core business, but I also have a collection of different websites that I am developing with the view to selling.
These are essentially separate businesses but I am having difficulty locating information on how to value an online business. I would assume the same principles apply but any information you can include on valuing a “virtual” business would be wonderful. Thank you for approaching such a tricky topic!
May 22nd, 2008 at 6:50 pm
It’d be great to see some kind of database where sales and investments can be catalogued and used for comparative valuations - in the same way RPdata and Residex do for property transactions. At the end of the day it is a marketplace and market forces apply so the issue of comparative sales is a big one and this data is very hard to get at present !
May 22nd, 2008 at 7:57 pm
James - fantastic idea, as long as no one expects the holy grail!
Going through it at the moment & have the benefit of a friend who works for a guy that is in the Forbes top 250 & all he does is buy, chop up, improve & sell businesses.
I by no means have the holy grail, but what is becoming clear is that it is really about a mixture of:
1. NPV
2. Uniqueness of brand, product, design, distribution & IP (hurdles to competitors)
3. Risk
4. Tension
5. Emotion
Rull of thumb multiples are a start & there are databases available, however, rule of thumb for an FMCG business is around 10 x earnings or 1 x revenue (different by country & category). Throw in projected earnings, risk & third party tension & you get the situation of Coke paying a reported 4.1 Billion US$ for a company with revenue of of only 360 Million US$ (Glaceau Vitamin Waters). I am sure it had something to do with the 10 year NPV from projected roll out, however, I am also sure the final figure had a lot to do with “we’ll go to Pepsi” & the fact that Coke see’s it’s innovation as pretty poor lately & may be a bit emotive because they are loosing their grip on the gloabl beverage market & are no doubt under pressure to get it back.
I think, at the end of the day, you maximise your value by knowing more about who your selling to than they know about themselves, reducing risk & adding tension & emotion…but then, I haven’t quite done it yet…
May 22nd, 2008 at 9:57 pm
There is more than one way to skin a cat my friends. The traditional DCF based version which I suggest is in general poorly done or understood, (good financial models make compelling arguments, but take time and some serious work) is certainly not the only option.
There is also a strategic approach which is gaining eminence now. We generally value the business in terms of what its worth to us rather than the right buyer… therein lies the holy grail…
May 22nd, 2008 at 11:31 pm
Hi James,
Your subject for the next issue is timely. I am evaluating buying an existing business whose owner said he wants to be paid $20M for it. Is it worth the price he mentioned?
After all the analysis and valuation approaches have been done, I will come up probably with a different figure and now the fun begins. Will the owner accept my offer? Will I accept his offer? Can we agree on a common price? At the end of the day, the value of the business is based on what we will agree its worth. It does not matter if the selling price is higher or lower than its real value but if the deal is not done, that figure is meaningless until a buyer agrees to buy it at that amount.
But I look forward to reading your next issue.
May 23rd, 2008 at 9:47 am
This is a great initiative. Valuation is the number one question that I get from start ups seeking capital and from people looking to exit.
In fact, valuation is what I do just about every day. I am looking forward to the blog and participating.
Have a look at my blog www.tomthemoneyman.wordpress.com for some of my other thoughts on investment, finance, economics and business.
Cheers
Tom
May 23rd, 2008 at 12:34 pm
Sounds like a fascinating thread, and I look forward to reading what you come up with, and contributing if I can add anything.
I suggest you separate the issue of Valuation from the Deal Value question. In abstract, Valuation is what the business is worth now, on its own and as it stands, and is something that you can assess with the business owner (as we often do) at the start of any sale/investment process, and is generally done by looking at the various different valuation methods (particularly DCF) and taking a middle ground somewhere. This gives you an abstract number that we use as the ‘keep it’ value - accepting a deal below this is probably losing you money (although there may still be reasons to do so).
Deal Value, however, is what a buyer/investor is willing to pay, and hopefully a higher value. You can put a ceiling on this by looking at the business plan for the combined (or post-investment) business, and doing the same abstract valuation exercise. We call a Strategic Investor someone who has other things to bring to the table - most often an existing complimentary business to combine with yours. This will hopefully improve the value of the combination with relatively limited additional cost to the buyer/investor, although a control cost to the vendor/investee.
This why we see strategic investors almost always putting a higher value on businesses than purely financial investors.
The difference between the two is effectively the value created by the deal (after you remove the valuation of their business as a standalone). Negotiation of a deal is usually about how to split up this additional value created - and if there is no additional value created, you each need some other, strong, motivation if you’re really going to get a deal done.
But at the end of the day, valuation is an abstraction, and the deal is the only real thing - which is why we spend a lot of effort getting from one to the other.
Cheers,
Paul
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[…] This is a question that we posed earlier this year when we offered to run a blog series on the ‘black art’ of business valuation. […]
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