Quite simply, business valuation is a process and a set of procedures used to determine what a business is worth. Entrepreneurs need to put a value on their startups in order to raise money, and investors need to put a value on their investments to generate liquidity. Entrepreneurs tend to place a high value on their businesses; however, investors are the ones that determine what your business is actually worth. Although this doesn’t seem to complicating, getting your business valuation done right takes preparation and thought.
This newsletter will first analyze how a business receives a fair valuation, through three distinct approaches. And second, discuss how a Valuation Risk functions and negatively affects the market and investor confidence.
APPROACH 1: ASSET APPROACH
The asset approach views the business as a set of assets and liabilities that are used as building blocks to construct business value. The asset approach is based on the idea of: What will it cost to create another business like this one that will produce the same economic benefits for its owners? Since every operating business has assets and liabilities, a way to address this question is to determine the value of these assets and liabilities. The difference is the business value.
The challenge is to figure out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then determining what each asset and liability is worth. For example, let’s analyze business balance sheets. They may not include the most important business assets, such as internally developed products and proprietary ways of doing business. However, if the business owner did not pay for them, they don’t get recorded on the “cost-basis” balance sheet. Therefore, the real value of such assets may be far greater than all the “recorded” assets combined. A test for this business approach is to discover what its special products or services are. And then ask if these are the ones that make it unique and bring customers in the door.
There is some room for interpretation in the asset approach Such as, deciding which of the company’s assets and liabilities to include in the valuation, and how to measure the worth of each.
APPROACH 2: MARKET APPROACH
The market approach relies on signs from the market place to determine what a business is worth. Here, the economic principle of competition applies:
What are other businesses worth that are similar to my business? If what you do is successful then chances are there are others doing similar things. If you are looking to buy a business, you decide what type of business you are interested in and then look around to see what the “going rate” is for businesses of this type. Conversely, if you are planning to sell your business, you will check the market to see what similar businesses sell for.
It is intuitive to think that the market will settle to some idea of business price equilibrium – something that the buyers will be willing to pay and the sellers willing to accept. That’s what is known as the fair market value. The business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties must act in full knowledge of all the relevant facts, and neither being under compulsion to conclude the sale.
Ultimately, the market approach to valuing a business is a great way to determine its fair market value – a monetary value likely to be exchanged in an arms-length transaction. This is when the buyer and seller act in their best interest. Market data is great if you need to support your offer or asking price. An effective way to think of it is “if the going rate is this much, why would you present more or take less?”
APPROACH 3: INCOME APPROACH
The income approach takes a look at the core reason for running a business, making money. Here the economic principle of expectation applies: If I invest time, money and effort into business ownership, what economic benefits will it provide me?
Since the money is not in the bank yet, there is the risk of not receiving all or part of it when you expect it. So, in order to figure out what kind of money the business is likely to bring, the income valuation approach factors in this risk. In continuation, since the business value must be established in the present, the expected income and risk must be translated to today. The income approach uses two ways to implement this translation:
Business valuation by direct capitalization
This method basically divides the business expected earnings by the capitalization rate. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two.
For example, if the capitalization rate is 33%, then the business is worth about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. In both forms, the result is what the business values today.
Valuation of a business by discounting its cash flows
This method works very differently than the one stated above: First, you project the business income over some period of time. This is usually measured in years. Next, you determine the discount rate which reflects the risk of getting this income on time. Last, you figure out what the business will be worth at the end of the projection period. Finally, this method’s calculation gives you the present value of the business. Ultimately, what it is worth today.
Valuation risk is the risk that a financial asset is overvalued and will equate to less than expected when it matures or is sold by the person who holds it. There factors to valuation risk may include incomplete data, market instability, and poor data analysis by the people responsible for determining the value of the asset. This risk can be a concern for investors, lenders, and other people involved in the financial industry. Overvalued assets can create losses for their owners. There are two primary steps individuals fail to take, leaving them in an at-risk situation. Uncertainty valuations, and Communication issues.
The first and probably most common risk on investing ventures is that the value the project is delivering is not known to those who should know and understand it. In order for a project to deliver the right product for investors to feel confident about, the business for that project needs to be known and clear. All too often this is not the case. We see three reasons why this uncertainty occurs: The project has no value, the value for the project is unknown, or the project doesn’t deliver the value it expected. A simple way to resolve this issue is to realize and become familiar with the start-up business you are investing in. If the value is not known, stop the project until somebody knows the business value of it.
This risk occurs when teams work on a project without properly understanding the business value. Although this is similar to the previous risks, the difference is that the teams faced with this uncertainty invent a business case and deliver their made up business case. This case is often not explicitly stated and so there is no way for the investor to know that the project team has properly understood why the project has been funded or created, until it is too late.
Investors are usually less familiar with “protect revenue”. If a team believes their project should increase revenue, the team will often distort the requirements until they increase revenue, rather than protect revenue.
Start-up valuations are imperative for a business’s success. They allow investor confidence to increase, entrepreneurs to demonstrate the company’s values and assets, and ultimately gain monetary funds. Although they have many positive factors, the Valuation risk of over-investing a non-profitable company is a consequence that can’t be left un-noticed. There are many ways to protect yourself against this, but they can be tedious and trivial. Make sure you are informed and educated on start-up Valuations before making any sort of investment decisions.
If you are interested in learning more about Business Valuations, and how it may affect you, then please contact Larry Horwitz at firstname.lastname@example.org.