How do you value a start-up business – The art of valuation
This article is about how do you value a start-up business, and has been written by Russell Bowyer.
So why would you need to value a start-up business?
One reason is when you are looking to sell equity to raise capital for expansion. Especially where bank finance is not available or not an option.
In this situation a valuation of your business will be necessary.
Many of us have watched Dragons Den. We’ve seen business owners get hammered by the dragons where their valuation is too high.
It is much easier to value an established business.
There are many models to obtain a value for an established business. The most popular valuation model is to work on a multiple of profits.
However, with a start-up business, profits may be either non-existent or very low. The business is even more likely to be suffering losses.
The other problem is the lack of history, as most buyers buy based upon historical data. In many cases looking back between three to five years.
The importance of this is to establish a pattern. Where profits have been stable for the last three to four years, or if they’ve been steadily growing, there’s no reason to suppose this trend will not be maintained.
With a start-up business there is less of a trend to base a valuation decision on. Which is made worse where the opening years are loss-making. This makes it much harder in the case of a start-up to predict the future, which for established companies is a challenge in any case.
Selling the future…
With a new business, the owners are much more likely to be selling the future. They will be focused more on the potential of the business.
However, in my experience, even with established businesses, the vendor is always extolling the virtues of the future potential of the business.
They are trying to push up the perceived value by talking the business up.
Confidence makes all the difference
The advantage the established business owner has over the start-up one is confidence.
The buyer of an established business can choose whether to take account of future potential or not. However, what they do have, is the historical data to back this up. Whereas, a newly established company doesn’t have much history to rely on.
The mismatch gap between buyers and sellers on new business valuations is usually greater. It is usually much more of a challenge to bridge that gap too.
What are the other considerations for business valuation?
Using benchmarks from similar businesses is useful.
However, this assumes the business is in an already established market place.
With a completely new type of business where the owners have invented something, this is more difficult.
It is also notoriously difficult to find reliable data on an industry, especially data specific to smaller entities.
The entrepreneurs will more than likely have to buy the information from a database type service. But reliable and sound background data could be the make or break of getting an investment.
Emotions play a big part in the investing process
Emotions are another big factor that come into play when valuing businesses. This emotion is on both sides of the fence too.
The business is the entrepreneurs ‘baby’ and they will have an emotional attachment to it. They are more likely to place a much higher value on their ‘baby’ than an outside investor will.
On the other side, the ‘gut-feel’ emotion can play a big part in getting an investment. This is reliant on the investor having a gut feeling that the business will succeed. It can also depend on whether or not they intend to get involved in any capacity or not. Their involvement could have an impact on the level of success of the business too. It could affect the investment decision outcome too, and it may also be a condition of the investment by the investor.
Emotions can play big part where you are seeking investment from more than one investor. This is true in a crowdfunding scenario.
The human instinct is the need to join a queue and many have the sheep follow mentality. Usually, once you get the first investor or two on board, others will join. The first investors have given the investment their thumbs up, so it makes it okay for others to join too.
This is better explained by way of an example:
- XYZ Limited is owned by two equal shareholders who started the company investing £50,000 of their own money.
- In addition to their own capital, they also secured a bank loan against their own property of a further £50,000.
- The business has made a small profit of £10,000 in year three, but in the prior two years a loss was made totaling £85,000.
- The directors of the business are predicting a profit of £25,000 in year four and 75,000 in year five after the investment.
- The company is looking to raise a further £50,000 of equity to expand their production and are offering a 10% stake in the business in return.
On the basis that the investors are paying £50,000 for a 10% stake, this makes the business worth £500,000 (i.e. £50,000 x 10).
The cumulative loss of the business sits at £75,000. Although I’m sure the owners will be trying to ignore or overlook this fact and will be focusing on the profit made in year three. They will also be drawing the investors attention to the profits forecast in years four and five.
There are many businesses that defy normal investing logic and some have proved the investment to be sound. I’m talking about companies like Amazon, Facebook and other large internet start-ups.
Amazon made huge losses for quite some time before the investors saw a return on their investment. The company was valued based upon huge future potential. The early investors will now have been paid back in buckets by now though. The same will be true for Facebook investors and similar businesses.
However, lets assume for the above example that the investors are not willing to take account of future profits. Their logic for this is they are investing now. With ‘Now’ meaning, what the business is worth at this point in time, and not what it is worth in the future. What has it achieved in profits so far?
If I were being generous, a multiple of 5 times profit would be pushing it. This would put the business at a generous value of £50,000 (i.e. £10,000 profit x 5; ignoring the losses).
This value is a long way off the £500,000 value they’ve placed on the business. Well actually, to a factor of ten.
However, now turning to the future, if the company does make a profit of £75,000 in year five, the investors will own 10% of this. 10% of £75,000 equates to £7,500.
However, cumulatively the company has only made £25,000 profit. A company can only distribute dividends out of distributable reserves. So in this case they’d probably only receive a maximum of £2,500, or 10% of £25,000. This assumes the company is distributing all of its profits, which is unrealistic, as it will need to retain some of the profits for working capital and future growth.
However, by year five if it is making £75,000, and by using the same profit multiple of 5, the business would then be worth £375,000.
Assuming the company were to distribute say 50% of its profits, this equates to £1,250 in dividends. This represents a 2.5% return on investment (ROI). Not a great ROI.
So what can the business owners do in this situation?
Negotiation is normally the first step in any investment process. To begin with, the investors could ask for more equity. Start-up company owners need to bear in mind that investors tend to have targets for the return they expect on their investment. So if the return they are suggesting is below the investors target, it will be a non-starter.
For example, if they wanted a 20% stake instead this down-values the business immediately to £250,000. However, in year five they’d receive 20% of the dividend, or £2,500. This represents a ROI of 5% now, which is better, but still not amazing. However, assuming the above valuation of £375,000 at this stage, the investors have made £25,000 on their investment money (£375,000 – £250,000 = 125,000 @ 20% = £25,000).
The above scenario only gets better the higher the percentage stake. Plus not forgetting the importance of the percentage owned in the eyes of the law. For example, a 25% stake will give the investors more influence over the company.
However, the existing owners would have to be happy to retain 37.50% each after the invest. They will have to consider the phrase; ‘having a lower percentage of something that is worth more is better than having a higher percentage of something that’s valued less.’
Another negotiation tactic is to review the type of shares held and the return the investors get. For example, you can issue A and B type shares and alter the dividends on the share types. There are also preference shares, however, these don’t normally carry voting rights.
Ultimately the valuation always boils down to what someone is willing to pay…a willing buyer married to a willing seller.
What should the sellers focus on to encourage investment?
As a start-up has less solid data to rely on, there is much more judgement involved about the company’s potential.
In which case the entrepreneurs need to paint as rosy a picture as possible, taking the following into consideration:
– Growth and how fast the business is growing
Taking account of the principle of ‘time value of money’ (i.e. money is better receive sooner), if a business is growing fast the investor is more likely to get his return sooner.
So the start-up entrepreneurs need to convince the investors that the speed of growth is going to be such that they get their investment back fast.
If early returns are important to the investors, this will be key.
However, the investors will need to trust and believe what they are being told.
– Profitability of the business
As already discussed, most businesses are valued on a multiple of profits. So assuming the investors are willing to believe the numbers, by demonstrating good profits as soon as possible, they are much more likely to invest.
This is where a sound business plan with good research of the market and the competition is crucial for how plausible your forecasts are.
Having sound facts and information about the size of the market, combined with a realistic appraisal of how much the company’s share of this market will be, could be the difference between an investment or not.
Having a USP (Unique Selling Proposition) will help greatly, especially when you are breaking into an already established market.
– The exit strategy
Value on paper is completely different to an offer and a sale at that value. Selling businesses is notoriously difficult, so you’ll need to discuss what the exit strategy is. Investors may or may not be looking to exit within 5 to 10 years, that depends, but you need to address this point.
There are a number of options with this. It could be that the whole business is to be sold at a set point in the future. This will provide the investors with their final ROI.
Alternatively, the owners could to include in their plan how they intend to buy-out the investors stake themselves instead.
A further option is to find future investors to buy-out the initial investors.
The final option is to float the company. In this case the investors will be more than happy to wait for this to happen, as their potential ROI could be huge.
I hope this article has helped you if you are looking for investment into your start-up business. If you enjoyed reading this article on the How do you value a start-up business, please share it on your favourite social media channel below. Thank you for reading inBusiness Blog.