Let’s explore a number of methods to value your business. Many buyers use a combination of methods, throwing out those that do not fit the appropriate form of business.
Corporate Valuations Using Various Methods
There are at least ten recognized ways to value a business. Some are inappropriate for young businesses or those engaged in certain enterprises, such as software development – where fixed assets are not usually important enough to use for purposes of valuation. Here they are, with short explanations of each:
1. Sales Multiple:
The usual limits for use of a sales multiple for valuation are from .5 to 4 times gross revenues for similar businesses. There is some latitude based upon the growth of the Company, using trailing (last 12 months), actual (fiscal year projections) and forecast (next twelve months or next fiscal year). For some businesses, when purchases of goods for resale are a large component of cost, the value is determined after first deducting all cost of goods purchased from third party sources. (A $3,000,000 business engaged in resale of hardware costing $1,700,000 would be valued as if it were a $1,300,000 business for this purpose.)
2. Price Earnings Ratio:
This traditional method of valuation has been applied to companies in all industries and is the most often quoted method of valuation for public companies. A P/E multiple of between 5 and 30 is common, with growth of company and growth of industry directing the selection of the number. The market sector in which the company works usually has a narrow range of price earnings multiples. You can find that average number in the quarterly Business Week Magazine report of public company earnings, among other resources.
Earnings for this, and other valuation methods below, are usually based upon net income after taxes (or reserve for tax), but sometimes are calculated before deducting interest and tax, with the assumption that borrowing is a function of capitalization, not earning power, and tax is a reflection of a company’s current status within a multiyear tax planning horizon, perhaps with previous losses shielding present tax liability.
3. Free Cash Flow Model:
[Email readers, continue here…] This method is often used to value privately held companies with a range of five to eight times the cash available to spend after operating expenses are paid. Free cash flow is important when the buyer intends to finance the purchase using the revenue from the purchased company itself.
4. Book Value Method:
This is the basic net worth of the Company on the balance sheet. It is not relevant for early-stage companies, since the value of the intellectual capital and future growth are discounted entirely using this method. This value is often multiplied by two or three times in growth environments, then used as a sanity check against other methods.
5. Liquidation / Salvage Value:
This value is only used as a minimum floor below which no offer should ever fall. It represents the amount the company or a secured lender would realize in a distressed sale and is never high unless the company owns significant undervalued real estate or fully depreciated working assets.
6. Replacement Value:
This is one of the best ways to create some minimum value, especially for young companies, where the investment in technology has been heavy and the life span of the technology is long. Replacement value goes up where there is a high barrier to entry due to proprietary tools or patents. The problem with using either liquidation value or replacement value is that usually an appraiser is required to determine the value. The cost of the appraisal is often a barrier to a small company’s use of this method.
7. Similar Company Transaction:
A very logical way to examine the value of a company is to base the value upon what someone else is willing to pay for a company like the one being valued. This is often done with public companies. Unfortunately, using public companies for comparison often greatly overstates the value of private enterprises.
Private statistics are rarely available, except when public companies purchase privately held firms and must reveal the amount paid in their 10-Q and 10-K forms for public scrutiny.
8. Recent Same-Company Transaction Price:
This value often sets the basic minimum if there has been such a transaction in a relevant time period. Qualifying transactions would include actual company share sales prices, qualified stock options granted (which are taxable if below market value), valuations by independent appraisers (if used for Employee Stock Option Plans under ERISA or IRS Rule 409a), or internal buy-sell transactions between partners. There is flexibility here, as in any valuation, through the negotiation of how the payment is to be made and over what time period.
9. Internal Rate of Return Method:
Internal rate of return is a classic financial methodology used in valuations, where projected profits are discounted back to the current period. The problem with early-stage companies is that most of them do not have a stable enough history to rely upon the numbers. In more stable environments, the calculation might use up to ten years of projected cash flow, discounted back to present value and discounted a further thirty percent for risk. Technology companies would never use more than five years, and would employ a higher discount factor of forty percent or more. Sometimes, the period is reduced to three years for such high-risk technology companies. To find the valuation using this method, use your projected net income after tax for each of the next three years. Calculate the present value of each of the two future years by deducting seven percent from year two from the net number and fourteen percent for year three. Multiply each of the three results by 70% as a risk reduction. Add the three resulting numbers, and you have the three-year internal rate of return. If the value of your business is so high that it would take ten or more years of cash flow to pay the purchase price for your shares, the company is too highly valued for most investors, unless strategically “buying” technology not cash flow.
10. Comparable Public Company Valuations Method:
One way to find the value of your enterprise is to compare it to similar companies already on the public market. Usually, an investor making such a comparison will deduct about 20% of the value of a comparable public entity in calculating your value, just to account for the intrinsic value of being a public company. This sanity check may surprise you – as many small public companies are now valued at less than their cash reserves, a sign that the market does not expect such a business to be able to become profitable in time to protect its cash on hand. To find the “market capitalization” (enterprise value) of a public business, visit MSN Money or Yahoo Finance and look for “market capitalization” within the summary of financial information for a listed company.
The actual value of a business is often determined as a blended average of the ten methods above, subjectively placing weight upon one or several of these.
Then there’s The Rule of Thumb Method:
There is an eleventh method – but it is one I use only as a rule of thumb to size up the first ten. For early-stage companies, I use the “Berkus Method” approach which you will find with a quick Google search. This one is used only for businesses in their earliest stage in an attempt to quantify value based upon reduction of risks among other measures.
Valuing an early-stage company is not a precise exercise, even if the above methods lead you to believe that there is some precision in doing so. Yet the value of the business is most important to determine at each stage of equity financing to strike a careful and fair balance between the needs of the entrepreneur to retain control at the early stage and of the investor to find the opportunity for reward to offset his risk of investment.
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