“What is My Business Worth” is usually the first question an entrepreneur asks when they decide to pursue a capital raise. Here’s the answer:
Your business is worth what someone is willing to pay for it. Nothing more, nothing less.
That statement is wholly unhelpful for anyone who is trying to understand what their company is worth but it’s important to highlight since many entrepreneurs tend to fall into a valuation trap. They get a specific valuation in their head and are then disappointed when no investors put in offers at that valuation.
If you get multiple offers from investors, they will probably fall within a fairly narrow valuation range. That’s because most investors will view your business through a similar lens and conduct a similar analysis to arrive at a valuation.
Instead of focusing on a specific valuation number that you think your business is worth, it’s more productive to determine a likely range you think investors will pay for your business today. This post will help you do that.
The Price of a Business
In the capital markets, the price of a business is called a “valuation.” There are two types of valuations you should be aware of: Equity value and Enterprise value.
- Equity Value is the price an investor puts on the equity portion of your business. This is often referred to as “Pre-Money valuation” by investors. The Equity Value = the Price Per Share x Number of Share Outstanding. This is most commonly used when raising growth or venture capital.
- Enterprise Value is the total market value of your business. Many businesses are financed with both equity and debt. The enterprise value accounts for these multiple stakeholders. Enterprise Value = Equity Value + Net Debt. (FYI: Net Debt = Debt – Excess Cash.) Enterprise Value is most commonly used when selling all or a portion of your business.
In a perfect world, an investor performs a Discounted Cash Flow Analysis (“DCF”) to determine the appropriate valuation. A DCF projects out expected cash returns for the investor and then applies the level of return an investor expects to receive to arrive at the present value of those cash payments. The present value represents the price an investor is willing to pay for a business today. This is a highly simplified explanation of a DCF, for more information on DCF’s check out this link: Discounted Cash Flows Analysis.
But, we don’t live in a perfect world.
The practice of using a DCF to value private businesses requires many assumptions. You have to make assumptions about the business’s industry, how efficient the company is at deploying capital, how fast the company can grow, etc. A DCF also ignores supply and demand dynamics in a market. Further, for anyone without a finance background, DCFs are complicated and confusing to explain.
So, to simplify valuations for private businesses, the capital industry created two ways to value private companies:
Market Multiple Method
For established businesses with revenue and profitability, the market multiple method is the most popular valuation method. To value a business, investors apply a valuation multiple to either Cash Flow, EBITDA, Revenue or some other industry appropriate metric.
For example: If your EBITDA is $1M and the market multiple is 6x, then $1M x 6 = a $6M Enterprise Value.
How do you find the right valuation multiple for your business?
The multiple an investor will pay for your business is the simplified version of all the assumptions that go into creating a DCF analysis. Here are the primary factors driving valuation multiples:
- Your industry: Some industries are more attractive to investors than others given their growth potential or risk profile, thereby commanding higher valuation multiples.
- Your market position: Companies with market leadership or differentiated offerings command higher valuation multiple. Investors have likely seen several other businesses in your space. They will be able to benchmark you compared to competitors.
- The stage/size of your business: The larger your business, the higher the multiple usually is, assuming other factors about your business are favorable.
- Your historical and future growth: The faster you’ve been able to grow, the higher your multiple usually is.
- Your visibility into future earnings: The more visibility you have into future earnings, the less risky you are and the higher multiple you’ll have. Companies with recurring revenue and high margins have higher multiples.
- Your scarcity value: There is a lot of capital chasing a small number of ideal investment opportunities. If your business falls into this “ideal” zone for investors, investors will pay up to get the deal.
- You: Experienced entrepreneurs with excellent teams command higher multiples than one-person shops or first-time entrepreneurs.
In summary, the lower the risk of losing money and/or the higher your visibility into growing the business, the higher your valuation multiple will be.
You can get a pretty good idea of the multiple range an investor will use for your business by taking a few data points and then applying those data points to your business.
For most businesses, there are companies in their industry or with similar business models that trade on public stock exchanges. By going on free websites like Yahoo Finance, you can find the EV / EBITDA and EV / Revenue multiples for these businesses. Note that small businesses almost always have lower multiples than large public companies (Smaller companies are riskier). Use public multiples as the absolute top end of the range for most industries.
There are usually recent deals in your industry where a company has sold or raised capital. Sometimes valuations are publicly disclosed and available. They serve as a useful benchmark, particularly if you can find information on similar size companies as your business. Comparable transactions are usually why entrepreneurs get fixated on an unrealistic valuation. If a company you perceive as similar to you trades at a very high valuation, then you may expect the same valuation. What you don’t know is how that company differs from your business and the motivations of the investor driving the premium valuation. Don’t go into a capital raise process expecting outlier valuations. Go into a process with a realistic view of where all deals in your space are trading.
For many industries, the comparable public comps and transaction multiples are publicly available through research reports by Investment Banks. Try googling “your industry, valuation multiple,” and you may get lucky and find some good data points.
Investment bankers and advisors who specialize in your industry are often helpful in giving you a rough sense of where valuations will shake out at. They’ll usually give you some range or guidance on what you can expect for free, and if you hire one, they’ll do a lot of work to narrow down where you can expect valuation to shake out at.
Speculative Valuation Method
Speculation: assumption of unusual business risk in hopes of obtaining commensurate gain.
Sometimes it seems as if early-stage valuations are pulled out of thin air with no correlation to the actual performance of the business. In some cases, this is true. In most cases, there is a fair amount of analysis that goes into valuing a startup.
All investors seek to generate a certain level of return for the risk they take investing in private business. Startups are very risky. To compensate for this likelihood of losing capital, investors hope their well-performing investments will generate outsized returns.
To generate outsized returns, a startup must grow very quickly into a big business. Growing this fast is hard work. Teams need to stay incentivized to do this hard work.
When assigning a valuation to a business, a few factors come into play:
- The attractiveness of the company and its team. Some companies check every box for investors and have experienced and capable teams. These companies command higher valuations.
- What the growth plan is. Businesses that want to and can become multi-billion dollar businesses command higher valuations than those who will likely only grow to $10M of revenue before exit.
- The amount of capital being raised to achieve the growth plan. The more capital you raise, the bigger the valuation needs to be to avoid the management team who is running the business from taking too much dilution where they are no longer incentivized to grow the company.
- How likely the investor is to lose money. To put money in at high valuations, investors often require preferred equity and liquidation preferences. This prevents the investor from losing money and shifts risk on to the management team to execute.
The investor will consider all these factors and then back into a valuation today that they speculate will allow them to achieve a certain return in the future when the company exits.
Valuing early-stage and high-growth companies is an imperfect art, not a science. Seek help and trusted advisors to help you determine an appropriate valuation range for your business.