What is Business Valuation?
In simple terms, business valuation is how much someone would pay to buy the company. While many business owners place sentimental value on their business ventures, there are many reasons to determine a more grounded, realistic value.
If you’ve ever watched the show “Shark Tank,” you’ve watched as the “sharks” (investors) demanded details from contestants about how they arrived at their business valuation. Contestants who fail to offer a valid rationale for their stated valuation often find themselves without an investment at the end of their pitch. It’s a great example to illustrate just how vital a proper business valuation is to investors.
Why is this number so important to investors? It’s their first indication as to whether they will make or lose money on their investment. If startup founders offer an investor a 5% ownership stake for $1M, they are basically saying that their business valuation is $20M. If the investor doubts that valuation, they won’t agree that 5% is worth the $1M.
As important as the valuation is, there’s no one way to measure it. The Motley Fool describes three methods for determining a value for an ongoing business. One, multiple analysis, holds that, generally, a business is worth two times its revenues or five times its cash flow. Another, which it says is a more conservative method favored by banks for business loans, emphasizes physical assets that could be sold off if the borrower defaults.
There are plenty of reasons why a business should know its valuation, beyond seeking investors. These include:
- Determining the value of ownership stakes when there is more than one partner or their degree of ownership changes
- Planning for succession
- Determining the optimal amount of insurance to carry
- Planning for retirement when the business is your biggest asset
- When deciding to sell the business or buy another
Pricing the unknown
Valuation can be especially tricky for startups. These companies’ track records are short, but a compelling story about a startup’s bright future can go far. Startups.com describes 10 approaches to calculating valuation. One method looks specifically at human capital, the “value of ideas, know-hows, and human potential of the team,” and more measurable things like market size. Another emphasizes a startup’s customer base and what it costs to acquire, keep, and monetize them.
Investors also look at where a startup is in its stages of development. For example, investment firm Lighter Capital has “pre-money” valuation methods for startups that have yet to receive any funding. It also has “post-money” valuations for those that have obtained outside funding.
Selling stock can be a great way for a business to raise capital, but it means a whole new world of valuation analysis for its initial stock price. A business going public will work with an investment bank that’s registered as a securities broker with the Securities & Exchange Commission (SEC).
The investment bank’s analysts undertake a process similar to a business valuation, an almost alchemical mix of tangible financial data and intangibles such as:
- The company’s potential
- The timing of the sale
- The personality of the founders or CEO
The investment bank is motivated to get this valuation right because it underwrites the initial sale of the stock. That means it’s on the hook to buy any unsold shares.
This initial stock valuation determines what is called an offering price to institutional and accredited investors. Once investors put their shares into the securities exchange markets, the opening price — what the stock sells for on its first day of trading — is set by the market itself.
Of course, there is no such thing as a free lunch, and the capital that can be obtained through the sale of stocks comes with a steep price. These costs include the time and costs needed to prepare for an initial public offering (IPO), as well as a host of regulatory requirements. Making your company public also means that your formerly private business performance will thereafter be public information.