How Do Investors Determine Your Valuation
Monday, November 29, 2010
This is discussion I have with a number of clients as they considered the various ways to raise funding for their company. These clients take the various forms like the seasoned executive who is leaving corporate America and wants to start his own business and is not sure which way to fund a new start up, to the young entrepreneur who has been in business for a couple of years and is ready to start out on their own. In either situation, understanding the different kinds of investors and valuation models is important to evaluate for your particular situation and considerations for level of autonomy and loss of control.
Let’s start with the types of investors:
Friends & Family – is typically your first round of money and it is quite literally passing the hat to get your friends & family to throw some money into the new venture. This investing is the accumulation of smaller amounts between $5,000 to $20,000. From a personal perspective, this kind of funding can be risky if the investment does not meet the expectations of both parties and can be damaging to long standing relationships. It is very important to clearly define goals, objectives and milestones to set those expectations appropriately.
Angel Investors – are usually high net worth individuals that will invest in amounts from $25,000 to $ 2 million. They may invest alone or as part of a group of angel investors. These investors may not be well versed in your industry or technology so there will be a level of education and due diligence not necessarily required by a friends and family round and thereby lengthening the funding process.
Venture Capital – This group is viewed as the first round of professional money. They want a sizeable return (usually 10X) on their investment and want a sizeable percentage of the company. This “smart money” comes with tough terms and high expectations for their investment (such as higher percentage of ownership and ratchet provisions for non performance.
Private Equity – This group offers the most sizeable amount of investment through a variety of financing instruments such as debt, equity, warrants, etc. This group will require this highest cost for investment; including higher percentage of ownership, board seats and their own management teams. Some PE firms specialize in turnaround opportunities where they acquire distressed organizations and bring in their own team to turn things around.
Company Valuations Using Various Methods
This list of valuation methods comes from a great mind in this area; Dave Berkus. Dave is a brilliant man who had invested in many high tech companies.
- Sales, Profit or EBITDA Multiple
The usual limits of a financial multiple valuation is a number is used to multiply against a top line number (revenue) or bottom line number (net income) or other variations EBITDA (earnings before interest taxes depreciation and amortization). This can be viewed using trailing (last 12 months), actual (fiscal year projections) or forecast (next 12 months or fiscal year).
- Price Earnings Ratio
This is most often used for public companies. The P/E ratio is equal to a stocks market capitalization divided by its Net Income over a 12-month (4 Quarters) period, called Trailing Period.
- Free Cash Flow Model
This method is used to value private 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.
- 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 intellectual capital and future growth are discounted entirely using this method.
- Liquidation / Salvage Value
This value is only used as a minimum floor below which no offer should ever fall. It represents the value from a distressed sale.
- Replacement Value
Good for young companies where the investment in technology has been heavy and the life span of the technology is long. Value goes up when there is a high barrier to entry. Usually an appraiser is required to determine value and this is expensive.
7. Similar Company Transaction
This logical way to determine valuation looks at what other people pay for like companies. This is often done with public companies; unfortunately using public company for comparison greatly overstates the value of private companies.
- Internal Rate of Return Method
IRR is a classic financial methodology where projected profits are discounted back to the current period. The problem with early stage companies is that most don’t have stable enough history to rely upon the numbers.
- Comparable Public Company Valuations Method
Compare your business to similar companies that are on the public market. Usually, an investor making such a comparison will deduct about 20% of the value for the intrinsic value of being a public company.
Valuing private or early stage businesses is also a function of what type of money you are bringing in. Is it “smart money” or “dumb money”? The difference being smart money comes with investors that can add value and help scale and grow your business. Dumb money is just money, nothing else.
Liquidity (Merger & Acquisition) valuations also have huge ranges depending on the buyer and are they a “strategic buyer” or a “financial buyer”.
The strategic buyer will pay a larger premium for your business because they see a strategic need for your product or service.
The type of investor you will choose is usually a phased approach and depends upon which stage of evolution your company is in. The valuation method used will depend upon whether you are public or private, the stage of your company’s growth and comparables in the market. Comparables being the other companies in your industry or similar growth stage.