Now, you simply can’t imagine the surprise I got today morning when I realized that for some unknown reason my blog for last weekend was not published. That blog was entitled Critical Lessons from Steve Jobs That Every Entrepreneur Must Know – Part 2. I diligently worked on the blog and finalized everything, did a preview of the post and thought I hit that last button to publish. I seemed to have gotten too busy during the week and never went back to the blog, only to get this shocker this morning. Anyway you have the blog published today, plus the below that I’m also shooting right now.
Today I will write about business valuation. I will write about some key issues regarding business valuation that an entrepreneur should know. Of course I know that many entrepreneurs out there are gurus in this, so probably may not get so much value from this. However, some entrepreneurs have no clue about this animal called valuation, and certainly need some tips. Time may soon come when they need to carry out valuation of either their own business or someone else’s business they intend to buy. I always say that a clueless entrepreneur will oftentimes make serious gaffes, so better be warned!
Can we now take a look at some of these facts?
- There are several reasons for valuing a business. The majority of people think that business valuation is not required often and can only be used when selling or buying a business, or determining how much equity to give to investors or partners. This is not the case. Other uses of business valuation include obtaining credit from financial institution (though these focus more on cash flows), strategic planning, estate planning, tax planning and reporting, litigation support relating to fraud, bankruptcy, shareholder disputes, marital disputes, Additionally, as an entrepreneur grows his or her business over the years, it’s advisable to know the value of the business once every few years at a minimum. Some entrepreneurs however, prefer to know the value of their business every year. The choice is yours Mr. Entrepreneur, but be smart. Remember, when you have a sizeable business say employing 100 or more people and you look blank when someone asks you the value of the business, you might not look smart at all!
- There are several methods of valuing a company. Valuation methods are usually categorized into cash-flow based (income approach), asset based (asset approach) and market based approach. All these approaches tend to be multiples-based, hence the notion that the multiples based approach is the most common. Income based approaches could use discounted cash flows, economic value added methods, earnings capitalization, build-up method, and excess earnings method. Projected cash flows have historically determined valuation of businesses in most cases. This is why the EBITDA (earnings before interest, tax, depreciation and amortization) approach is very common. When the EBITDA is derived, a multiplier factor ranging from 3 to 10 or even more could be used, with the multiplier dependent on several factors and also being non-static over time. It’s vital to mention here that it makes more sense to use present cash flows (with future projections based on current realities) because future cash flows are quite uncertain and moreover, future cash flow is the sweat of the new owner and not the old owner in cases where the business is being sold. Future cash flows are estimated based on the going concern assumption but if the business is being liquidated to satisfy creditors then a number of things change. Pre-money (before investing money) or post money (after investing money in equity) are valuation options that need to be clarified and understood. Additionally, in industries where major investments in fixed assets are needed to sustain growth, normally what is called free cash flow (FCF), defined as EBITDA less capital expenditure is used. Business valuation could also be based on multiples of sales revenue, price earnings ratio method (for public companies), multiple of gross margin, etc. In the internet world some unique factors such as unique monthly visitors at a website also have impact on business valuation. The asset approach considers both the tangible and intangible assets, and the liabilities in determining the value of the business. The asset approach has the alternatives of using the book value, liquidation value or replacement value. You could also use the market approach which compares the business with similar businesses in the industry. That’s pretty enough for this point, as I’m not going into any calculation dynamics for today. In any case you can simply go and study that, or even consult if you like. Ok?
- A host of factors and considerations need to be taken into account while valuing a business. My dear entrepreneur; let me warn you here that so many factors influence business valuation. This is an important fact about business valuation that you should know. A good starting point would certainly be the numbers if they are available and they make some sense. After looking at the numbers (as explained briefly in point number 2 above), look beyond the numbers into several non-financial aspects. Beyond the numbers other factors include the reason for the valuation, why the seller is selling the business (if valuation is for sale), whether the sale is under duress (such as auction) or not, the state of the economy, stage of the company development, competition, regulation, the quality and age of fixed assets available, intangible assets available, whether the buyer is a strategic buyer or simply a financial buyer, the person valuing the company, the industry, whether the business is a private one or public, the management team in the business, impact of speculation, projected future performance, capital available etc. Don’t you now agree with me that a host of factors determine valuation of a business? You simply need to remain focused and only use the relevant facts; otherwise you may get drowned in the multiplicity of factors above.
- Valuation process is not a hard and fast science. While most business valuations are based on numbers or calculations, in practice and in the real world business valuations could be full of ambiguity, tricks and might not entirely rely on quantitative issues. Goodwill or the intrinsic value of a business, which might not even be expressed in the numbers you are looking at, is another important element. Again, where the business being valued for sale is heavily indebted or under threat – it’s a different story. Mr. Entrepreneur, never be intimidated by this complexity in valuation. Being an entrepreneur, you have got to understand this element of your business and face valuation challenges head-on just like you do to other business challenges. You can make it simple – Yes You Can! Do you understand me? Come on!
- Valuation of startups is oftentimes an illusion. Now, business valuation even gets trickier with start-ups! I mean, what fundamentals do you have for startups? What historical numbers can support your projections and other calculations? In this case, you hardly have a strong foundation and history to base your valuation on. The true value of a business is indeed determined in the market place where it operates, but what about a start-up whose name alone could be largely unknown and could even sound in a way that makes children run away! Oh, what a nightmare it could be! Nevertheless, you don’t need to worry too much. If you read and consult a little bit, you will have a starting point. The business idea and potential are critical to consider for startups. I guess you have seen some millionaires pour astonishing amounts of money in startups. Don’t think that they are mad. They are not. They are very sane. On their side, they may be looking at your conservative idea that makes you refuse to invest in that startup, as old school and entirely dumb and clueless. They may be seeing and sensing things that you don’t!
- There are always conflicting opinions about the value of a business depending on different perspectives, and many valuations do not match selling entrepreneurs’ expectations. The seller wants the best, and the buyer or investor also wants the best deal. As an example, an entrepreneur inviting a venture capitalist to invest money in his business would want a high value so that he gets more money in exchange for a smaller portion of the business. The venture capitalist on the other hand will be working towards greatly undervaluing the business so that he takes more control or shares in the business. What is important is that you work for a win-win situation based on your objectives for the deal, and if you don’t agree (which is a possibility), please don’t call each other names. It’s simply a business negotiation with a non-agreement, just like walking out of a boutique because you think the seller has seriously overpriced an item. Don’t lose your cool. Ok? The entrepreneur’s grandiose expectations arising from false or inflated opinion about their business, early stage traction yet with unproven business model, lack of research and understanding of the market, psychological attachment to the business, and other factors might all be far from reality. So, different and conflicting opinions are normal. This is another important fact about business valuation to know.
- The date of valuation of the business matters and a business can have several values depending on some of the factors above. By the way, don’t go about waving with pride a business valuation report done ten years ago, to make your business case now. Times and things change. If you need a business valuation report now, please redo the valuation instead of springing up with a ten year old report. It makes you look smart and tuned to current realities. Again, don’t shout unprintable words to someone who has come up with a business valuation you don’t like. Where there is contention about the valuation of a business a reasonableness test could be done by an independent party. It’s good to use experts (preferably accredited appraisers or valuation technocrats) for business valuation but don’t be cheated into losing an arm because of this. Use common sense. Qualified valuation consultants give more comfort to investors as they are usually more objective and experienced.
I think the above is enough for today. I believe they are important facts about business valuation that every entrepreneur needs. Possibly another day I could write more issues on business valuation. Stay tuned!
Till then, have a blessed new week.
The Wise Entrepreneur