When I was a kid, back in the late 1960s and early ’70s (yes, I am that old!), families would take long trips in cars, driving across the country.
I’m from Texas, so we would drive to California or Wyoming. At that time there were stretches of highway, sometimes for a few hundred miles, where there were no gas stations.
Cars back then were not very fuel efficient, so you had to make sure you had enough gas to get to the next gas station, or you could run out and get stranded.
Funding a startup is a lot like that — you have to plan far in advance for your funding rounds to ensure you raise enough money to carry your enterprise to cash flow positive, or at least to your next funding round.
Just as with a long trip driving, you need to plan for any contingencies — stopping to see the sights, detours, stopping for bathroom breaks, for food, etc. You don’t just plan to have the bare minimum amount of gas to get from one gas station to the next.
The same is true for startups — you need to raise enough money to get from point A to point B, plus enough of a cushion to address any possible unforeseen issues that may arise. In general, it always takes longer than you expect and it always costs more money than you thought it would.
In later articles I will dig much more deeply into structuring funding rounds. This article addresses one of the key aspects of structuring a funding round — company valuation.
Determining the appropriate valuation for your business is critical for fundraising, but it is also important for many other reasons. Attracting, compensating and retaining key personnel is one of those reasons. Complying with IRS requirements is another.
Now that we have established the importance of company valuation, let’s discuss how to determine an appropriate value for a business.
There are three basic methods for valuing a private company — asset method, income method and market method. In practice, entrepreneurs (or the consultants they hire) can use any of these, or sometimes can use a hybrid or combination of these.
Additionally, there are methods that are derivatives of these, like the “First Chicago Method” that can involve some aspects of more than one of these basic methods.
The asset method determines an estimated value of the enterprise by placing an estimated value on each asset of the firm, and then adding up those individual values to estimate the overall value of the business.
With this method, both tangible and intangible assets must be valued. Tangible assets are typically fairly easy to value — things like capital equipment, vehicles and the like can either be valued based on current market value (what they could be sold for), or book value — the value on the balance sheet.
For companies that have been in business for a longer period of time, book value can drift farther from market value, but for most early stage businesses book value should be pretty close to market.
The tricky part of the asset method is valuing intangibles. Intellectual property (IP), which most early stage companies tend to have, can be very difficult to evaluate in terms of valuation.
Valuation of IP is, essentially, a bringing together of the economic concept of value and the legal concept of property. The presence of an asset is a function of its ability to generate a return and the discount rate applied to that return.
The cardinal rule of commercial valuation is the value of something cannot be stated in the abstract; all that can be stated is the value of a thing in a particular place, at a particular time, in particular circumstances.
A deeper discussion of IP is beyond the scope of this article, and I will address IP in greater detail in future articles, but for purposes of company valuation, IP tends to be the most valuable asset of the typical early stage firm, at least in our market, which has a heavy focus on technology and technology-related products and services.
For IP that has been formally protected through patent or trademark, valuing it can be much more straight-forward. We can look at either the investment in the IP (cost basis), or find comparable IP in the marketplace (assuming there is something comparable), and look at how that asset has been valued.
Gaining access to comps can be incredibly difficult for and from private companies (more on this below). If we can find sales or licensing of IP that is similar, this can provide a good basis for valuing IP.
As mentioned above, determining the total investment (cost) of the IP, or the cost to replace (recreate it) can serve as a good valuation metric.
Once a value has been established for all assets, tangible and intangible, we can add those values together to establish an estimated value for the enterprise as a whole.
The income method is the most common way of determining the value of a business. If you went to business school, or took just about any finance course, you are probably familiar with the discounted cash flow method.
As with all of these approaches, there are various assumptions we can use to create a discounted cash flow (DCF) model. Typically, we would develop a five-year forecast of operations, and then use the weighted average cost of capital (WACC) to discount those projected future cash flows back to present day, to determine the estimated value of the business.
Determining the WACC can be fairly involved. You need to determine your cost of debt and equity, an appropriate tax rate and other inputs. Significant financial modeling skills are required for digging deeply into this method.
There are a number of challenges to using this method. First and foremost, the typical startup or early stage business doesn’t have any cash flow.
While a DCF approach typically relies on a forecast that is based on current operations, we can build a five-year forecast purely based on assumptions about our future expectations for company performance.
Entrepreneurs will need a detailed financial forecast for their business plan, private placement memorandum and any associated investor materials, should they need to pursue funding, and this same forecast can be used to generate a DCF model for valuing the business.
However, the more assumptions we have to make to develop a model, or a valuation, the less reliable or compelling will be that model or valuation. With that stated, investors are likely to challenge any valuation we present to them. The strength of the assumptions used determines the relative bargaining power of the entrepreneur, at least to some degree.
If your business is more developed and you have sales and cash flow, the current year’s performance should be the basis of the forecast. Future growth rates for the five-year forecast can come from internal estimates, based on customer acquisition and the expected ramp-up in sales efforts, or from external sources — comparisons with other companies at similar stages of development in similar product or service categories, to the extent that this information is available.
With this approach, once you have your discounted cash flow, you would typically use a multiple of cash flow (or EBITDA — earnings before interest taxes depreciation and amortization) based on similar company’s multiples of cash flow, and multiply that multiple by your discounted cash flow value to get a company valuation.
The market method, or market value method, used comps — comparable company valuations, to determine the appropriate value for the business.
It can be difficult to find values of other private companies, but one way to work around this is to look at recent acquisitions that are similar in terms of product, service, industry, market penetration, size, etc. Often when companies are acquired, the price is published, which provides a data point that we can use.
Usually we try to find as many comparables as possible, and then take some kind of average or a weighted average, depending on the relative sizes/stage of development of the comps in comparison to our company.
With this method, finding the comps is the tough part. The more novel your business, product, service, etc., the more difficult it will be to find comparable private company sales. We can also use public company information, again using comparable companies, to the extent we can find them.
Typically, we can determine the current multiple (multiple of market capitalization — or enterprise value — divided by EBITDA) from the financial information for comparable public companies, which is readily available.
Often, with public companies, we will need to apply some kind of discounting factor to adjust the data since we are applying the public company information to a private company valuation.
Public companies have easier access to capital, are readily liquid since they trade on public exchanges, and are typically much more developed, so we need to take those factors into account when trying to make a reasonable comparison to our company.
We can adjust the multiple down or up, depending on our evaluation of the relative comparability of our firm with the average publicly traded company in the peer group we have created.
As mentioned above, there are hybrid or combination approaches we can use, taking aspects of these basic approaches to help us establish a more accurate valuation.
One method I have used is to create three scenarios. This is similar to the First Chicago Method. Typically, I use a best case, realistic or base case, and a worst case.
The best case it usually the one based on the financial forecast I have created for my business plan, or PPM. If I am using a multiple of EBITDA, my best case will be a multiple of the EBITDA from my forecast.
From that best case, I can apply some kind of discount to the multiple for the base case and worst case, or I can adjust the EBITDA forecast down by some percentage.
Once you have your three scenarios, you can take it one step further by assigning a probability to each case and then calculate a final valuation using those probabilities.
What I have presented above is a very general overview of some of the possible approaches an entrepreneur can take to establish a valuation for their firm. Each of these methods requires significant financial forecasting and analysis skill and knowledge. There are some software packages that can be used to complete some parts of this complex process.
The key takeaway should be that determining an appropriate valuation is not an exact science, but it critically important to the entrepreneur’s ability to fund and grow the business.
There are many specialty valuation firms that can determine a valuation for any business. The cost of these services can vary greatly depending on the firm doing the work, and the complexity of the business being valued. Prices range from a few thousand dollars to tens of thousands.
Regardless of whether you decide to create your own company valuation, or hire an expert, the methods discussed herein will at least give you a starting point from which you can understand the basic approaches available, and the steps required.
As with everything, you can look to the Internet for more information on any of the topics I have discussed.
— Craig Allen, CFA, CFP, CIMA, is president of Allen Wealth Management, and has been managing assets for foundations, corporations and high-net worth individuals for more than 25 years. He can be contacted at craig@craigdallen.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.