When deciding to sell your business, it’s important to understand what your business is worth from a financial point of view as you enter the M&A process. There are various ways to determine the value of a business, and various reasons to conduct a business valuation.
Here is a comprehensive overview of the business valuation process, including common valuation methods, when and why a valuation should occur, and things to consider following the outcome of a valuation.
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What is a Business Valuation?
A business valuation is the process of analyzing and determining a company’s economic value. Professional evaluators are typically brought in to determine the value of the business. They then use one or more valuation methods to arrive at an objective number.
5 Common Business Valuation Methods
Below are five of the most common company valuation methods:
1. Asset Valuation
To determine your business's worth, this method involves an analysis of your company's assets (both tangible and intangible) using either the book or market value. Count all the cash, equipment, inventory, real estate, stocks, options, patents, trademarks, and customer relationships as you calculate the asset valuation for your business.
2. Historical Earnings Valuation
A business's financial worth can be determined by its gross income, ability to repay debt, and capitalization of cash flow or earnings. If the results of the analysis suggest your business struggles to bring in enough income to pay bills, this will cause the value to drop. Conversely, repaying debt quickly and maintaining a positive cash flow improves your business’s value. Use all of these factors as you determine your business’s historical earnings valuation.
3. Relative Valuation
With the relative valuation method, you determine how much a similar business would bring if they were sold. The calculation is made by comparing the value of your business's assets to the value of similar assets, which then provides you a reasonable asking price.
4. Future Maintainable Earnings Valuation
This method uses the potential future profitability of your business to determine its current value on the market. You can use the future maintainable earnings valuation method for a company’s business valuation when the company’s profits are expected to remain stable. It analyzes the sales, expenses, profits, and gross profits from the past three years before valuing your business’s future maintainable earnings. These figures help you predict the future and give your business value today.
5. Discounted Cash Flow Valuation
If your business’s profits are not expected to remain stable in the future, you can use the discounted cash flow valuation method. It takes your business’s future net cash flows and discounts them according to present-day values. This will allow you to adjust the valuation of your business based on how much money your business assets will make in the future.
For the best and most accurate results, compare two or more methods so you’re prepared for the merger and acquisition process and can confidently stand by the value of your business.
Pre-Money vs. Post-Money Valuations
When selling your business or seeking financial investments, it's important to understand the concepts of pre-money and post-money valuations. Here is a brief look at these valuation models, as well as the similarities and differences between the two methods.
In the simplest of terms, the pre-money valuation method is the financial figure used to describe the overall value of a business prior to any capital investments. This type of valuation is generally calculated by evaluating factors such as assets, liabilities, revenue, profits, and a series of other pertinent financial factors that are often dependent upon the nature of the business and the segment of the economy in which it resides. In addition, the analysis will likely include an examination of the company’s business plan and marketing strategy, global business strategy, the relevant market, competitors in the space, and other external economic factors that will ultimately influence the business’s ability to grow and thrive. This assessment is based on the company’s standing before there are any fundraising rounds.
The post-money valuation method is a financial approach used to determine the value of a business after the injection of capital, often through some form of fundraising. With a post-money valuation model, an investor offers a sum of money based on a stated post-money valuation. Of course, this means that there is also an implied pre-money valuation amount inherent in that offer. The value of the shares prior to the investment is simply the pre-money valuation divided by the number of outstanding shares. However, to receive the investor’s capital, new shares must be issued. This means that the overall number of shares increases, which then dilutes the original shareholders portion of the pie.
For example, if a business initially issued 100 shares to the market worth 10 dollars each, and an investor offers $500, then the investor will receive 50 shares ($500/$10). Then there would be 150 outstanding shares with the original shareholders owning 100 shares and the new investor owning 50 shares. This means that the original shareholders’ portion is reduced from 100% to 67%. But if business goes well and more money is invested down the line, the value of the shares should begin to increase as well as the post-money valuation of the company. Thus, even though investors may own a smaller percentage, they do so at a higher value per share.
How Frequently Does a Business Valuation Need to be Performed?
A business valuation may be performed at different points in a company’s existence for various reasons, most often related to investment decisions, exit planning strategy, a potential sale or buyout, or due to an impending IPO.
Because it is recommended to hire a reputable analyst to perform the valuation, the process can be costly to carry out. It’s also a time-consuming process given the amount of information that needs to be collected and analyzed. For larger enterprises, the time and complexity involved often serve as a deterrent to engaging in regular valuation assessments.
However, the economic climate is frequently in flux, influencing the financial status of virtually every business, which is why many companies find an annual valuation analysis to be desirable. Although there is no hard and fast answer as to how frequently a business valuation should be performed, here are a few ways to approach the process.
Very Rarely or Never
For smaller companies that do not plan to receive financial support, seek capital infusions, or sell their businesses at some point down the road, it may be possible to avoid going through the valuation process altogether. Granted, this seems like an unlikely scenario, but there are entrepreneurs who are quite territorial when it comes to their hard-won creations, so this certainly could happen. But even if a company does not intend to engage in any large-scale investments or transactions, it could end up being helpful to determine a company’s valuation for planning business, financial, and innovation strategies and increasing profitability. As a result, learning the business’s valuation one time or perhaps every five to ten years may prove worthwhile.
Every One to Two Years or As Needed
There are plenty of companies that engage in high-volume investing, seek financing and capital on a regular basis, or participate in other types of activities that necessitate the occasional valuation. In these instances, the analysis could be conducted as needed or every one to two years. Obtaining an occasional valuation is probably sufficient for most companies. Because the economic landscape shifts so frequently, most valuations are likely only accurate or valid for a year or less.
On a Regular Basis
Performing a business valuation on a frequent basis is most common for large companies engaging in high-stakes activities and transactions. However, these companies are likely seeking the valuations of other firms more than they are assessing their own valuation. Additionally, for startups experiencing significant success in a short period of time, their estimated valuations will change more dramatically, but these cases tend to be the exception rather than the rule.
Considerations Before Conducting a Business Valuation
Many startups become consumed with the valuation process, in hopes of obtaining higher levels of funding. Although valuation is undoubtedly a key figure in the fundraising process, there is also some potential downside that results from a high valuation.
Here are some of the common outcomes for companies that receive a high business valuation:
If a company manages to secure an impressive valuation at the outset, they are usually expected to soar to success in record time. In general, a high valuation will entail some hefty investments, and anytime substantial sums of money are on the line, some pretty high expectations go along with that. Unfortunately, such high expectations may be an impediment to a startup's ability to succeed. With so much pressure to deliver, companies often try to do too much too soon. Clearly, there is a belief that monetary resources will support such efforts, but a lack of structure, skills, and know-how often prove problematic for a business.
Rather than impose stressful expectations from the beginning, conservative goals and measures should be put into place. Then, if a business does extremely well, they are exceeding expectations instead of falling short or barely meeting them, which is far more likely to occur with a high valuation in the early stage.
In addition to the imposition of high expectations that may be difficult to meet, large investments associated with a high valuation often correspond with other conditions and restrictions. Although investor mandates are usually meant to mitigate risk and protect invested capital, these restrictions can make it harder for company founders to act in a strategic manner that would eventually behoove the business.
It is a lot easier to engage in risky maneuvers when someone else's money is at stake, but a lot harder to justify and deal with the potential fallout. A higher valuation may seem like more dollars to work with, but it generally results in far less flexibility.
Potential Down Rounds and Dilution
In some cases, high valuations actually end up damaging a company when unforeseen circumstances arise and subsequent fundraising rounds are needed. In the event that things do not proceed as planned, companies may be forced to engage in a down round, undermining the company's value and essentially negating the high valuation given in the first place. And, down rounds ultimately mean dilution for the original investors, who may balk and bail as soon as possible, further damaging the business. Companies have to proceed with realistic valuations or risk having all of their hard work be for naught.
A financial or capital infusion creates a lot of opportunities for budding entrepreneurs, but there is something to be said for creating something big out of something rather small. The ability to grow and problem-solve on a frugal budget typically bodes very well for a company’s future. And, if taking that path, any subsequent need for funding to further accelerate that growth trajectory will actually help to justify a decent valuation, without having to worry about the external hindrances and obstacles that a high initial valuation may have presented.
Even entrepreneurs who understand that valuation is just one of many important facets to a deal probably have to fight the urge to seek the highest number possible. In some cases, bigger simply is not always better, especially in the early stages, and ascending to that peak must occur via a more natural progression.
How a Virtual Data Room (VDR) Helps During a Business Valuation
If you’re ready to move forward with your business valuation, investing in a virtual data room (VDR) to help organize and securely share your sensitive company documents is a good next step. Even if you aren’t ready for a valuation, using a virtual data room as an ongoing repository helps keep your important corporate information in a central location, so you’re always prepared with the documents needed for analysis, a valuation, and other M&A activity. A VDR is a secure online database used to share confidential information, most commonly related to major financial transactions. Because a company valuation typically requires outside parties to access sensitive company information, many businesses adopt a VDR to expedite the process.
SecureDocs Virtual Data Rooms include helpful features such as:
Permission-based user roles - VDR administrators can assign granular levels of folder access to third parties performing the business valuation
Audit logs - admins can see who accessed various documents and other actions performed in the data room
Advanced security features - multi-factor authentication, data encryption, document watermarks, and other security measures ensure your sensitive data is shared only with authorized users
Unlimited users and documents - invite as many users as needed to get the job done without worrying about added fees
Start your free trial of SecureDocs to see how easy it is to get your virtual data room up and running.