Three approaches to valuing your business

Your business is thriving, but to continue to grow, you need capital. Before you enter the market, you need to know what your company is worth. With headlines about outrageously valued start-up companies running side-by-side with stories on volatility in the public equity markets, this is a good time to discuss valuation.

By Laura Lindsey

Associate Professor, Finance

Your business is thriving, but to continue to grow, you need capital. Before you enter the market, you need to know what your company is worth. With headlines about outrageously valued start-up companies running side-by-side with stories on volatility in the public equity markets, this is a good time to discuss valuation.

Valuation is important whether selling a business as a whole or accepting investment capital — that is, selling in part. As one might suspect, the actual value placed on a business will depend on the overall economic outlook, current attitudes toward the product or business model, the quality of the management team and the relative bargaining power of the parties buying and selling.

Broadly speaking, there are only a few methods, but each has numerous variations and nuances.

The first way to think about valuation is a transaction-based approach. It is easy to know the value of a firm traded on a stock exchange, for example, because part of the company ownership changes hands every day. Similarly, any time a private firm raises money, there is an implied valuation. The implied valuation is the total number of shares that exist in the company multiplied times the price per share that the investor paid.

It is often easiest to think in terms of the portion of the company purchased: if $1 million buys half of the firm, the firm is worth $2 million. (Some jargon: the $2 million figure is known as post-money value. To get pre-money value, just subtract the investment amount.) It is important to realize, however, that the notion of a fixed ownership percentage in a private transaction is usually overly simplistic; the way the deal is structured can affect outcomes greatly.

A second approach is to find a company or group of companies comparable to yours. The idea is to use a ratio of some measure of value to some measure of operating performance from similar companies that have had recent transactions — either from the public markets or a recent funding round — and apply the same multiple to your company. Let’s say you had sales of $50; a company similar to yours had sales of $100 and is valued at $500. Its price to sales ratio is five; therefore your company might reasonably expect to be valued around $250. It is also fairly common to apply these ratios for sales or earnings expected in the future.

While ratios are easy to apply, it may be difficult to find truly comparable companies. Choose firms in the same line of business so demand and profit margins are similar, but don’t forget that it is also important to consider firms with similar growth trajectories. Also, the various ratios available can lead to an “alphabet soup” of metrics to consider.

Lastly is a class of models called discounted cash-flow methods. While more complex than ratios, they are also more flexible. There are several versions, but all involve forecasting some measure of profits (usually free cash) anticipated by the firm, or a particular class of the firm’s investors, over multiple years. Then, these forecasts are collapsed down to a single number according to a formula that recognizes cash flows now are more valuable than cash flows later.

The mechanics of the models can be learned, but the valuation only will be as good as the initial forecasts and other assumptions.

All financial markets go through cycles, and the market for private firms is no different. Knowing some basic approaches to valuation can aid an entrepreneur or an investor in negotiating a better deal. Any corporate finance textbook should cover the basics, and web sites such as Investopedia also can be helpful for defining terms. To find data on comparable companies, public firm information is readily available on the finance pages of Yahoo or Google as well as on specialized sources like TechCrunch or trade press reports on important funding events for private firms.

"Getting Started" is an entrepreneurship column by the faculty of the W. P. Carey School of Business at Arizona State University. Laura Lindsey is an associate professor of finance and an expert on venture capital and private equity, corporate governance and financial contracting. First published in The Arizona Republic, September 14, 2015.