Thursday, April 28, 2011

Valuation - What's Your Company Worth?

The Mystery of Valuation

I get asked often either directly or indirectly "what is my company worth"? Usually it comes in the form of "I want to get $X investment. I don't want to give away more than Y%. How does it all work"? Well, it all comes down to valuation.

There's plenty of ways to back into the value of a company. Which one is right? Depends on who you ask. Each investor will have their favorite methodology. Entrepreneurs sometimes have their own favorite as well. Your goal as an entrepreneur is to present a fair, unbiased value. Why not aim for the highest value? Sure it'll boost your ego, but ultimately you'll be the only one who touts the figure, and no one else will go along with it. Instead, give a fair & accurate figure, and you'll add to your credibility, and save time justifying your inflated overvalued amount.

So what is fair? Out of all the valuations I've seen, the best way is to do several, then average them. If you can show investors that you've done your homework and shown all the angles, it's easy to reason why a weighted average is the best representation of your company.

I've used 4 methods lately.

1. Current Assets & Investment (10% weight)

2. 5 Years Projected Net Income (25% weight)

3. 5 Years Projected Sales Discounted 10X (25% weight)

4. Present Value of 5 Years Projected Cash Flows (40% weight)

Calculating the valuation based on each of the 4 metrics above, and then averaging based on the weight, you bring the high and low to a mid ground, and can justify your number as both reasonable, and possibly conservative. Being based on 5 years projections, you would need to have a financial forecast model in place, with reasonable assumptions & growth rates.


Company ABC

1. Current Assets & owner investment: $500,000

2. 5 Years Projected Net Income: $7.2M

3. 5 Years Projected Sales Discounted 10X: $8.2M

4. Present value of 5 Years Projected Cash Flows: $6.4M

If you chose just 1 valuation method, most likely you'd choose 5 Years Sales, discounted 10 fold. You could even argue that you discounted at a high multiple, so it's conservative. Yet looking at other methods, that is the highest valuation of them.

Weighting the amounts at 10/25/25/40 and doing a little math, the weighted average valuation is $6.46M. Drastically different than the stand alone $8.2M.

A note on #1. Current Assets & Investment. Why include it? It'll obviously be far less than the others. While not a fair representation of the potential of your company, it adds in a base level, current figure, and it is lightly weighted. It's all part of being conservative.

Now that you have a valuation of $X, it becomes much easier to put a value on Y%. Depending on existing investments and shares granted, a Capitalization Table can break down how everyone's investment & share holdings relate. Best of all, you've put a solid number down in writing of what your vision is worth, and can feel confident in justifying it to friends, investors and yourself.

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