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Coming up with a business valuation is a right of passage for every founder. Search online and you can find various complicated models for how to approach pinning a price tag on your business.
Whether you’re valuing your business ahead of investment, sale, or to get an accurate picture of your business’s health, this guide is designed to help you make it happen.
What is a business valuation?
A business valuation is the process of putting a price on a business. In order to do this, different aspects of the business are analysed and assigned economic value.
What’s the point of a business valuation?
Typically a business valuation will be carried out when a business is doing at least one of the following:
- Reviewing its high-level strategy
- Looking for new investment
- Merging with another business
- Acquiring another business
- Being bought
How do you value a business?
There are a number of different methods and combinations of methods that can be used to value a business. When valuing a business, it’s important to consider the following points:
Why you’re carrying out a valuation
The process of one method may be more useful to your end goal than another
The type of business you’re valuing
Not all methods will suit every business model and sometimes it makes sense to use a combination of different methods.
It’s not all about the numbers
Other factors can come into play too, such as intangible things like the potential strategic value to a prospective acquirer, for example. These can be trickier to refine and factor in, but confider things like reputation, trademarks, intellectual property and people. Loss-making startups might be valued highly based on their future potential, but some investors or buyers may value an established profit-making customer over an uncertain bet. Your customers matter too – a diverse, loyal customer base is likely to translate into more value than if you rely on a single major customer.
Common business valuation methods
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- Times Revenue
- Earnings Multiplier
- Seller’s Discretionary Earnings
- Discounted Cash Flow
- Entry cost valuation
- Asset value
- Liquidation value
Times Revenue Method
Also known simply as the Revenue Method, this method applies an industry-based multiplier to the business’s revenue. This multiplier is determined by the entire sector’s position within the broader economic landscape.
For example, a software startup brings in £3 million in revenue each year. Therefore, its time revenue method valuation might look like this:
- Annual revenue = £3 million
- Industry multiplier = 3
∴ Valuation calculation = £3 million x 3
Making its times revenue-based valuation £9 million
Earnings Multiplier Method
Price-to-Earnings Ratio = Price per share / Earnings Per Share (EPS)
This is considered more accurate than the times revenue method, as it bases the valuation on profits rather than revenue.
Seller’s Discretionary Earnings (SDE)
When valuing a startup, many analysts start by recasting the business’ earnings to calculate your Seller’s Discretionary Earnings (SDE). You’ll need to identify a multiple, based on relevant factors like your company’s customer base and position in the market. Multiplying this by the business’ SDE can give you a rough value for your business.
Discounted Cash Flow method (DCF)
This method is complex and relies on the forecasting of future cash flow. It essentially takes the business’s current cash flow and projects it into the future. It can be helpful to use a net present value calculator.
Put simply: how much would it cost somebody to set up a similar business to this one? This would take into account things like employee costs, equipment costs, and building brand reputation and recognition over time.
This method assesses the value of the assets, considering any debts. It sometimes makes sense for businesses that are based on the ownership of tangible assets. For example, a vehicle rental business or property management company.
Similarly to the method above, this method calculates a value based on the selling off of the business’s assets. However, a key difference is that it is calculated based on its selling immediately on the open market (therefore likely resulting in a lower valuation).
Mistakes to avoid when valuing a business
Overvaluing your business
This is a common mistake, which can be a hindrance to getting investment in the short and longer term. In the short term, it may put off investors and give the impression of a naive leadership. In the longer term, it can make later funding rounds more challenging, as investors will expect you to have met certain metrics in order to justify another round.
Not working with an expert
Not all methods of valuation work for every business or situation. In the same vein, it makes sense to work with an expert who's experienced in valuing businesses in your business's industry, as they'll have a far better understanding of your business and the market.
Not getting a second opinion
Even if you do work with an expert, valuation isn't an exact science, so it's a good idea to get a second opinion. Especially if you're looking to make big decisions based on your valuation, such as investment or a sale.
While a valuation isn't purely dependent on numbers, numbers are a crucial starting point. An expert can only value based on the information that they have, so if this isn't accurate, you're going to end up with a valuation that reflects this.
Not sharing the right information
Again, the valuation expert can only work with what they've got - and it's important for you to work with them to ensure that you're providing the correct metrics. Even small reporting mistakes will be amplified to significant proportions when calculating a valuation.
Carry out a valuation too soon and the economic and market environments may have changed - not to mention your own business - by the time you need to take action. Leave it too late and you won't have enough time to collect and analyse all the information necessary to form an accurate valuation. It's important to work with all stakeholders to plan how long it'll take to work on a solid valuation.
Comparing apples and oranges
Making assumptions based on businesses you consider to be similar (e.g. competitors) is likely to result in misjudgments. There are so many circumstantial factors that are likely to differentiate you, even if your offering is similar.
“People often look at a similar business a few years down the line to compare. But you don’t know the circumstances... They may have had additional help from family and friends, or they might just be lucky.”
Angel investor, Lucy Viggers
Only focusing on data
Data’s integral but it’s not the only thing that counts. If you’re looking for funding, communicating a compelling ambition and vision is just as important for securing funding - particularly for eraly stage businesses. Angel investor, Lucy Viggers, says vision is one of the key factors she looks for in a founding team and also good indication if they’re all on the same page.
“The most important thing is that you agree about the ambition for the next five years and what you’re going to do with the business... If you agree about all those things, then you should agree about the valuation. If you’re massively far apart then perhaps you’re talking to the wrong people.”
And finally, don't forget to ensure you have the right legal support and risk management, including business insurance. Things don't always go to plan so it's important that you've got the right protection in place.
This content has been created for general information purposes and should not be taken as formal advice. Read our full disclaimer.