Before you approach potential investors or buyers for your business, you need to assess the value of your business. Learn about the different ways to calculate the value.
Before you approach potential investors or buyers, you, and any other existing shareholders, need to have an idea of the value of your company. Prospective investors will also assess the value of your business when they consider your proposal. The process of determining the value is called valuation.
You and the investor both need to determine what you think is the value of the business because the value will be the basis for negotiating:
Here's a simplified example: if you feel your company is worth $10 million and you're asking for a $2.5 million dollar investment, then the investor will get 25% of the shares. But what if the investor feels the company is only worth $5 million? He will expect 50% of your shares for an investment of $2.5 million. You and the investor will each use valuation methods you think are right to determine the price and the equity share. This is when the negotiations will begin.
Valuation is not an exact science, and there are different ways of valuing a business. These methods use different assumptions and financial information and typically result in different values. For instance, you could base a valuation on a company's assets (how much it owns). Another approach is to use projected revenues or cash flows. Investors prefer methods based on cash flows, and we will cover them in more detail. But it's important to know about a variety of methods because they can be useful as benchmarks to check the validity of the value and the price you determine.
Earnings and Cash-Flow Based Methods:
Discounted Cash Flow
The prevalent method for valuing firms for investment purposes is the discounted cash flow approach. This complex accounting procedure is used to answer three critical questions:
The discounted cash flow method is preferred because it can be more accurate than other methods. Its accuracy and complexity are due to the fact that it:
In this method, cash flow predictions are discounted, or reduced, to adjust for the risk the investor faces and to make up for the fact that the investor could invest the money in something else.
The underlying idea of a discounted cash flow is that $100 today is worth more than $100 a year from now. In fact, $100 today is equal to $110 next year or $161 in five years, if you accept an interest rate of 10% per year. One hundred dollars in the present is equivalent to $161 in the future because the $100 you have today can be invested to earn interest and there is no risk you may not receive it. This idea is called the "time value of money", and it is the basis of the discounting method.
Investors will ask you: "Why should I give you $100 today?" Your answer must be that you can offer a return of significantly more than $161 in five years. If you can't do that, the investor may not be attracted to your investment, because simply taking compound interest at 10% would yield that much.
Investors are looking to be compensated for their risk, and their benchmark rate - or "discount rate" - will adjust for the time value of money. They will choose a discount rate and compare your proposal against that rate.
The discounted cash flow method is very effective because it allows values to be determined even when cash flows are fluctuating. A start-up or new venture may expect to lose money in the first years and then make money in later years. These changes in cash flow are taken into account by the discounted cash flow method.
The method has several disadvantages:
Business valuation is a complex task. If your valuation doesn't consider all factors or if it uses inappropriate valuation methods, this can create significant problems. Understandably, a financial advisor who has experience as a business valuator is critical.
|Value: How much is this company worth today?|
Let's say investors are considering an investment in your company and plan to take their money out in five years. To them, your company is worth today what it can earn during the five years, plus their share of the value of the company at the end of the five years. This is like saying, the value of a five-year 10% Canada savings bond is the interest it will earn each year plus the principal amount paid back at the end of the term. The interest is equivalent to cash flows, and the principal is equivalent to the value of the company at the end of the year. The big difference is that the cash flows and the value at the end of the term are known for certain with a savings bond, but for investments in active businesses, these are unknowns. The discounted cash flow method applies adjustments or "discounts" to account for those unknowns.
Using this method, the value is the total of the cash flows, adjusted or discounted, plus the value remaining (or residual value), also discounted.
discounted cash flow value = discounted cash flows + discounted residual value
A Simplified Example
A company is projected to have fluctuating cash flows (e.g. losses of $200,000 in the first two years, a gain of $300,000 in the third, etc.) that total $1 million over five years. How much is it worth today?
a) Discount the cash flows
The cash flows are discounted at a rate acceptable to the investor — say 20% (see chart). This leaves a present value of $0.4 million. In other words, the calculation indicates that getting $1 million in five years is the same as having $0.4 million today, using a discount rate of 20%. (This rate is used to calculate a discount factor for each year; the first year's cash flows are only discounted for one year, by about 80%; but the fifth year's cash flow must be discounted for five years, so it's discounted by much more, about 40%.)
|Year 1||Year 2||Year 3||Year 4||Year 5||Total|
|Projected cash flows (000s)||-$100||-$100||$300||$400||$500||$1,000|
|Discounted cash flows (@ 20%)||-$83||-$69||$174||$192||$200||$414|
b) Find the residual value of the company and discount it
The company's value at the end of the five years is calculated as being $10 million. This "residual value" is then adjusted by a discount factor (based on the 20% rate the investor finds acceptable), leaving a value of $4 million. You can think of the "residual" as an estimate of how much someone would pay to buy the whole company at the end of the investment period.
c) Add the discounted cash flow and the discounted residual value
|Cash flows||Residual value||Projected Discounted to present value Notes|
|$1,000,000||$400,000||Discounted at 20% over five years.|
|$10,000,000||$4,000,000||Capitalized and discounted based on 20% discount rate over five years.|
|Discounted cash flow value||$4,400,000||Estimated fair market value today.|
The cash flow value and the residual value are then added together. The estimated value of the firm using the discounted cash flow model is $0.4 million + $4 million or $4.4 million.
|Rate of return : What rate of return will the investor expect?|
Investors want to calculate their rate of return. To do that they must compare the amount of the investment to the amount they will earn at the end of the investment period. But how can they know what they will earn in the future? Again, they must use the discounted cash flow projections to estimate the future value of their investment.
A Simplified Example
If investors had invested $500,000 and received 35% of the company's shares, how much will their return be at the end of the investment?
a) Take estimated cash flow for the final year.
The cash flow in the final year is used as a basis to decide the value of the company. Imagine that the company is projecting earnings of $500,000 in the final year.
b) Estimate the value or sale price of the company based on the cash flow.
How much will someone pay for this company in five years? Perhaps companies will be selling for 5 times or 10 times their earnings. Investors must decide what they think the market will be like and choose a multiple to multiply the cash flow by to convert it to a value for the company. Let's say the investors choose 8 times earnings. Then the value of the company when the investors will exit should be 8 times $500,000 or $4 million.
c) The value of the investors' share is calculated.
If the investors have purchased 35% of the shares of the company, they can expect to take away $1.4 million when the business is sold.
d) The investors determine their rate of return.
The investors' original investment of $500,000 is then compared to the return of $1.4 million. The return is the equivalent of a return of 23% compound interest for five years.
|Equity share: How much of the company do the investors get?|
The valuation information you get from discounted cash flow also allows you to consider the percentage of shares the investors receive in return for their investment. In the example above, the investors' share was assumed to be 35%. At that proportion, and given a value of $4 million at the end of the investment period, the investors would make $1.4 million, or 23% on the initial $500,000 investment.
If the investors feel that isn't an adequate return, then one way to increase the return is to give them a greater equity share for the same investment. So, for example, if their $500,000 investment bought them 45% of the company instead of 35%, they would get 45% percent of the $4 million exit value - or $1.8 million. And that is equivalent to a 29% return on their investment.
Value, Return and Exit Strategy
The way the values and rates of return are calculated depend on the specific exit strategy used. In the next section, the implications of different exit strategies on exit values are discussed.
|Going Concern Value|
The going concern value method calculates a company's value based on its capacity to produce a stream of cash flow in the future. The greater the cash flow it will produce in the future, the higher the value today.
How It Works
The going concern method determines the value of the business by working backwards: starting with the cash flows expected, choosing an acceptable rate of return and then calculating the value required to yield those returns. For example, suppose you know that your savings bond will earn $100 per year and it is paying 5% interest. What is the value of the bond? You can divide $100 by 5% to find that it must be a $2,000 savings bond. You're probably more accustomed to thinking of it as: $2,000 at 5% yielding $100 per year. Reversing the calculation gives you the value of the initial investment.
Assume XYZ Inc. will be a viable company generating a stable and maintainable cash flow of $40,000 per year forever. What is the value to investors today? The going concern value of XYZ is calculated this way:
|Cash flow from operations||$40,000|
|Less income tax at 42% ($40,000 x 0.42)||-$16,800|
|After tax cash flow||$23,200|
|Divided by the capitalization rate||÷18%|
|Going concern value (present value)||$128,888|
Based on future cash flows, and using a capitalization rate of 18%, the present value of the company XYZ Inc. is $128,888.
You may wonder what the capitalization rate is and where it comes from. It is the rate used to translate a cash flow, or a stream of income, into "capital" value. In practice, it is the rate of return required by the investors. This rate is based on a number of subjective factors and conditions at the time of the valuation. One of the main factors affecting the rate is the amount of risk involved in the investment: the greater the risk, the greater the expected reward.
For example, a person who has $100,000 to invest could put the money into Canada savings bonds to earn future cash receipts in the form of interest payments. On the other hand, the person may invest $100,000 in a business venture. In both cases, the investor compares the future receipts (cash inflow) to the original investment (cash outflow). But the investor also takes into account the relative risks.
Canada savings bonds have lower risk and, therefore, a lower expected yield than investments in growing companies. So an investor might be prepared to accept a 5% return on the relatively risk-free Canada savings bonds investment, but no less than 25% in a revenue-generating business that is riskier. Risk affects the price tag of the sought-after economic return. The going concern value, therefore, looks at future cash flow expectations and the relative risk associated with the investment.
This value is simply your company's net worth or shareholders' equity, as shown in its financial statements. At its most simplified, subtracting liabilities from assets gives net worth or book value. Technically speaking, book value can be described as the historical value of an asset that, at a given time (the day it was purchased), represented the economic or market value of the asset, less its accumulated depreciation.
How It Works
To determine the book value, subtract the liabilities from the book value of the assets. The difference gives you your net worth or shareholders' equity. In practice, book value is seldom used in the process of securing venture capital, although it is widely believed to be a realistic approach to measuring a small company's net worth.
Here is an example of the book value calculation for XYZ Inc.
|Total liabilities and shareholders equity||$125,000|
A liquidation value is assigned to a business being sold in order to satisfy its creditors. Tangible assets, such as land, usually have a liquidation value close to their market value. Inventories and accounts receivable, on the other hand, are usually valued at less than what is shown in the books.
How It Works
To determine the liquidation value, all assets are assigned distressed values, and all debts are totaled at book value. Most assets sold under duress are discounted from their fair market value. The difference between the distressed value of the assets and the actual or book value of the liabilities is referred to as the liquidation value.
The liquidation value doesn't reflect the real worth of an asset or a business; in most cases, it is substantially below the market and book values. This method is typically used only if a company is in serious financial trouble.
Here is an example of the liquidation value calculation for XYZ Inc., compared to the book value calculation.
|Assets||Book Value||Liquidation Value|
|Total liabilities and shareholders equity||$125,000||$70,000|
In matters of price, the market rules.
There is a truism in the venture capital industry that "the value of a company is only what someone is willing to pay for it." In other words, in the end, the market - and your ability to attract investors and negotiate with them - will determine the value or selling price.
Each investor will have a different view of the value of your business. This view will be based on each investor's perceptions of the future risks of your business and the returns to be derived. And other factors will enter their calculation of your business's value (and therefore the price they are willing to pay):
- - Their level of knowledge of your business's strengths, weaknesses, opportunities and threats
- - How strong their desire is to make a deal
- - Your relative negotiating positions and strengths
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