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Earlier this week, I called out for your most pressing questions about selling a business on several social media channels.
The common theme among the questions raised tells me many business owners are uncertain about how to establish a value for their business, regardless of its stage of development. In various ways, readers asked me about how to value ideas, start-ups and mature businesses.
I’ll tackle the various business stage valuations one at a time:
The first question is “How do I value a business idea for investors?”
An Idea is Not a Business
The late Peter F. Drucker said it so eloquently when he declared “Ideas are cheap and abundant; what is of value is the effective placement of those ideas into situations that develop into action”. And without action, an idea has no value. Period.
In my opinion, there is a wide divide between the vast number of Wantrepreneurs and a successful Entrepreneur. Until an idea is tested and developed, it is virtually impossible to place a monetary or commercial value on it.
If however you are able to successfully file for and obtain a patent for an idea, it may be possible to sell or license the patent to a business enterprise for its commercialization. In fact, if you chose to patent an idea, this is exactly what I would recommend you do. Otherwise you will need several hundred thousand dollars to invest in protecting your patent rights. And that’s before you make a single sale.
If you’ve got an idea for a product and/or service and you are seeking investment from friends, family or an Angel who shares your passion for your idea and is confident in your abilities, your first round of investment should include:
- Founder/Inventor’s Financial Capital – without this, subsequent rounds of financing from other sources of capital will be difficult to obtain; and
- a definition of how the capital raised will be used; and
- a set of milestones and its respective timeline before another round of capital may be raised; and
- an accountability reporting process for investors; and
- a definition of the roles and responsibilities for founder/inventor, investors, and other key employees.
In such a situation, the value of a business idea is decided between the parties and is often tied to the limited risk an investor is willing to take to assist the founder/inventor in determining if the idea has commercial merit.
Another business owner asked me “How do I sell a business when it’s in the start-up stage?”
A Start-up Must Prove its Business Model is Viable
Start-ups are ideas in search of a profitable business model. And until the start-up is profitable, most buyers will heavily discount its value. Unless of course, you’ve developed a product or service that a dominant market player with a lot of cash sorely needs or a set of employees ripe for a talent acquisition.
If that’s the case, and you successfully sell your start-up for an incomprehensible multiple of sales (because you never reached EBITDA), you’re now the equivalent of a Rockstar. Congratulations!
Let’s set that notion aside and talk about how the rest of the world’s start-ups are valued.
Once a start-up has revenue, it is on its way to determine the level of sales and operating expenses it will require to reach profitability known as a breakeven point. Knowing when a start-up should reach its breakeven point is a key to a start-up’s success.
Armed with this information, the value of a start-up for a buyer or investor will be based on these additional factors:
- Revenue over the past 12 months
- Gross Profit Margin
- Net Profit Margin – although, profitability is not absolutely necessary in a start-up
- Industry Size – Is the opportunity in a $1B market or a $1M market? Are there geographical limitations?
- Overhead Costs – Is this a retail business with real estate requirements or a SAAS business with low overhead?
- Booked Future Sales – Contracts, Purchase Orders, etc.
- Does the start-up solve a user’s problem or serve a user’s passion?
- Potential Investor or Buyer’s ability to bring something to the start-up otherwise absent, such as introductions to synergistic relationships, selling opportunities and/or reduction of costs
If there are any shortcomings in one or more of the eight factors noted above, the start-up may not be in a good position to sell its business or take on an investor for an attractive valuation. It may simply be too soon to take on new investors or sell. Or the business model may not be working and a pivot may be needed.
The last question asked was “What is the best way to come up with a fair valuation for my business when I sell it?”
Mature Businesses are Measured by Cash Flow First
Once a start-up has matured and is producing consistent cash flow, proving viability is no longer a concern to a buyer (or investor). Instead, the type of buyer and the business’ cash flow will have the most impact on how a mature business is valued.
A business buyer who is a competitor may desire to acquire your business for strategic purposes. Such a buyer may want to expand into your geographical area quickly or to acquire the knowledge and business contacts your employees possess. For these, and many other reasons, your business would command a higher valuation and price from a strategic buyer.
On the other hand, a financial buyer who simply desires a good return for his investment dollars will likely value your business at a lower amount.
Regardless of the type of buyer your business is sold to, all buyers first look at cash flow from operations as a factor to determine its value. Depending on the industry and size of the business, cash flow may include measurements such as EBIDTA (Earnings Before Interest, Depreciation, Taxes and Amortization), EBIT, Seller’s Discretionary Income, and in some cases Annual Sales). A ‘multiple’ is applied to the appropriate cash flow measurement which differs by industry and changes over time.
The product of the cash flow multiple becomes the basis for valuation. Adjustments are then applied based on the particular circumstances and other factors.
In addition to the buyer type and cash flow there are many other factors which will impact the mature business’ valuation. These factors may include:
- Fixed Assets to be transferred to a buyer
- Liabilities to be assumed by a buyer
- Current Assets such as cash, investments, accounts receivable and inventory transferred to a buyer
- Intangible assets used in the business (Patents, Trademarks, URLs, Trade Secrets, etc.)
- Lease rights and obligations
- Contract rights and obligations
- Pension Plan Liabilities
- Cost of Capital
- Future Industry Growth
- Revenue Growth Record over past three years
- Projected Company Growth one-to-three years
- The M&A Environment
Unfortunately for the business owner, a single formula to compute the value of a business does not exist, regardless of its stage of maturity.
Nonetheless, it’s important to understand how business valuation factors change as the entrepreneur begins with a business idea which evolves into a start-up and then ultimately matures into a viable business.