Archive for September, 2016

Business appraisers usually pick two approaches when valuing a start-up: the income approach and market comparables valuation.

Income valuation challenge: earnings forecast

If you focus on the income approach, be aware of its limitations. Since the young companies have limited track record of earnings, it is challenging to forecast the income stream with any accuracy. Your business valuation is likely to suffer if your earnings forecast fails to match reality.

Market valuation challenge: few comparable companies

For start-ups in new technology driven industries, market comparisons are often limited or non-existent. By their very nature, tech start-ups are technology innovators and often blaze a path unseen by existing companies. Apples and oranges comparisons don’t work too well here.

Despite all these difficulties, start-ups need to be valued for a number of reasons: to grant and value stock options to employees, comply with the tax and financial reporting requirements, attract investment, in acquisition or IPO scenarios.

How to avoid the pitfalls?

Here are some points to bear in mind when valuing a start-up:

Be prepared for a conservative business valuation if you delegate the task to a professional appraiser. The number may surprise you even compared to valuations you got from prior investment rounds.

The reality is most start-ups don’t make it to the IPO. Many more are sold or acquired, or close their doors. Your business valuation will likely reflect this as a possible outcome.

Your start-up valuation is always made at a certain point in time. Just because the company was worth more in the past, does not mean its value has grown by a desired amount. Your appraiser may spot headwinds on the horizon or challenge your earnings or market share growth assumptions. The result may be a business value lower than you expected.

If your start-up goes public and its value jumps, don’t assume your private valuation of a year ago was wrong. Public companies with stock traded openly on the market are worth more than their private counterparts. The reason is stock liquidity, which attracts many more investors, and drives up the stock value.

As the company gains momentum, its earnings forecasts become more supportable. So your business appraisal is likely to be more accurate. This holds true for successful start-ups. If you are the proud founder of a successful start-up, congratulate yourself. Take a look around and note that many competitors of yesteryear have fallen by the wayside.

Successful and rapidly growing start-ups are likely to attract the attention of large public companies. This increases the appetite for ownership of these young firms, and drives up their valuation.

Business people, investors, and creditors pore over financial statements to make decisions. If you are a business owner, you look at the company’s financials to see how well it has done, and what investments are needed to achieve its goals in the future. Investors, of course, want to know if the value of their investment is growing. And creditors are interested to make sure their money is safe.

Notice that all these needs depend upon the future outlook for the company. Will the business generate enough income to pay its owners? Will the growth in business earnings justify the money invested? Will the company have enough funds to pay off its loans?

The central question is: where does all this money come from? Firstly, from business revenues. Revenues must be compared against the business operating expenses as well as the capital required to support its sales and expansion plans.

So how can a business meet its cash requirements? Here is the short list:

  • By generating cash flows from operations
  • By selling shares of its stock
  • By borrowing from creditors
  • By selling some of its assets

If you consider borrowing from a commercial lender, you will quickly discover that their view of business comes with a large dose of skepticism. Bankers expect the worst, so they try to protect their interest assuming the worst case scenario for the company. Should the business cash flow fall too low, how will the loan be repaid?

The typical answer is by selling some business assets. That’s why the lender is likely very interested in the value of business assets. Note that this is very different from the book value carried on company’s financial statements. The real question for the lender is this: should the company fail to come up with cash for loan repayment from its profits, what can certain business assets fetch on the market if offered for sale?

In other words, the lender is interested in the liquidation value of business assets. The book value of depreciated assets shown on the company’s books is not helpful here.

As the saying goes, if you are not selling your business assets, you are buying them. The market value of these assets is what your company owns. Find out what the assets are worth before asking a banker for a loan.