You’ve got a company that you want to sell. Maybe you’re one of the lucky people who have a unicorn startup. Or maybe you’re looking to inject some cash flow into a rapidly growing company and know one of the fastest ways to get cash flow is to bring in investors.
There are different business valuation methods out there, of course, but here is a list of some of the most common points most business investors will be performing during your business’ valuation.
Is The Idea Disruptive Enough?
Are you looking to launch a new company, or just a new product? There are a few different questions investors will ask before the business valuation. How exactly will the new product change the landscape of the market you’re selling to? What is the need the customers have, and how does your product answer it? All these questions and more will go through the mind of any venture capitalist you seek.
Competition and Durable Competitive Advantages
While these look similar to the questions above, they are a little different. How much competition is in the industry? Are the barriers to entry high or low, and what’s your company’s pricing power? Does the industry as a whole have a “moat”, or a competitive advantage? For example, Coca-Cola has a very large competitive advantage; which is the power of its brand. Pepsi has the strength of its brand and its diverse food holdings.
The third place most investors will look is at the company’s past performance records, as these often give a good idea of what the company will be like in the future.
Return on Assets
Next, the investor will examine the company’s assets. This will include not only physical assets, like property and equipment; but also intangible assets, like the company’s intellectual property. Combined with the historical financials, this allows the investor a clear view into two important things. First, what is the ability of your company to generate a return on assets? (The return on assets, or ROA is net income divided by total assets). Second, what is your ability to generate free cash flow (operating cash flow minus capital expenditures)?
Management’s Track Record
This may not apply to a brand new company that has little to no guidance records, but companies have managers and these managers have histories of working at different companies. If you own a larger, already established company, then a good way to examine management performance through the eye of an investor is to compare guidance against the results achieved.
Culture and Strategy
Culture is important because it drives the “why” of the organization, and a company that is dedicated to changing the world, even in a small way, with a CEO who holds that vision is very attractive to investors. Strategy is also important because it helps to maintain the durable competitive advantage. Like the gears of a machine, a company with a clear strategy also has a solid framework for management’s plans, meeting or exceeding guidance, and generating good cash flow.
Future Assets & Discount Rates
Now that the investor has a clear picture of your company, the next few steps of their business valuation methods are the fun part: Forecasting future financial flows, and assigning a discount rate. A discount rate is the minimum required rate of return in order to make a profit. There’s a few different methods you can use to judge the discount rate, but the essence is this: Durable competitive advantages plus management’s track record (and overall competence), plus risk of government regulation and risk of changes in competitive dynamics.
When it comes to forecasting future financials, most investors will forecast anywhere from 5 years to the end of the assets life, depending on the industry and the company.
Now comes the best part. Your company is highly valued according to all of the factors above; but what is the investor willing to pay for it? Well, that depends upon the investor.
Some investors will typically want to build in a margin of safety (around 20-30%) and pay less than the intrinsic value.
Others will look at the discount rate and pay full value on the company.
A third group will look at other companies and acquisitions in the field before offering you a price.
Company valuations are an iterative process. There is no one single number an investor can toss at companies in a certain market. The investor really has to look at your company, your management, your financials and everything else, multiple times, before assigning a value.
In the end, it comes down to this: If the investor likes your proposition and your company, he will express interest in investing and offer you a proposal. You, as the entrepreneur, should not ask first for the investor’s proposal, because you may not know if your company will meet the needs or wants of the investor. And remember that if the valuation doesn’t meet your needs, then be prepared to walk away. Company valuations are a two way street.