How to Value a Company: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
To value any company requires applying one of several processes and corresponding set of procedures that will help you to determine valuation.7 min read
What is Required to Value a Company?
To value any company requires applying one of several processes and corresponding set of procedures that will help you to determine valuation.
What are the Most Common Processes Used in the Valuation of Companies?
To value a company, you must determine the most suitable process to use, based on the type of business and the business’s liquidity. There are three common processes: asset-based, market-based and income-based. Here's how each one works:
The asset-based process places dollar values on both the company’s assets and liabilities. The basic formula for this valuation process can be stated as:
Assets – Liabilities = Company Value
Valuation factors to consider with the asset-based process include:
Assumptions of value.
Who controls the asset.
Marketability of the asset.
Whether the business is asset-based or income-based.
Whether the business is a going concern.
The problem with the asset-based process concerns deciding on which assets and liabilities to include in the valuation, and how to accurately value those assets and liabilities. The values of liabilities are set and therefore easily valued. The accurate valuation of assets, however, is not quite as simple.
In order for the asset-based process to work, both tangible and intangible assets must be taken into account. A good place to start on the valuation of tangible assets is the company balance sheet. Keep in mind, however, that valuations listed on a balance sheet do not take into account the added value of company-developed specialized products and proprietary processes, resulting in an undervaluing of those assets.
In addition, valuations of intangible assets, such as patents, trademarks, management, employees, salespeople, even customer relationships, must be included in the asset-based process. Placing accurate valuations on these intangibles can be very difficult.
The asset-based process works best for established companies whose businesses are tangible asset-based. The asset-based process is typically not a great choice in the valuation of young companies, income-based companies, and companies that are primarily based on intangible assets, like new technologies and other intellectual properties.
The market-based process values a company according to its earning potential, based on market demand for its goods and services. There are two basic steps to valuation under the market-based process:
Market Size: Start by determining what the company does, i.e., what goods and services the company provides or intends to provide to its customers. Your determination should include an assessment of the company’s “goodwill,” that is, the difference between what someone is willing to pay for the company and the amount of the company’s net assets. Then, conduct an analysis of the actual and potential market for those goods and services. In other words, estimate the size and potential growth of the company’s market. This will include assessments of both the company’s competition and, if the company is just starting out, any barriers to market entry.
Comparison to Similar Companies: After completing the analysis of the company’s market, compare the company’s current and potential footprint in that market to other similar businesses in the same market.
The goal of the market-based process is to determine a “fair market value” for the company. Put another way, the market-based process should result in a valuation equal to the “going rate” price for the company if it were sold. Bear in mind that that the going rate must be based on a company sale made in an “arms-length” transaction. An arms-length transaction, in this case, can be defined as a transaction made between two unrelated (i.e., not related by blood, marriage, etc.) parties.
The market-based process works best when the size of the company’s market and its potential place within that market are easily determinable. The process is less suited to companies in markets whose size is difficult to assess, or where there are no companies in that market of similar size offering similar goods or services.
The income-based process involves estimating a company’s future cash flow and then discounting it to determine its present-day dollar value. The process requires the application of a “discount rate” which takes into account the level of risk involved if someone were to invest in the company. The younger the company, the higher the risk, which means a higher discount rate should be applied to the company’s future cash flow estimates.
Valuation using the market-based process will require making a number of calculations involving the following terms:
After Tax Profit: Calculated by dividing profit after taxes by revenue received.
Pre-Tax Profit: Company earnings before taxes as a percentage of sales or revenue.
EBIT: Earnings before interest and taxes.
EBITDA: earnings before interest and taxes plus depreciation and amortization.
Other Valuation Processes
Capitalization: When a company uses the net present value of projected profits (or cash flow), it is called capitalization. The earnings estimate takes into consideration future earnings and dividing them by a capitalization rate. The formula is:
Net Operating Income/Current Market Value = Capitalization Rate
There are two methods of determining capitalization:
Single Period Capitalization: This is the easiest method to use for a business with steady cash flow and that knows its growth ratios. A drawback to this method is that it requires an assumption that cash flow and expenses will remain stable over a predetermined period of time. The calculation works as follows:
Net Income/Discounting Rate = Value
(Example: $300,000/.15 = $2,000,000)
In general, there are certain discount rates that apply. Public companies are typically discounted at 10 percent, private companies with high growth at 15 percent, and private companies with slow or irregular growth at 20 percent.
Multiple Period Capitalization: Simply put, the Multiple Period Capitalization Method determines market value based on more than one period, typically two or more.
Super Simple Income Approach: One of the easiest methods of valuation is to use the company’s current annual earnings and divide it into the long-term treasury bill rate. In other words, you simply use the long-term treasury bill rate to establish the upper rate of your valuation. For example, assume a company with $200,000 annual earnings and a long-term treasury bill rate of 0.55. The calculation would be: $200,000/.55 = $363,636, meaning that tp earn $200,000 annually, you'd need to invest $363,636. One problem with this method is that it requires the assumption that the company will earn the same amount annually going forward.
Liquidation Value: The liquidation value process bases its valuation on the value of a company’s assets if it were forced to sell those assets within a short period of time (less than 12 months). Put another way, liquidation value would equal the remaining balance after the sale of a company’s assets at current market prices and after payment of its liabilities.
Owner Benefit: The owner benefit process is often preferred by small business owners and does away with the issue of guessing what may happen to the business in the future. Owner benefit is often referred to as Seller's Discretionary Cash Flow (SDCF), but the SDCF and owner benefit are different.
To determine the value of the company using the owner benefit process, start with this formula:
Profit (Pre-Tax) + Company Owner's Salary + Additional Owner Benefits + Interest + Depreciation - Capital Expenditures Allocation = Pre-Multiple Owner Benefit
Once you have calculated this pre-multiple owner benefit figure, you must apply an appropriate multiple to determine the company valuation. In most cases, the multiple for the sale of a small business will fall somewhere between one and three. The multiple may be bigger for a larger, more established company. Factors influencing the multiple include company size, length of time in business, ownership of proprietary items or technologies, level of industry growth, sales territory exclusivity, as well as the size of the pre-multiple figure itself.
A generally acceptable multiple for a small company in business for three years with one or more of the above factors in play is three. Here’s a valuation example using the owner benefit process:
$300,000 (Pre-multiple owner benefit figure, as calculated using the above formula) x 3 (Multiple, based on evaluation of the factors, as described above) = $900,000
5 Key Numbers a Buyout Firm Uses to Value Your Company
If you are considering selling all or part of your business, there are specific figures which will be used to value a company.
Net Income: Earnings before interest, taxes, depreciation and amortization.
Growth in Revenue: Compounded annual growth.
Margin: Net income divided by revenue.
Leverage: The amount an investor will borrow to purchase a business.
Ownership: The percentage of ownership that the current business owner will transfer to the new owner upon sale of the business.
Frequently Asked Questions
- How does an early-stage investor value a startup or young company?
Three factors that an investor will take into account when considering an investment in a startup or young company are: traction, reputation and revenue. Simply put, if you are a business owner seeking seed capital or early-stage venture capital, an investor is more likely to consider an investment if you can show that your company is gaining new customers (traction), that you have experience getting things done (reputation), and that you have current income (revenue).
Seed investors and venture capitalists will, of course, require additional information, such as the number of shares that the company has set aside to attract new talent (a potential negative factor), but solid evidence of traction, reputation and revenue will provide you with a positive start to landing the funding you are after.
- How do I value a company based on its revenues?
To value a business based on company revenues, using the revenue method, one must first determine a time period for measuring revenue, most commonly the most recent full fiscal year. To find a multiplier, one must determine the potential growth of the company. If slow growth is anticipated, the factor may be only one; if higher growth is anticipated, the multiplier may be much higher. Remember, this method may be most accurate if the projected future income is considered realistic.
- How do I value a public company?
A simple formula for the valuation of a publically-held company is:
Equity Value + Debt – Cash
Financial information for a public company is typically readily available, so finding the figures needed for this calculation should be easy.
- How do I determine the value of a private company?
The best option for valuing a privately-held company may be to compare it with a publicly traded company that is similar in size and type. Remember, however, that private companies do not have the same liquidity as their publicly-traded counterparts so, all other elements being equal, the private company will have a lower lower value than the similar public company.
- How do I value a franchise business?
If you are a franchise owner interested in selling your business, contact the franchisee and review the franchise contract. In many cases, the contract will set a specific price at which the franchisee will, under stated circumstances, buy back the franchise at a fixed price. Your franchisee may also help you determine a value for your franchise unit by locating one or more potential buyers for your unit.