Business Valuation from an Investor or Business Buyer's Perspective

Most every business would like to know what the real value of their business is. The truth is an accurate answer can only be found out through an exhaustive process of selling your business or trying to raise funds. Traditional standard valuations do not really provide a true value for a small business, mainly due to the subjectivity involved.

With that said, you can get close. In order to get as close as possible to an accurate valuation of your business, sometimes it is best to forgo the traditional business valuation template, (which in most cases is fairly useless,) and instead put together multiple scenarios that will help you to understand the value of your business to a buyer as compared with other alternative investments or assets the buyer is considering. This exercise will have an added benefit outside of understanding of your company's value, by also helping you to understand what you should focus on in order to make it more valuable in the years to come.

Just like you make an investment, buyers will be looking at buying your business versus alternatives. High Net worth investors will look at your business objectively as an investment or source of income. Strategic buyers will have a choice of buying your business or trying to grow organically. Or let the competition buy the company and spend the money on marketing. We will look at each buyer type, and how they will look at your business.

The majority of small businesses exit through a sale, and therefore one of the best ways to put a value on a business is to determine the price someone will pay for your business. In that respect, a lot of the information below discussed by the experts at CL King will be with relation to selling a company.

Passive Investors

Passive investors are those that will not participate in the day to day operations of the business. These might be high net worth individuals such as "Angel Investors", small funds, or possibly a financial institution. The value they will put on your company will be based on two characteristics:

1. What return can they get from the business?

2. What interest do they have in the industry?

These investors will typically have investment portfolios that contain a wide range of investments, from assets such as stocks, bonds, real estate, commodities, to other business opportunities, charities, etc. Each of these instruments will have an expected return associated with it, and the principle rate of that return is based on the risk of that particular instrument.

When you are seeking an investment from this group, you are really competing against other investments they would like to make. In other words, they are going to invest this money, is it going to be purchasing stocks, real estate, or equity in your company? To understand the value of your business, you need to look at these other investments as your competition, and compare the rates of return for these alternatives and compare them to the rate of return on an investment in your company.

Although this is not a pure science, the rate of return on a $250,000 investment (ordered by risk) could be described as follows:

Instrument Rate Risk/Liquid Investment Expected Value - 5 yrs

• Government Bond - Rate of return of 2.7%, very litte risk/illiquid, expected value in 5 years, $285,622

• Bank CD - Rate of return or 3.0%, very little risk/illiquid, expected value in 5 years $289,818

• Stocks (taxes deducted) - Rate of return of 5.5%, Some Risk/liquid, expected value in 5 years, $314,163

• Real Estate (income producing - no leverage) - Rate of return of 10%, Little risk/illiquid, expected value in 5 years, $375,914

• Aggressive Growth Funds - Rate of return of 12%, Somewhat Risky, expected value in 5 years, $406,301

• Angel/Strategic Investor (50% of equity) - Rate of return of 15%, High risk/non-liquid, expected value in 5 years, $500,000 (assuming $1million value)

• Outside Investor (50% of Equity) - Rate of return of 32%, High risk/non-liquid, expected value in 5 years, $1,000,000 (assuming $2 million value)

Let's try to use the above chart in an example. Let's assume you are trying to raise $250,000. In your chart, you are projecting approximately $230,000 in earnings in 2012. Let's assume 5 years is 2014. The business will need to be worth $2 million by that time.

There are a couple of items to keep in mind.

Every investor will beat up your projections, and chances are they will knock them down.

The exception to this rule is the Angel or Strategic Investor who understand your business, or would like to add substantial value to it. They are in it for more than just a return on their investment. They enjoy working with small companies. It is very difficult to find angel investors, and hard to determine what value they will put on the company, since it typically not an objective calculation.

Most companies are valued based on a multiple of earnings. Let's define earnings as the amount of cash someone from the outside would see come to their benefit assuming they were able to take over the business and run it themselves. So you would add health insurance, car payments, taxes, etc back to the earnings to make it higher.

For a business with "average" risk, most buyers will value the company based on a number that is (arguably) 3.5x's the "adjusted earnings number". (more on this multiple below) Therefore by the date you are thinking of realizing your "goal" valuation number you have to make sure that your earnings are that goal valuation number divided by 3.5. If you compare this to the chart above, I believe you will find the logic behind this multiple makes sense.

You will face an enormous amount of scrutiny if you are presenting a sudden increase in your earnings to an investor to justify a higher than 3.5x's multiple valuation, so be careful. You will need to back up any number you put in front of a potential buyer or investor with concrete evidence and facts.

Institutional Investors and Funds

A typical venture capital company will look to make a tremendous multiple on their investment, because you have to pay for the failures they invest in and they can still have a 20% return to their investors. Therefore, they will typically look for an annual return of 40% on any of their investments. In addition, they want to know they have a rock solid exit within five years, whether through the public markets, an industry consolidator, or a Private Equity Fund.

Institutional investors will only be interested above a certain revenue level, and knowing that there is a clear and predictable liquidity event as an exit. Private Equity companies will not invest in any company that has less than $1 million in EBITDA in the vast majority of cases. The Public Markets are even worse, where you typically need $3 million minimum in EBITDA to make it worthwhile.

Strategic Acquisitions

This is very difficult to estimate, since strategic acquires can be interested in a business for so many different reasons. They are almost always the investor or buyer type that will give you the highest valuation for your business. This is for a number of reasons, including:

• Lower risk since they understand your business, or at least the industry

• Potential synergies since some of the business functions are probably redundant

• Do not want your business to fall in the hands of another competitor, especially a well-funded or aggressive one that might cost them substantially when competing with them

What a Multiple of Earnings Means

The multiple is the amount multiplied by the earnings or the revenue that will compute to the price. In other words, if you were to use a 3.5 multiple of earnings, and the business is earning 100k, the price paid for the business will be $350k. If you are using a 0.8 multiple of revenue, and the company has $1 million in revenue, the price for the company will be $800k. The question is what multiple will an acquirer put on your business? As discussed above, it is mainly determined by risk. Unfortunately there is no concrete formula or absolutely definitive answer since no two businesses are alike. This subject will be discussed in other articles.

Conclusion

Your business is an investment to a potential buyer or other. You need to look at other investments as your competition in order to understand your value. By putting yourself in their shoes, and asking the question about how much you would be willing to pay for your business, you can begin to determine the real value of the company.

If you want to learn more, consult with the experts at CL King and Associates. You can call at 518.447.8050

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