Business Financing: The Art and Complexity of Valuations, Particularly Start-Up Valuations

For the last couple of weeks, we have been looking at business finance issues, and specifically, start-up business finance issues.  We started with a summary of finance options for business – sales, debt, or equity investment.  We then tied into the #ECOops team discussion at Entrepreneur Community Online and looked at the top five investor issues when your target market is investors.  Today, we will survey issue of business valuation with an emphasis on start-up valuation.  These topics are partly posted in anticipation,and recognition, of the Angel Capital Summit this week.

Specifically, the Rockies Venture Club’s Angel Capital Summit is this Tuesday and Wednesday, March 19-20, 2013, at the University of Denver, Sturm Hall.  The schedule includes networking, seminars, and pitches by up to thirty start-up companies.  I have the privilege of being on the Executive Committee for the event and am heading up the Venture Bucks program where attendees receive ten $10,000 Venture Bucks to invest in the companies who are pitching over the course of the second day. There will be ballot boxes for the companies, and the top three companies who receive the most investment votes will receive awards at the end of the conference.

Valuation Basics

When examining a business investment financing, valuation is key.  The issue is not merely what the actual, present day value of the company is, but what the value is likely to be over the life of the investment.  This survey of valuation techniques is in no way comprehensive, but is meant to merely create a framework for basic comprehension and discussion.

Comparable Businesses:  The first basic approach to valuation looks at the amount for which a comparable business within the industry sells.  For many businesses, the sale price is some multiple of earnings, cash flow (earnings after adding back interest, taxes, and depreciation expenses and amortization charges, i.e., “EBITDA”), modified EBITDA (which takes into account capital, capital spending, and taking out or adding back in extraordinary items and costs which should be normalized), book value or revenues, or some other standard formula.  This is a backward looking approach.  However, at the start-up stage, these amounts used to determine a sale price are generally non-existent or far off.  In short, a start-up rarely has significant cash flow, if any, or a positive revenue to work off of.

Replacement Cost:  The second basic approach looks at the basic cost to replace the assets and the going concern value of the company.  This method looks at he parts and pieces of the business to determine what would have to be spent to duplicate the business. This approach looks at the present situation of the business.  However, with start-ups, this is a very difficult, if not impossible, task to do accurately.

Discounted Cash Flow/Internal Rate of Return: The third basic approach looks to the future of the business.  This approach attempts to evaluate the future cash flow streams of the business, the future sale value of the business, and then discount those values back to the present using some reasonable rate.  The discount rate is based on both time-value concerns as well as the perceived risk or uncertainty of the projections.  Only if the amount of the investment less the discounted value of the future cash flow stream or sale exceeds zero, the investment expects a return and makes sense.  However, with start-ups, the future projections are speculative and the discount rate is very hard to determine so that the approach is often of limited help.

The Art and Complexity

Because the basic approaches to valuation are generally better suited to established companies, the use of such tools is only a part of the consideration for start-up valuation.  Instead, the valuation question for start-ups is tied more closely to perceptions and emotional, gut feelings of the parties involved about the accuracy and prospects of the company.  In short, there is more art to the process than just hard factual analysis. In addition, the terms of the investment related to voting rights, redemptions, conversions, income rights, limitations on management or additional debt or investment, all become as important as the actual investment amount because they affect the risk and prospects of the company going forward.

Start-Up Investment Approaches

As a result, investors often take one of two approaches to determining the percentage of the target they will buy with the money they invest.

First, an investor may take an “inside out” approach which attempts to determine the worth of the target and the investment.  For example, if a company is arguably worth $1 million, and $1 million of capital is needed, the investor may be willing to take a 50% interest.

More typically, however, an investor takes an “outside in” approach.  This involves the investor determining the return they want from their investment and then agreeing to take an ownership interest that is expected to result in that return amount. For example, if the company is arguably worth $1 million, and needs $1 million in capital, and the investor wants a 35% internal rate of return, an investor who reasonably believes the company will be worth $5 million in five years will want a 56% interest.

If you are in the area this week, I hope you will join us at the Angel Capital Summit.

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