Steps to Growth Capital Self-Study GuideStep 3

3.6 Put a Price Tag on Your Business

Before you approach potential investors, you, and any other existing shareholders, need to have an idea of the value of your company. Prospective investors will also assess the value of your business when they consider your proposal. The process of determining the value is called "valuation."

You and the investor both need to determine what you think is the value of the business because the value will be the basis for negotiating:

• how much of the company the investor will buy (how many shares);
  
• how much the investor will invest (the price of those shares); and
  
• the return the investor can expect to earn.

An Example

Here's a simplified example: if you feel your company is worth $10 million and you're asking for a $2.5-million dollar investment, then the investor will get 25% of the shares. But what if the investor feels the company is only worth $5 million? He will expect 50% of your shares for an investment of $2.5 million. You and the investor will each use valuation methods you think are right to determine the price and the equity share. And then the negotiations will begin.

Ways of Valuing a Business

Valuation is not an exact science, and there are a variety of ways to do it. These methods use different assumptions and different financial information and typically result in different values. For instance, you could base a valuation on a company's assets (how much it owns). Another approach is to use projected revenues or cash flows. Investors prefer methods based on cash flows, and we will cover them in more detail here. But it's important to know about a variety of methods because they can be useful as benchmarks to check the validity of the value and the price you determine.

Earnings and Cash-Flow Based Methods

Discounted cash flow

From the investor's perspective, this is usually the most accurate and effective way to estimate a company's value because it is based on future cash flows. And future cash flows, the money that will come in to the company, will ultimately determine the investor's return on investment. Essentially, discounted cash flow calculations try to answer this question: Taking into account the ups and downs of revenues and expenses and new investment, how much will today's investment yield tomorrow?

 

Going concern value

The going concern value, like discounted cash flow, compares the current investment to the future receipts (cash inflows). This method uses the revenues of previous years to project future revenues, and it assumes those revenues will not change. If the company had revenue of $500,000 in each of the last five years, this method assumes that future revenues will also be $500,000 per year. But investors and entrepreneurs prefer the discounted cash flow method because it accounts for changes in revenue, expenses and investment; in other words, the discounted cash flow method tries to be a more accurate and realistic forecast of cash flows. (For more information and an example, take a closer look at Going Concern Value.)

Asset-Based Methods

Book value

This value is simply the company's net worth or shareholders' equity, as shown in its financial statements. At its most simplified, subtracting liabilities from assets gives net worth or book value. Obviously entrepreneurs may feel that their exciting new invention is worth much more than the current value of their equipment, buildings, receivables and other assets. So this method is usually used as a reference point only. (For more information and an example, take a closer look at Book Value.)

 

Liquidation value

Liquidation, like book value, is based on a company's assets. It's the amount you would get from selling all of a company's assets. Equipment and land would typically yield something close to their market value, while things like inventory and receivables will usually be discounted and yield less than the value on the books. The liquidation value obviously doesn't represent the company's potential; it's a most pessimistic, rock-bottom value calculation. (For more information and an example, take a closer look at Liquidation Value.)

In matters of price, the market rules

There is a truism in the venture capital industry that "the value of a company is only what someone is willing to pay for it." In other words, in the end, the market — and your ability to attract investors and negotiate with them — will determine the value or selling price.

Each investor will have a different view of the value of your business. This view will be based on each investor's perceptions of the future risks of your business and the returns to be derived. And other factors will enter their calculation of your business's value (and therefore the price they are willing to pay):

• their level of knowledge of your business's strengths, weaknesses, opportunities and threats;
  
• how strong their desire is to make a deal; and
  
• your relative negotiating positions and strengths.

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