What's Your Business Worth: Determining "Value"
The ultimate point of a business--to its investors if not to you--is its value. An investor will give your business a dollar for only one reason: because he expects/hopes/prays that at some future time he will get back more that a dollar. That is what you must persuade him of when you ask him to invest. And, since you and your investors are in the same boat, that is what you must work towards in running your business.
Valuing your business
There are many ways to value a business, none perfect. Here, as in all technical fields, it's good to know the terminology. First, be aware of the distinction between liquidation value and operating, or "going concern" value.
Liquidation value assumes that the business is dead, and that you are selling off its assets and paying its liabilities. There are rare cases in which a company's liquidation value is greater that its going concern value, such as if a business owns a particularly valuable piece of real estate, or a valuable patent, which the business as it is being run cannot fully exploit. In such cases, the value of the business is simply the sum of the values of its assets, less the amount of its liabilities.
As the owner of a new business, you will deal almost exclusively with going-concern value, since the death of your business is something you won't want to contemplate. Here, again, you have to keep some things in mind. The most important thing to remember is that the going concern value of your business is exactly what an informed and uncoerced buyer will pay for it. Is it that simple? It sure is.
BUT--and here's the rub--you aren't selling your business!! How then, do you figure what an informed and uncoerced buyer will pay for your business when there is no such buyer around? That's where the art of valuation comes in. A valuation is an estimate of what an informed and uncoerced buyer would pay for the business. Don't ever forget that a valuation is only a prediction, a guess--perhaps educated, but a guess nevertheless.
So, treat all valuations with a healthy dose of skepticism, much as if the Groundhog is giving them. Don't take my word on this. Read the papers. I read recently that eToys.com filed for bankruptcy because it couldn't find a buyer. A year ago it had been valued at millions of dollars. The dot-com landscape is littered with examples of wishful thinking. What can one say about such valuations but that they were predictions gone awry?
That being said, however, you still cannot get away from making valuation decisions. Your investors are betting on the future value of your business. You have to give them some reason for believing that your business will have a future value. Why that is so is interesting but not our concern here. A cynic could well point out that we are perfectly happy buying lottery tickets and betting on roulette wheels, dice and slot machines without even pretending to be able to predict the outcome, and that there is no logical reason we should treat new businesses any differently. But investors do, and generally do not gamble on new businesses unless they have convinced themselves that the game is rigged in their favor. And that, pure and simple, is what a valuation does--it provides the intellectual rationale (if not rationalization) that an investor needs to support a decision to invest in your business.
Over the years, a number of approaches have been used to estimate the value of a business. Generally, those approaches fall into two categories:
Those that compare your business with other businesses whose values are believed to be better known.
Those that seek to determine value by measuring certain characteristics of your business itself.
The most common comparative measures of value are the so-called multiples. One can easily see, by looking at the statistics of other companies in your industry that are publicly traded, how the value of all their stock compares to their last twelve-month's earnings (basically net profits) or sales revenues to calculate a ratio of price to earnings or price to sales.
Drawing on the assumption that your company would be comparably viewed by the investing public, you can then apply the same ratios to your company and see how you stack up. For example, assume that the stock prices of other companies in your industry average 20 times their last year's earnings. If your company last year's earnings were $1 million, then you could estimate your company's value could at $20 million.
Internally calculated valuations are more heady, and involve trying to put a discounted present value on the business's presumed future dividends, cash flow or other operating parameter. The most useful analytical technique that I have encountered--and my own personal favorite--is discounted future cash flow.
Discounted Future Cash Flow --- In this method, a company's future free cash flow is predicted from its past operating results and discounted to the present to arrive at a value.
The technique is described in detail and very well in Valuation: Measuring and Managing the Value of Companies, 3rd Edition by Tim Koller, et al. In fact, this book should be required reading for any entrepreneur, if only for the insights it provides about valuations in general and about how the business should be managed so as to maximize value. This model emphasizes the importance of cash flow in the creating wealth, of which "value" is merely a measure. Cash, now more than ever, is king.
Now I can guess the next question: What if you don't have earnings? Yes you can still have a valuable business even if you don't make money, but only if you someday soon expected to make money. Any business, no matter how big, that is unprofitable for too long will cease to exist. So, for a new business, the overriding consideration will be how long will it take you to become profitable, and investors will scrutinize your business plan to find the answer to that question.
But think about what one is really doing when attempting to value a new business that has no operating history. You have nothing to go on except the projections in the business plan! So valuing a new business is really an exercise in (a) assessing the feasibility of the projections, and (b) applying valuation techniques to the projections to determine "values" at a future time. You and your investors will be applying uncertain valuation methods to predict what a hypothetical future buyer will pay for your business, based on predictions of how your business will perform that are themselves subject mostly to events that are outside your control!
Can any of this be valid? Not as a true forecast, of course not. There are too many uncertainties. You'd be better off picking a good day for golf in 2003 by consulting the Farmers' Almanac! I doubt that any business has ever turned out to be worth in fact what its founders and investors first calculated it would be. Business plan valuations are not "real" the same way your pocket change or your house is. They are mere analytical calculations based on shaky assumptions of the future. Never, but never, figure your net worth, or worse buy a new Ferrari, on the basis of a valuation of your business plan.
And yet, new businesses are routinely valued on the basis of their business plans, and for good reason. By insisting on rigorous projections and applying well-understood valuation techniques, investors can compare one new business against another, both equally subject to an unknown future. All things being equal, the company with the higher valuation based on sound projections will be favored. As the line goes, the race is not always to the swift nor the battle to the strong, but that is definitely the way to bet. Thus, while no one should realistically expect the business actually to turn out as projected, the projection and attendant valuation provides a veneer of rationality to what otherwise would be an investment decision based on hunch alone. It may be a mere fig leaf of intellectual cover, but there it is.