A common question I am asked is: Can this business be valued?
In the first blog in this series, the focus was on determining the value of a business that has been operating for years, but with incomplete or poor financial data.
The focus of this blog is on valuation of a start-up business.
How do you determine the value of a business in its infancy?
The starting point is the business owner’s forecast. Business owners typically have a forecast of projected revenues, expenses, capital expenditures, and income. The ideal starting point is having an income statement and balance sheet for the next ten years. The reality is the business forecasts I start with vary considerably: some may be a profit and loss statement for the next three years, with no balance sheet forecast. Whatever the owners have is my starting point and the ideal is rarely what I am starting with to prepare the valuation of a start-up business.
Building the Forecast
My next priority is to expand on the forecast from the business owner(s) and work with management to fill in the gaps. Sometimes capital expenditure planning is scant, or assumptions for market penetration, number of clients, or average revenue per client are needed for me to further expand the forecast.
Building and expanding the financial forecast is the foundation for developing the business valuation. While rudimentary valuation approaches may simply average the last three years of revenues and net income, venture capital firms and prospective buyers of a business are unlikely to accept this simplified calculation. Given the pandemic and its far-reaching effect on industries and businesses, an average of the past three years of revenue and net income is unlikely to represent a future business’ performance. The financial model I build looks forward, documenting key inputs and assumptions to pass the reasonableness test.
Factoring in Public Data & Risk
After working with management to augment the forecast, I turn to analyze public data. Useful public data includes price to earnings ratios as well as public information to incorporate into a regression model regarding returns based on the business’ financing stage.
Risk is applied when determining the value of any business. It is especially important when calculating the value of a start-up business. There may be no revenues and no history to support the forecast. That is where a higher level of risk will be applied.
Accounting for risk is factored into the discounted cash flow analysis. We have long embraced the discounted cash flow method, an approach that more business valuation professionals now utilize. This is the most accurate method. Once the forecasted financials have been expanded/developed in the above-described steps, now we factor in risk. The higher the level of uncertainty, the higher the rate used to discount the projected earnings.
Public data enables me to analyze rates used in valuing companies based on financing stage. A company with two to three rounds of financing will have a lower risk factor than a company at the seed level stage for financing. For self-funded start-ups, the financing stage is irrelevant, so risk excludes public financing data, but accounts for market and business risk inherent to the business.
Over the decades of developing business valuations that stand up to scrutiny, I have prepared detailed business valuations for firms having zero revenue as well as for business owners having an idea, but no product or service.
Determining the value of a start-up business can be done and is done frequently. Available public information, market information, and experience all support developing financial models that withstand the reasonable test and apply a risk factor to determine the valuation applying the discounted cash flow method.
If you are wondering if your start-up business can be valued, you now know the answer is yes. Now it is important to secure a certified business appraiser with the knowledge, proven approach, and experience so that the valuation is thorough and defensible. You have put a lot of time and effort into your start-up, do not sell the business short with an overly simple calculation.
When values matter.