How to Value Your Business
Valuing a company is one of the inevitable tasks a business owner will make in their life. Whether valuing a company you wish to invest in, or testing your own concept for a startup, or even valuing your company to take on investors, it is an invaluable skill. There are many ways to value a business but the more methodical the approach is, the more likely it is to be a reliable valuation. One of the easiest ways to learn about business valuations is to watch Shark Tank. The sharks often pound the valuation and relentlessly critique why the entrepreneurs are right or wrong (most often). It is very entertaining and very informative for business owners and investors alike.
Often potential investors look at the easiest numbers to quantify when giving a valuation, the business’s assets. Every business likely owns some assets, equipment, inventory, or property. Valuing these will give you the bare bottom number a business is worth as the replacement cost. These are the costs you would have to incur to start the business from scratch, so the business is worth at least the replacement cost.
The most common methods of valuation is to look at cash flow. The stream of cash that a business brings in can be a good indication of whether an investor will be able to profit from their capital. Don’t stop at just analyzing the cash flow, you will need to determine what is the total revenue at the very least and go deeper from there. Revenue is the basic factor in looking at cash flow. Some industries have average cash flows for certain size businesses, these metrics can help an investor understand where this business lands in the industry bell curve. The more revenue over the industry average, the better the valuation.
Don’t confuse revenue with profit. Some very high cash flow companies can operate at little to no profit. Amazon was one of the prime examples for several years. In 2002 it had nearly $4 billion in revenue but no profit. Profit is a much better indicator of valuation than revenue or assets alone. One common method is to look at the profit of the company for the last 3 to 5 years and project those earnings into the next 3 years. Of course the projection must be guided by general business conditions and industry specific factors to be of any use. After the projection is finished, investors add the three next year’s projections to any other considerations (generally any substantial assets) to value the business. This valuation method primarily focuses on making the investment back in about 3 years, a common goal for business investments.
If one is too busy to complete an industry projection (not recommended) you can also use the quick and dirty method of taking the most recent year’s profits and multiplying by 3. This will generally get you to a rough estimate of the method noted above. Some shoot from the hip investors have had great success by using this quick method and putting the business owners or other investors on the spot with a “now or never” offer. Caution is advised.
Lastly are the non-financial considerations every investor and business owner factors into every decision. Is it worth a little more to you to work from home? To have that ice cream shop you’ve always dreamed of? Don’t let the non-financials out-weigh the hard financial numbers. Too many business owners ignore serious number problems only to end up with a dream that has become a nightmare. A solid valuation methodology coupled with a comprehensive view of your goals and risk tolerance can help you start off your business or investment on the right foot and lead to success and profits. For a free consultation on valuing your business or other important business and legal questions, call Reidel Law Firm today at (832)510-3292 or use the contact form below.