Valuation is one of those four-syllable business buzzwords you’re going to have to deal with, eventually, if you either want to start a business or own a business. If it doesn’t come up when you start, it will come up later. Here is what I think you need to know, in five short points.
If it hasn’t come up yet, it will. Every business deals with valuation eventually. The place any business sees it is during the early investment phases; but most businesses don’t get investment, so they can ignore it at that point. But then if it survives, or grows, valuation comes up again, because even if the business is immortal, the people aren’t: so eventually you either sell it or pass it on to a new team, an acquiring company, or your own family. And there’s the divorce and estate planning elements that require valuation. So every entrepreneur and business owner should have some idea what it is.
(Image: courtesy of wordle.net)
How much equity do I have to give to angel investors? If you’re a startup founder looking for angel investment, you need to understand valuation. It’s a buzzword that people use in other contexts, too, which adds to the confusion. But it’s ultimately what determines how much of your company your investors will get, and how much you keep, if you manage to land an angel investment deal. So it’s a critical question that comes up a lot.
Equity means ownership. So 25% equity is 25% of the ownership of the business. Usually that’s a matter of shares. The math is fairly simple, but important: Logically, if an investor gives you $250,000, on a valuation of $500,000, that means half your company. The investor owns half, you own half. If the investor gives you the same $250,000 on a valuation of $1 million, then that means the investor gets 25%, you keep 75%. (Technically that’s what they call pre-money valuation, and there is also post-money valuation, but I’m not going to deal with that here. You get the point.)
What I’ve seen in practice, in nine years of membership in an angel investment group, is that valuation is an agreed-upon guess. There are no formulas commonly accepted formulas (although there are some formulas, such as you’ll see in this post from the angel capital association; it’s just that I rarely see them used in practice). In my experience, what really happens is all about saying no. Investors say no to valuations that are too high, startup founders say no to startup valuations that are too low. When the startup needs $250,000, the founders are rarely going to accept valuations of less than $1 million, because they need to maintain substantial ownership. When investors aren’t comfortable with valuations that high, they most often simply pass on the investment. I don’t see discussions in detail of components of valuation, like one sees in home buying transactions when buyer and seller go into details of square footage and comparable deals in the neighborhood.
Angel investment deals often postpone valuation by using convertible notes. The note is debt, supposedly to be paid off; but convertible means both sides intend to convert that debt to equity shares later, so that it should never be paid off, just converted to shares. In that case, angels are saying essentially, “we believe in you enough to give you this money, but we’re not sure of your valuation, so we’ll postpone that for later.” What both sides want is a follow-on investment, they hope for more money, from venture capitalists, to set the valuation later.
If it hasn’t come up yet, it will. Every business deals with valuation eventually. The place any business sees it is during the early investment phases; but most businesses don’t get investment, so they can ignore it at that point. But then if it survives, or grows, valuation comes up again, because even if the business is immortal, the people aren’t: so eventually you either sell it or pass it on to a new team, an acquiring company, or your own family. And there’s the divorce and estate planning elements that require valuation. So every entrepreneur and business owner should have some idea what it is.
(Image: courtesy of wordle.net)
It was a warm late-spring day in 1999. I sat in my office with a venture capitalist, my lawyer, and my son. The sun beamed in the patio outside my office. We talked about Palo Alto Software and its web subsidiary bplans.com. At one point the VC said:
You wouldn’t be an attractive investment for VCs. You’re too profitable.
I chuckled. I thought it was a joke. We’d grown sales in four years from less than $1 million to more than $5 million annual sales. We had to be profitable because we had no outside money.
He said:
That’s no joke. It’s like the Oklahoma gold rush, a land grab, and the assumption is that if you’re profitable, you’ve stopped too soon. You should be spending more to build traffic.
Those were strange times.
(Image: iDesign/Shutterstock)
I’ve posted here before on BizEquity, the “Zillow of small business valuation” site offering quick estimates of business valuation.
BizEquity founder Tom Taulli — a true expert in the field — has added some interesting new tools for the site. Most notably, a valuation wizard that can take your inputs and give you a quick and dirty estimate of what your business is worth.
I did a test run over the weekend, by inventing hypothetical numbers for an Internet company. I had it started just three years ago, growing sales to $350,000. It had little or no profits, a bit of debt, and a lot of dependence on the owner (the site’s auto wizard asked me the right questions). The estimate ended up at about $275,000, with interesting variations above and below that depending on how I set several sliders. You probably can’t read the details in the shrunken illustration below, but the sliders are asking how favorable the location is, the level of competition, and how you foresee the future financial performance.
With the way the sliders work, you can see instantly how valuation would change with different settings.
Obviously, these are just estimates. As with estimates of house values, before you list your house, these estimates give you some idea, but are far from exact. They’re based on some standard formulas that estimate valuation using factors like sales, profits, assets, liabilities, and so forth. Don’t even dream of using this for a tax-related valuation, which requires a certified valuation professional; but it’s still a useful first look.
I think valuation is fascinating. What is a company worth? With the larger publicly traded companies you can easily calculate a valuation using the wisdom of the crowd, the market itself, by multiplying shares outstanding times price per share. But in the real world of small business, gulp, this is much harder.
Concretely: how much is your business worth? How much could you sell it for? How would you decide? What formulas would you use? More importantly, what formulas would your hypothetical or theoretical buyers use?
Ultimately, like it or not, just about anything is worth what somebody else will pay for it. Your business is worth what you could sell it for.
And what would that be? Well, that’s really hard to know, until you go to the market. Some people talk about 5 or 10 or more times profits, but then face it, in small business, in the real world, profits is a very vague number, an accounting conceit. Some people talk about 1 or 2 or more times sales, which eliminates a lot of the accounting fiction. Others talk about valuations based on book value, or assets.
I’m amused at how much of this stuff is loosey-goosey, even though it’s in the realm of finance, which is supposed to be mathematical and exact. And isn’t.
I posted here last Fall about BizEquity.com, Tom Taulli’s really intriguing site that’s attempting to create a database of first-cut estimated valuations of businesses all over the United States. I talked to Tom last month after the big meltdown, and found, happily, he’s still optimistic about the long-term value of the BizEquity site. They’re working on it. I suggested he take his September data and multiply it by about 0.5 or so; and I was only partially joking. Tom knows this area very well, but of course the whole volatility burst has been a challenge. Last summer might not have been the most opportune time for Tom and his backers to start.
So I was interested yesterday Monday morning as I soaked in coffee and I noted — thanks to Ann Handley in Twitter — Advertising Age‘s Simon Dumenco’s angry analysis of the Huffington Post’s recent venture capital infusion at a valuation of $100 million.
His title, unfortunately, is What’s $200 Million Divided by 2009 Reality. That’s too bad, because the $100 million (or less) estimated valuation was widely publicized when Oak Investment Partners announced the investment last November. Simon doesn’t enhance his argument by referring to the twice-as-large-as-fact figure, $200 million, that actually appeared much earlier, last Spring. The phrase “straw man” comes to mind.
That glaring error aside, he seems offended by the VC’s reported valuation. He has references to the big Internet bubble of the late 1990s. It should be only $2 million, according to him.
I think he exaggerates his point, not just by doubling the figure, but also by lowballing his real estimate. The Huffington Post has made huge (and well reported) gains in traffic. Furthermore, unlike a lot of the Web 2.0 sites he wants to knock, this one has an actual revenue model. For better or worse, the Huffington Post is almost like old-fashioned media. It generates readers with news and opinion, and it sells advertising. So somewhere in the numbers — which are not public — is a number for revenues, and a valuation based on (among other things) revenues as well as traffic.
And it all goes to illustrate my point, today: valuation is hard to figure. It’s also important. And, in the end, a company is worth what buyers will pay for it. In the case of Huffington Post, it’s not a vague theoretical guess. The VCs who invested in Huffington set a price, and, with that, a valuation.
The best readily-available valuation of business consulting services is 1.12 times annual sales. For automotive repair shops, it’s .41 times annual sales. Physical fitness facilities are going for .66 times gross annual profit. Grocery stores are going for .28 times annual sales, and sporting goods stores for .34 times annual sales.
There’s a valuation report in Inc Magazine’s April issue that turned me on to Business Valuation Resources, which sells information like the above, culled from data on actual transactions. I registered (free) to get a free download of a complex chart — sophisticated, innovative, imaginative, but really hard to read. And I gather that the underlying data isn’t cheap, because I can’t find anywhere to send you for a link to the data table, industry by industry, that I used to do the snippets in my first paragraph.
Conclusion: if you’re dealing with valuation, this could be a good resource. Valuation information is something like insurance account numbers: you don’t need it very often, but when you need it, you really need it. Like when you want to sell your company, or sell part of your company, or predict valuation as part of an investment negotiation, or when there’s a divorce, and … well, you get it.
Gripe: once they’ve published the data and put it out into the world as hard copy, can I get it online somewhere? Oh yeah, I get it, there’s value to the data. Tough call for BVR, how much do you give away to promote your data?
(Note: I posted this on Up and Running yesterday. I’m crossposting it here for reader’s convenience. – Tim)
I really don’t like the word “valuation”; it sounds too much like an MBA buzzword. But I like even less the general confusion about the concept. We talk about starting businesses, we talk about running businesses, getting investment, getting financed, and we should take discussion of valuation for granted. Valuation is at the same time frequently necessary, obvious and extremely arcane. It is nothing more than what a company is worth. It becomes necessary more often than you’d realize, with buy-sell agreements and tax implications after death and divorce, plus financing and investment. It’s obvious because a business is worth what a buyer will pay for it. And then it breaks down into complex formulas and negotiations.
So here are 10 (I hope simple) rules for valuation.
Before you buy into the myths about startup investors, first consider whether you actually want startup investors for your new business at all. No, I’m not bitter … I had VC money in Palo Alto Software for a few years and they were helpful, collaborative, and good people. I’m not a bitter victim. And I’ve invested in more than a dozen startups, so I don’t hate investors; I am one. But I try to tell the truth. Most businesses are better off without startup investors.
Which would you rather — steer by committee, with people looking over your shoulder? Or just do it yourself, you drive, you decide?
Also, before I go too far, yes, there are opportunities that demand investment. These are the opportunities that you can only address with substantial deficit spending, which are also worth it, with a big pot of gold at the end of the rainbow. If that’s what you’re looking at, hooray.
I’ve said it before: bootstrapping is underrated. I get frequent emails from people asking how they can get investment for their new startup, and I’ve admitted to being a member of an angel investor group. But let’s not forget, while we’re thinking about it, these 10 good reasons not to seek investors for your startup.
The question on Quora was “What do investors ‘get’ that other people don’t?” I answered that question from the point of view of angel investors, specifically … not just investors.
Many people think that a good business makes a good investment. The truth is not necessarily. Many real good businesses are bad investments …
For example, the founder-driven business that generates enough cash to fund its own growth. It’s founders may choose to not exit soon enough to offer a good return for investors. In these cases, founders are better off without investors. And investors have higher risk of never seeing an exit.
Investors own shares in the business, not revenue, and not profits. They make money when they sell their ownership for money. Increasing valuation generates a return on investment. Profits, without the exit, don’t flow to investors in normal startup situations; dividends are for stable companies, not profits.
Angel investors make money on growth, not profits.
A company that loses money but grows well in terms of revenues, users, subscribers, and so forth can be an excellent investment because most valuations in high-tech startups are based on revenue, not profits.
Ironically, investors may be better off with high-growth that loses money because their money becomes more valuable, and more important, when it is all that stands between growth and not growth. Investment is more likely optimized when it funds growth.
All serious angel investors know that most startups fail. They don’t look for the low risk investment that might yield a more reliable return, because those startups fail too. So they look for the big win, the next big bonanza, the huge success that will pay for all the failures.
Market estimates, market share potential, sales, costs, and all the rest … investors want to see them because they show what you’re thinking and how well you understand the business. Ideally it shows that you understand the drivers and the fixed costs, plus cash flow problems, and all the rest.
Regarding market numbers, they are going to review them but they will look at your assumptions and decide whether they believe them or not. The best market estimates trigger the dream and the imagination of the investors.
Note above that angel investors don’t believe your numbers. How naive to think a number generated by assumptions compounding on assumptions has any actual metric value. My personal opinion is that when startups believe their IRR matters, they are too green, not long enough out of school.
(Here is the link to the original on Quora)
Question: What are some of the main arguments for writing a business plan?
Here are 20 good reasons to write a business plan. Please note, however, that a business plan is not necessarily a traditional formal business plan. It ought to be a lean business plan that gets reviewed and revised often. It ought not to be static, used once, and then forgotten.