Overestimating or underestimating the value of your company can make it difficult to get the right amount of funding or the right price when selling your business.
Whether you want to sell your business or bring in outside investors, it’s important to know what the valuation of your business is. There are a few different formulas business owners use, but you’ll mainly be looking at the following:
- Value of Liquidation: if you were to sell all your assets, what would they be worth?
- Value of Assets: what are your current assets worth to a new owner?
- Income Capitalization: determine what your future income would be, based on historical income and other factors.
- Intellectual Capital: if you have patents or trademarks, these will increase your valuation.
- Income Multiple: use a specified multiple with net income to determine a selling price.
- Value of Similar Businesses: by looking at what other businesses like yours are worth, you can use this as a determinant of your company’s value.
You may have watched the television program Shark Tank and wondered how the entrepreneurs came up with their valuations, especially when the investors think the amount is too much. The problem is understanding what your company is worth without going too high, which turns off investors and buyers, or too low, which may cause you to lose out.
A standard valuation formula is to take 3 times your gross revenue. So if your gross revenue is $1 million, your valuation would be $3 million. If you are selling your company, the idea is that the new owner could recuperate his investment in a short time: three years. This formula may be unfair if you have a lot of sales in the pipeline that haven’t paid yet. Let’s say you have $1 million in revenue, but you’re expecting another $2 million in sales by year end. Some buyers or investors wouldn’t count that $2 million as part of your valuation because it’s not guaranteed money until it is paid. With this formula, you lose out on an additional $6 million you could have added to your company’s valuation.
Another valuation formula, and one that is commonly used with web startups, is the following:
$1 millon per founder + $1 million per patent +$1 per active user
Let’s say you have a software company and two cofounders running it. You have three patents, and your software has 200,000 active users. Your formula for valuation would look like this:
$2 million for 2 founders + $3 million for 3 patents +$200,000 for your active users
What Knowing Your Valuation Does
If you are selling your company, knowing your business’ valuation essentially sets your sales price. If you are looking for investors, knowing your valuation helps you determine how much to ask for in funding and how much to give in equity.
In the example above, let’s assume you want an investor to help you expand. Your valuation is $5,200,000 and you want 25% more to make improvements to your factory. You can ask for $1,300,000 in investment in exchange for 25% of your company’s equity. If you ask for this much money in exchange for less equity, most investors would walk away. The balance has to be between the amount you want and the equity you can give.
How to Improve Valuation
If you are selling a physical business, it can help to upgrade your computer system, increase security and make sure the place is clean. You can also work to get new streams of revenue or new clients to add to your gross revenue. If you have any unique ideas, file a patent.
Give yourself time for all these activities to equal a higher valuation. For instance, you can’t get a patent filed quickly, so it may take several years before you can use that as a factor, though you can list it as an asset in the process. The more you put into your company, the higher your valuation will be.