How companies are valued for investment

Al Sisto

Blog by: Al Sisto - 19 / Apr / 2018

Attracting and securing investment is one of the biggest challenges faced by start-ups and SMEs. In many cases, it is an essential engine for business growth and product or service innovation, so it’s vital that the business in question is not only positioned as attractively as possible, but also valued accurately.

But is it an art or a science? There is no single agreed-upon formulaic method for valuing businesses of any size, let alone new and fast-growth businesses which are particularly dynamic. As one line of argument goes, a business is worth as much as someone is willing to pay.

However, there are some general principles that can be followed by any business owner looking to ready their organisation for investment. Essentially, all business valuation models fall into one (or more) of three general approaches: asset-based, market-based and income-based.

Asset-based

This approach is based, very simply, on the value of all of your assets minus all of your liabilities. It is generally most useful for organisations with a large volume of assets or particularly high-value assets, such as manufacturing equipment or other specialist hardware, or those which need to carry a large amount of physical stock. If the company is being sold rather than invested in, it can be a useful means of determining the asset purchase agreement too. However, it is also a complex, expensive and time-consuming approach, which requires specialist skills in asset and liability valuation.

Market-based

This approach involves making estimations on predicted future earnings by examining similar companies and the transactions and earnings they have recorded. Gathering and analysing these data can be difficult. First, there’s the challenge of actually identifying companies that provide a reasonable comparison. Then, there’s the challenge of accessing the relevant data. Then, you need to deploy pricing multiples, which allow you to estimate business worth in relation to business performance. However, this approach clearly contextualises your business in the marketplace, and can put investors’ minds at ease in terms of your competitor analysis and understanding of your own USPs. It is an outward-looking valuation model.

Income-based

This approach focuses on the business’s earning power and, as such, is the most future-focused and often considered to be the most accurate of the three approaches. Given that investors are naturally keen to maximise their return, it makes sense to predict as clearly as possible what your earnings are likely to be.

Nevertheless, all forms of future-gazing in business have to be treated with caution, and this model still requires some complex calculations in terms of either discounting or capitalisation of business earnings.

Mix and match?

Which of these approaches is most suitable for your business depends, of course, on your own unique context. What physical assets do you have in place? What sector do you operate in, and what do your competitors look like? What is your financial track record, and how can it be used to predict possible future earnings? Valuing a business for investment relies on a complex combination of educated estimation, established mathematical formulae and careful tracking of all constituent data – but, when done well, it can unlock huge growth potential.

If you’re planning to position your business for investment, it’s always worthwhile bringing consultancy on board to advise on the most appropriate model or models for valuation, and the data you will need to collect. Keep an eye out for further blogs and insight guides to help you on your journey.

 

Topics: investment funding, Company valuation

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