How to Establish Company Value
Establishing company value is exactly what a venture capital firm will be doing when they look at your firm. How do they do this? The first point to note about valuations is that there is no exact value for a firm. The value attributed to most firms is a combination of available data, methodology and unfortunately…opinion.
Why unfortunately? Well, it can actually be a good thing or a bad thing. We say “unfortunately” because it means that you can never quite pin down the exact value of your firm. But this can be a bad thing or a good thing, when you think about it; now, nobody can tell you that you’re wrong – provided that your figures are at least justifiable.
Let’s get going then. The first thing to note is that the value of your firm is the sum of all its future cash flows. Beyond how good your idea is (and it probably is pretty good if you’re already reading this), beyond how many competitors are out there and beyond your expertise in IT: how much hard cash is this company going to put in the pockets of its owners?
And not just for the next 12 months, but for the duration of the company’s life. This doesn’t seem so easy to pin down, but relax, the methodology to finding a ballpark figures isn’t that difficult. Once you follow a few short steps, which we are going to outline here, the valuation will begin to look clearer.
There is just one complication with valuing start-ups: no track-record to work with. So, valuing stable firms with a history of financial statements and lots of comparable firms is a piece of cake. Valuing a start-up early in its life-cycle is trickier because you’re guessing more figures than you would be if you already had a track record.
Think of it this way: who would have guessed in 2004 that in a market that included MySpace, Bebo, SmallWorld, FriendsReunited and others that Facebook would become an $80 billion company? That’s the kind of issue you’re dealing with when trying to value a young tech start-up.
Okay, let’s get going.
The most important things you have to estimate in this process are the cash flow and the rate at which this cash flow will grow. Right now, there’s a good chance you’re not getting any cash in. Don’t worry – this is a part of the process. Even Larry Paige and Sergey Brin went through this phase at the beginning with Google. You’re not expected to make cash at the beginning. If you do, it’s a bonus.
How do I calculate cash?
This question is straightforward but make sure that you understand it. The cash that we’re looking for is not the amount of cash that comes into the business. This is revenue. This is an extremely important point to note at the outset. Too many entrepreneurs fail off the bat because they don’t grasp the difference. Don’t fall into the trap of confusing the two.
Revenue is what you get when one of your clients pays you for the product or service that you’re offering.
Cash is what remains after you’ve paid for your rent, the salaries of your employees, office supplies, the internet bill, your ISP, that doughnut on your desk and anything else that needs to be purchased. The residual is cash.
You want to know why Microsoft is worth so much? Because they make cash. A lot of it. Why is Google worth so much? The same reason. And Facebook? Ah…you see…there’s where the second part of the equation comes in. Facebook makes cash. But it is worth so much because investors believe that the cash it makes is going to grow substantially.
It makes sense, right? They’re not making massive amounts of cash now, but the idea is that they soon will be. Just like your small business. It’s not in profit right now – but it soon will be. Soon, you’ll be swimming in cash. The more your investors think they’ll be swimming in cash with you, the more they’ll pay for your business.
Your second challenge is to calculate growth. Don’t worry – as we’ve said before, nobody can get this exactly right. Even investment bankers who have been working in valuations for 30 years can only get an approximation. Your job is to make it justifiable. Your cash flow is going to grow 50% this year? Sure. Show us how.
Large growth figures aren’t at all unusual in start-up firms. In fact, they’re expected. So if your growth figures for 40% for next year, 40% for the year after and 30% for the year after that – don’t worry. You’re not being ridiculous. By the sounds of it, you’re probably even on the right track.
Just be aware that high growth can’t last forever. Think about the logic behind this: you reach your target market, get a good market share and where do you go from there? You’re just supplying the same customers over and over, right? You can probably release a premium version of your product or service and gain that little bit more each year. In this way, it’s useful for a start-up to think of two separate types of growth.
“Wait – two separate types of growth? Growth is growth, right?”
Absolutely correct! And all growth is good for your firm – never have any doubt about that. But for the purposes of your valuation, it’s useful to think about two types of growth: growth in the next five to ten years (which will probably be double digit each year) and then a figure for long-term growth (once your company is established, it won’t manage double-digit growth figures each year).
Hopefully, this gives you an idea of where you’re going with this. Right now, we’d like to give you an example of what this all looks like in practise. Don’t worry if you’re not familiar with accounting terms – nobody expects you to be. You’ll soon grasp that all financial statements look very alike, whether it’s a small start-up or a multinational giant. The only difference are the figures (naturally enough).
Here’s a small sample of what you can expect:
First of all, make sure you can establish what your free cash flow looks like. You need to get a grasp of where money is coming in and going out and where you expect it to come into the business and flow out in the future. Work out this figure for as long as you can into the future. You know this year’s cash flow and next year’s should be reasonably easy as well. The year after is more difficult to foresee and so on. As a general rule of thumb, you’ll need the next six years to make the valuation.
The first five years will look something like this:
E(CF) is shorthand for “expected cashflow.” If this is negative, write it in the equation as being negative – no problem.
The (1+r) part below the line is what’s known as a “discount rate.” This isn’t easy to explain in layman’s terms, so if you’re finding it hard to grasp the meaning of it, don’t worry. There’s also a wealth of material online about the discount rate and what it means. Basically, it’s a measure of how risky your business is.
The good news is that as usual, nobody can provide an exact number for this. For a start-up, this figure is just about always over 30%. It’s a much higher number than for other types of companies because start-ups are much more risky. As time goes on, this will lower – don’t worry.
The final part of the equation is the horizon value or the terminal value. Remember what we said about two different growth rates? –About one being a high growth rate for the short term and a second, lower growth rate for the long term? The second growth rate is dealt with by the terminal value, which looks like this:
Again, the CF represents the cash flow. This time, it’s the cash flow after the cash flow you forecasted in the previous equation. So, if you went to year 10 in the first equation (which would be ideal), this second CF is year 11’s forecasted cash-flow. If you went to year 5 in the first equation, this second CF would be year 6’s cash flow. Think of this second equation as what happens later. And remember it’s just an estimation – something you can justify.
Below the line is the discount rate (which will be a lot lower here – use between 10% and 15%) and the constant growth rate into the future. What do you predict your company to grow at each year, on average, in the long term? Again, difficult to say! But the industry standard is around 3% growth per year (in line with the economy in general). If you say 3%, nobody will take you up on it. Therefore, below the line you have 10% - 3% (0.1-0.03).
Now it’s just a matter of adding the number you obtained from the first equation to the results you obtained from the second equation. See what value shows up. Does it look realistic? Be honest with yourself here. Lots of people move the numbers about until they find a valuation they like. That’s not the way this works! You need to be as honest with the numbers as possible and then and only then will you find the value of your company. Again, don’t worry if this all seems complicated. There’s so much material on the internet (and videos) that will allow you to play around with figures that you’ll soon have a much better handle on what’s happening!