5 things entrepreneurs need to know about valuation
Valuation is one of those four-syllable business buzzwords youâ€™re going to have to deal with, eventually, if you either want to start a business or own a business. If it doesnâ€™t come up when you start, it will come up later. Here is what I think you need to know, in five short points.
1. The word has vastly different meanings: donâ€™t you hate it when the same words mean different things? Valuation means at least three different things:
- A. What a business is worth to accountants for legal purposes, such as divorce settlements, inheritance taxes, and gift taxes. A certified valuation professional, usually a CPA, makes a guess. Most of them use financial statements and analyze financial details.
- B. What a business is worth to a buyer. Small businesses go up for sale with business brokers. Hardware stores, for example, get about 40-50 percent of annual sales plus inventory, as a starting point. Plus a bonus for growth and special strengths, or a discount for lack of growth and special problems.
- C. The pivot point in an investment proposal: itâ€™s simple math, but tough negotiations. If you say you want to get $1 million for 50 percent of your company, you just proposed a valuation of $2 million.
2. Whatâ€™s anything worth? Like your car, your house, and a share of IBM stock, somethingâ€™s worth what somebody will pay for it. The valuation in A is theoretical, hypothetical, but legal. With B and C, though, valuation is as real as agreeing to buy a house. Itâ€™s not what the seller says it is; itâ€™s what the buyer is willing to pay. And this cold hard fact drives many entrepreneurs crazy.
3. For small businesses, there are guidelines and rules of thumb. If you do a good search, or work with a business broker, you can find general rules of thumb for what your long-standing small business is worth. For example, a hardware story is worth roughly half a yearâ€™s sales plus inventory, with bonuses for positive factors like recent growth, and discounts for negatives like lack of growth. You could read up on it in Bizbuysell.com, Bizequity.com, or Business Brokerage Press. Or do a Web search and check the ads for valuation experts.
4. For startups, itâ€™s what founders and investors negotiate. Startups and investors and culture clash over valuation. Investors care about valuation. Founders often misunderstand valuation. And never the twain shall meet. Iâ€™ve seen these kinds of problems many times: founders walk into the valuation discussion full of folklore and fantasy like stories of Facebook and Twitter. They want lots of money for very little ownership. Investors see two or three people with no sales history thinking their dream startup is already worth $2 or $3 million.
5. Irony: sometimes traction, and revenues, make things worse. Itâ€™s easier to buy the dream than the reality. The same investors whoâ€™ll seriously consider a $2 million valuation for a good idea, business plan, and a credible 3-person management team â€“ but with no sales ever â€” might just as easily balk at a valuation of $600,000 for a company with three years history, 20-percent growth, and annual sales of $300,000. Despite the irony, it makes sense: few existing businesses are worth more than a multiple of revenues, but, still, before the battle, itâ€™s easier to dream big. Or so it seems. Iâ€™ve been on both sides of this table, and I donâ€™t have any easy solutions to offer.
If it hasnâ€™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 donâ€™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 arenâ€™t: so eventually you either sell it or pass it on to a new team, an acquiring company, or your own family. And thereâ€™s the divorce and estate planning elements that require valuation. So every entrepreneur and business owner should have some idea what it is.