Valuing a Company – Art or Science?
Posted on 11/11/2019
There are many methods for valuing a company. We outline half a dozen of these in another news perspective on “How to value a start-up company?” which you can find here. Although these methods are valuable for building confidence in what you think is a fair price, there are lots of other factors that will influence the decision of an investor buying shares in your company.
With any sales process, both parties will be looking to receive a good deal. It is often a complex discussion between investors and the company. There is no right answer, apart from the one that both sides agree on.
What makes this process all the harder, is the lack of transparency in the marketplace. We can estimate the likely value of a car or house, as we know where we can find the information. With a company, things get more difficult.
Recurring profitable sales
One of the main factors is the ability of your company to demonstrate traction in the market. This is where you can demonstrate that there is a customer need for your products and services. The best form of traction is profitable sales with recurring customer revenues. This is particularly the case for business to business (B2B) companies. With business to consumer (B2C) companies, the number of current users can also be a way of evidencing customer need.
Revenues make it far easier to value a company, yet what if you are not at this stage yet. The next best options to consider are collaborative research and development projects with end users, letters of intent from customers or even outputs from focus groups and market research to demonstrate that there is a strong customer need and market opportunity.
What's in fashion
The valuation of a company can sometimes be inflated if there is a popular trend towards a certain industry. During these hypes, a company can be more attractive and likely demand a premium valuation.
On the other hand, it is at times when investors have been burnt by investing in an industry that they are unlikely to invest in that industry again. Equally, if an industry has shown poor performance or is in decline, attracting investors can be challenging.
Supply and demand
It can come down to the number of companies seeking investment vs an investors willingness to invest; your classic supply and demand. If there are a high volume of companies seeking investment within your space and this outstrips the supply from investors, then the ability to raise investment and negotiate on valuation is limited.
This is accentuated by the desperation of a company to receive funding before cash runs out. The strength of your negotiation position is diminished as your need for funding increases.
As you are closing a round, you need to think about current dilution vs the security that additional funding can give. When your back is against a wall, your valuation will plummet, compared to the strength you have when in an over funding situation.
If a company is in an industry with lots of competitors, it is more difficult to stand out from the crowd and differentiate yourself in the market.
A company’s freedom to operate in their target markets and their ability to defend their position once in the market are important factors to consider. A well thought out intellectual property strategy can help overcome these barriers and increase the attractiveness to investors.
Your intellectual property strategy should be more than a patent filing; remember copyright, trademarks and especially trade secrets are often a more cost-effective means of protection.
Reputation of the team
The strength of the team to deliver on the company’s vision is vital. The ability to show a track record and the key positions in post for the next stage of development has a large influence on the ability to raise investment and negotiate a better valuation. Yet for many start-ups they have not necessarily grown a business before or have the breadth of skills required. If this is something you need to work on, you can check out our guide for building a team here.
Types of investment
Although there are common themes in what investors look for, there are different objectives and expectations from investors. These include the appetite for risk in taking a product to market, the level of ownership and the amount of funding required, the anticipated return on investment and when this return on investment will materialise.
The factors already presented are very much looking at valuation from an investor’s perspective. Yet as a company, it is worth considering what you want from an investor beyond the money. Will they will be able to provide expertise, an extensive network and support in future investment rounds? Make sure you look at the companies within an investor’s existing portfolio and talk to other entrepreneurs on their experience of working with them. The attractiveness of an investor could influence the terms you would accept and the amount of shares you’d sell for the investment.
Finally, remember you are never giving away shares in your company, you are selling them. This is often for cash, but also for the skills, network and reputation of the buyer.
These are just some aspects to consider that go beyond the science of valuing a company and into the art of raising investment.