How to value a business to raise capital
Business owners are often confused about how to value a business to raise capital and why investors value a business differently from each other, even for similar-sized businesses, at the same stage, in the same sector. Someone who asked me recently was referring to the TV show Dragons’ Den; however, the conundrum applies to many investment situations.
As you’re probably aware, there is more at play than the numbers when you’re trying to value a business to raise capital and it depends on a whole bunch of factors – some more tangible than others. There are fundamental considerations, but also a bunch of other factors to be considered. It’s often these other factors that create the confusion.
How to value a business to raise capital – the fundamentals
Here’s a quick run-through of the fundamental considerations when you’re looking to value your business:
- What does your business do? Is your business timely and in demand?
- What is the market like – fast growth or slow?
- What is the competition like? Is anyone else doing it? If so, how are they doing?
- How long (if at all) have you been trading? Is this a stable business with a few years under its belt, or a new idea?
- What are your margins and can they easily be improved if you had the clout, contacts, experience and trading volume?
- What does your balance sheet look like? What is your turnover, profit/loss?
- Accounting methods – investors may use a number of these models together to paint a picture of a business’s value. Here is a brief overview of the main ones:
- Asset valuation: this is useful if a business has significant tangible assets.
- Entry cost valuation: this is a way of valuing a business by effectively pricing up the cost of starting up a similar business from scratch.
- Price earnings (PE) ratio: this is often used when a business has a history of sustainable profit.
- Rules of thumb: particular sectors have an established standard formula for working out the valuation of a business in that sector.
- Discounted cash flow: this is a way of valuing a business today based on its future cash flow.
- The value of your assets and debt.
- Customer relationships: Do you have repeat customers? Is your model based on one-off sales or subscription? Is the product/service you sell something that requires repeat buys? What is the drop-off of new customers?
- Your team and their experience: Is it just you? What is your background? Do you have a track record? Have you worked in this sector before? Have you run a business before? For more information relating to this, check out our article on balancing your company’s board of directors.
- The economic climate.
- Intellectual property (IP) ownership: Do you have a patent (is it possible to patent)? Is the product/service easy to copy? Trademark? Copyright?
- Marketing and advertising activity (spend, and results achieved).
- The reasons why you are raising investment: what are the circumstances?
- What risks are there with the business? Does your business have a good spread of customers and clients? Check out our ‘is it a good idea to have one big client?‘ article, for more on this point.
- The type of business being valued.
- How does your business plan read? What are your forecasts over the next few years? Personally I care very little about someone’s five-year forecast as I’ve yet to come across a business who delivered anything close to their five-year forecast. However, they do serve a purpose by giving an idea of the ambitions of the business, which helps as part of the overall picture that you are painting for investors.
How to value a business to raise capital – other factors
Once you address the points above, it’s still possible that potential investors may value your business differently from each other, particularly if they are early stage investors. Why is this? Well as mentioned, there are also a number of other factors that may come into play, such as:
- Whether the potential investor actually likes you as a person and feels they could work with you. Even if you have a great business on paper, an investor is unlikely to want to invest if they find you really irritating! Investors often invest in people.
- Whether your business/service touches their heart. Is your product/service something they are deeply passionate about?
- Whether they know they have the contacts and quick route to market for your business.
- Whether your business ties in with, or compliments, other businesses in their portfolio.
- The opposite – whether there’s a clash with one or more of their other investments.
- It sounds too messy. Often you’ll find investors don’t like investing in businesses that are part of other businesses, or have a complicated structure. Family businesses are often avoided – “Yes there are some existing investors. My brother’s uncle has a second half cousin who has been promised 5% every year if we hit the targets set by our Granny” – investors can’t be bothered with all that and the alarm bells will be ringing for sure. Investors generally like investing in nice, clean, straightforward businesses, with straightforward share structures. Read more on the pitfalls of giving shares away in our Giving company shares to employees article.
- You kept something from them – “Oh er yes, I own another business that has £450k net profit, but that’s not included”.
- Gut feeling – these investors (in general) are experienced. Really experienced. They’ve probably seen it all before and have a list of things that ring alarm bells for them.
- What percentage to take in order to keep all parties interested. There is no point an investor demanding so much of the business that the founder loses interest.
A key thing to remember when asking yourself how to value a business to raise capital, is that whatever valuation you give your business when pitching to investors, you’d better be ready to justify it and explain why you feel it is a fair valuation. The key thing to remember is that a business valuation will vary according to who is valuing it and what their motives are.