Business Valuation Methods

Valuation is part science, part experience. It is not devoid of emotion or bias. Previous experiences can also impact objectivity. Intuition plays an important role. There is no correct answer.

We present below a number of methods in common use among investors.

Most investors do not rely on just one valuation method -- they combine several of the valuation methods to arrive at a proposed valuation.

But rules of thumb play a big role in investor valuations.

The type of business plays a big role too. For example, the potential ROI and time to exit, for an infrastructure (iX) investment, e.g., a Smart Grid 1.0 investment, will likely be much lower, and longer, respectively, than a Smart Grid 2.0 investment enabled by Smart Grid 1.0 iX. However, one could argue that a relatively mature iX investment is less risky, and as such, merits a lower investment hurdle rate.

Traditional Venture Capital Valuations

The rule of thumb that was traditionally used by VCs was a goal of 10x in five years, i.e., 58.5% ROI, or 5x in three years i.e., 71% ROI, reflecting the risk of early-stage investments, the fund's targeted portfolio return on investment, and the desired amount of time to realize liquidity on the investment.

Obviously, these high hurdle rates force down the initial business valuation offered by the funds.

Valuation Multiples

Public companies are usually valued as a multiple of profits, i.e. valuation = "multiple" x EBITDA. The chosen EBITDA might be lagging (the last calendar year's or the past 12 months') or based on a forward year forecast. Typical multiples for relatively mature companies might be in the range of 6x to 10x.

This approach does not work for many early stage investments because they are not profitable. As a result, a multiple of revenues is sometimes used, e.g., 1x or 2x revenue, but not solely relied upon.

Valuation of Comparable Public Companies or Transactions

If one can observe the multiples of a reasonably comparable public company or a set of companies in, e.g., a Smart Grid sub-sector, then it is not unreasonable to value a private company in the same sub-sector on the same basis.

The same applies to a comparable public M&A deal with known multiples.

Private, arms'-length financing rounds or acquisitions of comparable companies can be also be used as benchmarks if the deal terms are reported.

Investment banks assign research analysts to various sectors of interest, including CleanTech, and the Smart Grid sector. Their regular reports on the public and private transactions in the sectors that they are following are very useful sources of comparables.

Discounted Cash Flow (DCF)

This approach is based on the economic principle that the value of the business is the value of the net cash flows it will generate in the future, discounted to the present day, typically based on a five-year net cash flow forecast. However, the calculated outcome is strongly dependent on two subjective choices: (1) the appropriate discount rate, i.e., one that reflects the riskiness of the cash flows, and (2) the "horizon value", i.e., the multiple used to value the company at the end of the five-year forecast -- the discounted value of the horizon value usually dominates the valuation calculation.

So, even though this DCF method seems more "exact" than the above-presented rules of thumb or market-based methods, the approach actually leaves plenty of room for negotiation.

Valuing Very Early-Stage Companies

What if the business being financed is pre-revenue? Typically, this would involve an "angel"-type or a seed-fund investment. Experience, rather than calculation, coupled with a heavy dose of negotiation, usually leads to pre-money* valuations maxing out at $2 million, and often considerably less than that. An influencing factor is the amount that had already been invested to get the business to its present position. Typically, an angel investment amount would be anywhere in the range of $50,000 to $1 million, with the expectation that further rounds of investments would be provided by institutional investors.

Valuation is Not Just About Equity Price

The valuation offered by an investor is just one element in the terms of a transaction. These are embodied in a "term sheet" written by the investor, which is usually a 6-10 page document summarizing the terms and conditions of a proposed investment. Term sheets are complex instruments. The terms are designed by investors to limit their down-side risk in the event that the company's performance does not meet mutual expectations. While negotiating a satisfactory valuation is of primary importance, the business owner should view the valuation as part of an overall package of terms, and attempt to trade-off some onerous terms (or increase management protections) for a higher valuation offer, rather than focusing solely on a valuation negotiation.

Bridging the Valuation "Gap"

There is rarely a meeting of the minds regarding valuation between the business owners and the new investors. Usually, the difference is eliminated through negotiation. Sometimes, however, there is a strong difference of opinion coupled with a strong desire by both parties to get a deal done. This can lead to a bridging of the valuation "gap" through an "earn-out" approach. Basically, this approach rewards strong business performance with a higher valuation, ex post facto, and vice versa. That is, if the business performs as well as the owners forecast that it will, they receive a higher valuation; if the business performs less well, according to the expectations of the investors, then the investors receive a lower valuation. Not everybody likes this "fix", mostly because the metrics of business performance are difficult to define objectively, and can be manipulated.

Stock Price Modeling

For early stage companies, the expectation is that they will require additional rounds of capital to support their expected fast growth. Typically, there might be a small seed round, followed by a series of rounds at progressively higher valuations, often referred to as Series A, B, C, D, and perhaps E. If the company's trajectory is to an IPO, there might also be an additional bridging mezzanine financing round to that event. An exit based on an acquisition can occur at any time during the series of rounds.

Even allowing for its entirely speculative nature, it is a useful exercise for the business owner to create a stock price forecasting model that can simulate the expected rounds of financing over time, and their associated expected valuations. Capital requirements, provided by the five-year cash flow forecast of the business, can drive this model. One of the outputs of the stock price model will be the (usually) decreasing equity ownership percentages of the original founders, and the ownership of each investor that comes in during the financing rounds. By running multiple scenarios, business owners can get a feel for the range of ownership they can expect to retain for different performance levels of their business. This is a very useful tool in support of a valuation negotiation strategy.

It is also a useful tool for simulating the capital structure of the company, including the design of stock option/equity incentive plans.

Customized Business Case Services

Dr. Geraghty also provides customized consulting services off-line related to the development and analysis of SG-related business cases – see here.

More details and advanced tools for estimating and modeling valuation and capital structure are available to registered members of SGiX.

* A pre-money valuation is the value of the company before the fresh capital comes in. The post-money valuation is the value of the company immediately after the fresh capital is injected and equals the pre-money valuation plus the amount of fresh capital. Above, we deal solely with pre-money valuations.

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