What am I bid?

4 February 2008

There are, it’s said, only three things certain in life: death, taxes and the inevitability of your business being undervalued. Anyone who’s had to stand in front of sceptical investors and defend their valuation calculations will know what a relief it would be if there were a universally accepted, purely scientific rationale to fall back on. But for early and most later-stage companies, that’s simply not going to happen.

Because of the high level of risk and the absence of meaningful revenue and profit trends, traditional quantitative valuation methods are of little use in many entrepreneurial valuations. You can forget your price/earnings ratios, post-tax profit multiples and discounted cash flows - the true value of your business is what investors think is a fair reward for the risk they’re taking with their investment.

“I think the valuation of companies is much more an art than a science,” says one company founder who recently went through the valuation mill with investors. “It probably comes down to a simple question: have the investors got enough, and have the entrepreneurs been left with enough?” If that sounds a little too “Dragons’ Den” for your liking, then you’d better get used to it. If you do end up selling part or all of your business, you’ll have to confront the reality that it’s only worth what someone’s prepared to pay for it.

Andrew Heslop, author of “How to Value and Sell Your Business”, points out that in finance, there are no absolutes, drawing a parallel with the current stock market malaise: “Even science isn’t science is it? Consider the FTSE100. It just dropped like a stone for no reason. The FTSE businesses are the same as they always were but now people like them less. Can you see any hard business logic in this?”

If you fall back on a core tenet of valuation, such as the “multiples” method, you can easily come a cropper. Even if investors agree on an approach to multiply post-tax profit by x times, both the profit and multiple are open to negotiation or interpretation. If you ask a range of investors, the difference between the lowest multiple and the highest can be as much as two and half times, driven by a host of different factors.

Heslop adds: “The art is to identify what factors influence investors – partly on an emotional level – and maximise their impact. Of course, the valuation process very much depends on the business fundamentals, the sector you are in and your longevity. Generally, maximizing the valuation is about creating the best future story rather than historical analysis. A business is worth what the buyer or investor values it at, not the seller.”

Making your case

There are, in fact, some important pieces of evidence you can bring to bear in support of your arguments, including the size of the market you’re looking to address, recent M&A activity with companies engaged in similar activities to your own, and the value of your intellectual property. This supporting evidence needs to trip off your tongue like a nursery rhyme – you can’t rely on your accountants to draft a prospectus with footnotes explaining it all.

It’s worth approaching the evidence as if you were building a legal case, with a whole portfolio of evidence in support. “There’s been a lot of corporate M&A activity in our sector over the last couple of years,” says the entrepreneur, “so we can point to any number of UK and European deals with small companies, and that forms part of the matrix of our valuation.”

Heslop points out that the evidence is the investment story, and draws on historical performance, current and future market trends, all interwoven with a clear rationale as to why the business makes money and will grow and develop capability in the future. “Obviously, the better the quality of argument, presentation of materials and hard data, the more robust the proposal,” he says.

He adds that it’s essential to ensure your advisor understands your business sector. “Some advisors are good, experienced, have good contacts and help manage the process – others are at the other end of the spectrum. One idea is to try to find sector specialists who genuinely know the economics of their market. My advice would be to test any adviser thoroughly before engaging them – can they prove their value in recent and similar situations?”

So where do founders typically go wrong when they’re valuing their business? According to Bill Payne, author of “The Definitive Guide to Raising Money from Angels”, they place too much emphasis on product or service and not enough on other factors. He argues that product only accounts for 10% of a company valuation, with 30% down to the management team, 25% to the size of the opportunity, 10% to the sales channel, 10% to the stage the business is at, and 15% on other factors. The management factor is critical - take Flickr, which began life as an online game before the management team saw an opportunity with the emergence of camera phones to share photos online.

Another tactic is to put less emphasis on the long-term goals of the business and concentrate on earning short term revenue, perhaps through consultancy or licensing agreements. Traditional quantitative valuation measures such as assets, stock or the employee base may be less appropriate for today’s companies, but nothing helps point to a successful future like cash in the bank.

Finally, Heslop recommends asking as many people as possible. After all, it never hurts to get a second opinion – and a third and fourth. “You should try to boost the valuation: why wouldn’t you? There are many tactics that may be appropriate, but I would recommend going out to the widest possible market. Cast the net wide.”

By David Longworth, Webster Buchanan