It’s a scenario that plays out on weekly episodes of Dragon’s Den, Shark Tank and at local Angel investor meetings: compelling pitch, impressive team, investor buzz…and then the entrepreneur confidently states the company’s valuation. Silence. Raised eyebrows, crossed arms and the meeting spirals downward.
Caroline Somers, veteran Angel investor and entrepreneur, has had a front-row seat to such scenes for over 25 years. We sat down with her for a brief lesson in Valuation 101.
When should a company embark on a valuation process?
If you’re simply running your company along, it’s not crucial to do a valuation. It may be important when you need a loan to expand the business. But when someone is looking to buy your company or to buy equity, when you’re drumming up investment or developing your exit strategy…those are the situations when valuation really matters.
Let’s talk about the mechanics. Is it true that valuation is both an art and a science?
Yes, although it’s probably more of a science when you’re a solid company with solid revenues. But it’s not rocket science. For a small to mid-size, fairly mature company, cash flow has to be one of the best ways to determine what a company’s assets are. There are pretty straightforward formulas to arrive at a value using different methods like Discounted Cash Flow, as well as others like Going-Concern Value, and simply valuing the assets. Some assumptions have to be made if you are in a growing business or a business that’s making a strategic change in direction as the future value is uncertain.
So where does the ‘Art’ come in?
There is a host of soft factors to consider, or the ‘art’, if you will. For starters, the team. This is probably the biggest for most investors. If you lose that team, then what? The market: what’s the growth potential in this space? Big relationships can factor in….major partners, large customers. Your reputation and brand, the competition, your IP…all these things can influence a company’s value.
I like the Berkus Method as it brings in many of these factors. It’s an approach that emphasizes both the absolute value and the ‘art’ of assembling a valuation. It makes a lot of sense to me as an Angel, and it’s what I use as a sanity check when the companies come out with valuations.
Another way that investors set the value of a company is by comparing them to similar companies. Let’s say I’ve already looked at Company X and I know it’s worth a certain amount. If Company Y claims they’re worth way more than that, I’m going to question it. It’s what Angels do.
But the comparative factor can work in the entrepreneur’s favour, too. Here’s a classic example: If the number one competitor in your space just sold for $1M, even though your cash flow valuation may only be $250K, you may be able to entice a buyer to pay up to that amount for your company just so they can stay competitive with your competition which was valued at $1M.
Value can also change very quickly. In the case of mergers and acquisitions, a valuation – or the price you may have paid for the company – is not realized. Why? Perhaps the financials were wrong to begin with. Or they didn’t have the right management team. Or the management team left or is de-motivated post-acquisition. This can happen in startups as well as well-established companies. Any valuation model includes many variables and many assumptions, which can change either way. The key is to focus on the value creation items.
Why are Angels and entrepreneurs sometimes at odds over valuation?
Presenting an unrealistic pre-money valuation is a sure-fired way to lose credibility with investors. Just watch Dragon’s Den and you can tell the investors have walked away after hearing an unrealistic valuation. If the valuation is way too high, the investors may now see the founder as greedy or not really understanding their business. In those scenarios investors are either using a quick method like Berkus to come up with their own valuation or comparing with other similar pitches to create a valuation range. For investors or anyone buying into the company, the valuation has a direct impact on their return.
What advice do you have for a small business owner when it comes to valuation?
Whether you’re an entrepreneur raising money for your startup or a small business owner ready to sell an established company, do your homework. Look at others in your space. Check out those formulas for calculating valuation. Get professional help – from your accountant or investment advisor. And look at activities, team members or customers that don’t have a positive impact on your value. Why would you keep them? Focus on value creation!
About the Author
Caroline Somers has over 30 years of business and operational experience including co-founding a successful startup and angel investing in more than two dozen companies. She currently is Co-CEO of Cassidy Bay Group, which coaches entrepreneurs as they grow their companies. Caroline sits on the boards of CHEO Research Institute and Digital Opportunity Trust, and was previously a board member of Capital Angel Network, OCE and DNA Genotek along with a number of others.