If you’ve ever perused an equity crowdfunding campaign page, you’ve likely seen the company’s “valuation” listed—but what does it mean?! And why is it important? In this week’s edition of the Arora Blog, we’re sharing all the details.
Chances are, if you invest solely with equity crowdfunding, you’re what’s known as a non-accredited investor. As such, you may lack knowledge about the nuances of investing, like balancing risk. It also means you’re more likely to make a reckless investment, or be struck by the unforeseen consequences of seemingly insignificant decisions.
Being able to accurately evaluate whether a startup is a worthwhile investment is one of the most important ways to keep yourself protected. And part of that evaluation should always be checking a company’s valuation. So if you’re unfamiliar with what a valuation is in the first place, read on—it’s an important factor to understand in order to become a savvy investor.
A Quick Overview of Transferable Value
Knowing the baseline valuation of a business is an excellent starting point to help you decide if the company you’re interested in has transferable value. In simple terms, this is what the business is worth to someone else, without its original owner.
Think of it this way: true transferable value is determined not by how well the business is run, but by how well the business runs with the owner out of the picture. If the owner permanently left the business today, would it be able to function with minimal disruption in operations and cash flow?
Institutional investors look for things such as transferable value to ensure their investments are stable through any potential changes. A company with little transferable value might not make the best investment if the owner’s absence causes upheaval to the day-to-day operations.
Okay, but What Does That Have to do With Valuation?
In a way, transferable value has everything to do with valuation, especially when it comes to equity crowdfunding. Since there is not yet a secondary market for shares purchased via ECF, one of the only ways for shareholders to make money from their investments is through an acquisition or IPO. Both of these options are made nearly impossible if a company’s transferable value is too low.
Why Else is Valuation Important?
Startups who choose to raise capital aren’t simply small businesses looking to give their owners and employees a reasonable salary and maintain a consistent level of business. By definition, startups are industry disruptors intent on hyperscaling their venture.
Having an accurate valuation of a business will help you, as an investor, assess both opportunities and opportunity costs as the startup plans for future growth and (hopefully) a transition, either by acquisition or by going public.
In addition, valuations:
- Are the gateway to gaining capital: Any lender or investor is going to want to see the leverage that lies in a business so they can understand its intrinsic value. Companies who want investors or buyout offers must be aware of their valuation, and ways to increase it.
- Provide a baseline: Without knowing an accurate baseline for how a company is performing year-to-year, you won’t have any indication of what the company is doing well and what they could be doing better.
- Help chart a course for the company’s future: It may sound cliché, but there’s no way for a company to know where they’re going if they don’t know where they are. In this way, valuations can help a company improve their business over time.
- Can identify gaps: Valuations are a comprehensive look at the business as a whole, including underlying non-financial aspects that add value. By analyzing their valuation consistently, companies can pinpoint weaknesses in their operations.
- Create accountability: Companies who use their valuation as a way to strategically manage their business can be more disciplined about accomplishing their goals, and this is great for investors.
A Literal Definition
Before we go over the process of how a business calculates their valuation, we need to understand what a valuation is.
Simply put, it’s the process of determining the fair market value using objective measurements and evaluating all aspects of the business as a whole. Therefore, the literal meaning of valuation can be summed up in one simple sentence:
What is your company worth to someone outside?
How to Calculate
There are various means and methods for calculating a company’s valuation. Some of the equations depend on complicated factors, such as vertical market, industry performance, and proprietary technology.
But for the sake of simplicity, we’re only going to list the most common factors for determining valuation.
- Company Size: Typically, the larger the company, the higher the valuation. This is due to the fact that smaller companies have the potential to be more negatively affected by the loss of leadership. Additionally, larger companies tend to have more available capital.
- Future Growth Potential: Markets or industries that are expected to grow, or opportunities to expand a company’s product line, are factors that increase a business’s valuation. Generally, the higher the likelihood of future growth, the higher the valuation.
- Market Traction: This covers how big a company’s market share is, how much of the market the company already controls, and how quickly they can control more of it.
- Profitability: This one seems like a no-brainer, but businesses with higher profit margins are valued more highly than those with tight margins or those that operate at a loss, even temporarily.
- Competitive Advantage: Does the company have something, such as a product or service, that sets them apart from their competitors? For this to increase a company’s valuation, a company must have a sustainable way to differentiate itself from its competitors.
Four Common Methods
From there, calculating the valuation of a company can be relatively simple, but there are 4 common methods to choose from, based on the type of company.
- Book Value (Asset-Based)– This method quantifies a company’s assets and liabilities to arrive at the valuation using a simple formula: Assets minus liabilities equals business value.
Assets include anything that has cash value, such as inventory, equipment, or real estate. Liabilities are generally debts such as mortgages or bank loans.
This method is one of the most used, but can result in a falsely higher valuation if a company doesn’t accurately account for intangible assets such as their reputation or customer base.
- Discounted Cash Flow– This method is more complicated, and focuses on future performance as opposed to historical data. If a company’s cash flow has historically been consistent, a valuation can be reached by estimating a company’s projected lifetime cash flow and then discounting it back into current dollars (otherwise known as net present value).
You also must take into account the level of financial risk caused by the company’s industry. An example of that would be the risk inherent to a brand-new tech company versus a grocery store.
Many business owners utilize this method of valuation because it focuses on a positive asset (cash flow), but because it’s based solely on projections, it’s easy to overinflate or underestimate the accurate valuation.
- Revenue and Earnings– This method uses a company’s gross income (revenue) or net profit after all expenses (earnings) and uses an industry multiplier to come up with a value. For example, if an industry’s standard multiple is two times sales, and the company’s sales revenue was $500,000 then the business would be valued at $1,000,000.
Companies use this method because it is relatively easy compared to other formulas, but it is once again based on projections, making it difficult to be entirely accurate.
- Market Comparison– This formula compares other companies that have sold in the same market and that have a similar product, similar customers, and generate a similar revenue. However, this method is based on availability of information, and it is sometimes difficult to find the sale prices of similar companies.
The Bottom Line
Estimating valuations can be an extremely nebulous process, and as you can see, they’re easy to overinflate or underestimate. But having a good grasp of a company’s worth is essential to understanding if they will be a good investment, reducing your risk as an investor.
And if you’re a founder ready to launch a campaign, we’d love to partner up. Regardless of the valuation of your company, if you have the traction and a market-ready product or service, we can get you where you want to go. Ready to get started? Apply now.