There usually comes a stage for an owner of a start-up or a thriving businesses where they are having discussions with potential investors to secure funding. Often these discussions start with the topic of valuation. If you or your client is in a similar situation, you may be looking at valuing the business in question before initiating any funding discussions.
In this brief article, we set out two basic approaches that you could use to arrive at a ballpark valuation figure for your business to initiate discussions: Cost approach; and Post-money or pre-money valuation approach.
It should be noted that valuations are subjective and there a number of other valuation approaches that could be used to value a business with each approach having its pros and cons. Ultimately, a business is only worth an amount that the seller is willing to accept and the buyer is willing to pay for it. In this situation, it would be what the business owner and the investor agree it is worth.
The cost approach method values a business based on its replacement or reproduction cost (i.e., how much it would cost for an interested third party to set up a business similar to that in question). This approach is often useful for businesses with a lot of intellectual property that has been built over the years. It is a fairly simple and reliable approach to adopt as the business owner could look back at what key costs they have incurred in setting up and growing the business (e.g. costs to buy any equipment, research and development costs, operational costs, staff overheads etc). Estimating these costs at today’s rate would provide a value of the business using the cost approach.
It should though be noted that the cost approach does note take account of any expected future growth of the business and value predicted to be driven from the intellectual property built to date. This approach is likely to provide a lowest point for the value of a business.
Post-money or pre-money valuation approach
The post-money or pre-money valuation approach provides the value of a business after or before an investment has been made. This is also considered to be the least technical of all valuation approaches.
For instance, if a business owner is looking for a £2 million investment in exchange of giving away 20% interest in their business, the post-money valuation will be calculated as follows: £2 million ÷ 20% = £10 million. The pre-money valuation in this scenario will be calculated as follows: £10 million – £2 million = £8 million.
The above example illustrates the basic concept of this approach. In reality, there may be different capital structures (e.g. convertible loans, share options etc) that will need to be taken into account. Also, it is important to note the more a business raises the higher the valuation will be with the post-money or pre-money valuation approach. Therefore, a business’s valuation using this approach would not usually equal its market value.
If you are looking to understand what your business, shares or assets are worth then please get in touch with Asim Sheikh here.