Company Valuation – How To Calculate It Correctly For Equity Investors
It is safe to say that there are over 1 million investors in the world and that you might be tempted to get in touch with at least one of these to invest in your company or product. The advantages over other forms of funding are deceptively obvious. In exchange of equity you can get a considerable sum of money without the risk of a bank asking for all your possessions as collateral in case of default. A proper company valuation can also get you a strategic partner who can open doors you alone could not get access to.
Let me start by saying that, any investor who puts hard earned money into your business is going to want to see a return, usually fast. If you intend to shift the risk of your business completely onto the investor, then you must be ready to offer more than 75% equity, and unless you have a proven business even this percentage won’t be enough. Do not look for an investor if you are not ready to work twice as hard to return back the investment within a short period of time.
One of the main questions the investor is going to ask you is, “How much is your business worth?” Another way of asking this question is, “How much equity are you offering for how much money?” If you are offering €25,000 for 10% equity, then you are calculating your business is worth around €250,000 (10% is €25k, 100% is 250k). So far, simple enough.
The next question will then be, “Why are you giving such a valuation?”
This is a fair question. The investor wants to know what reasoning you used to get this valuation and your answer will show the investor if you are a smart, cautious, ambitious or downright crazy entrepreneur.
Valuing a company is difficult, because a valuation is not a static number. Value changes constantly and is affected considerably by demand, supply, environment and time. You can only expect to sell a small bottle of water in London for about 40p but you can give the same bottle of water a valuation of £90 when selling it to a rich, thirsty and desperate person, lost in the desert.
This being said, there are ways to achieve a close to proper valuation of your business, depending in which category it falls under:
You have researched and created a working proto-type of a product and it’s ready to be launched. You have no real sales yet (sales to friends and family, unless they are count in the 100s, do not count). You have a registered company and possibly a patent, but nothing much else. You work out of your garage. You have so far invested €100,000 to create the prototype and you believe that within the first 5 years of rolling it out you can sell over €5 million.
Here are some important points to keep in mind before I give an estimate valuation:
1) Investing €100,000 shows that you are confident that this product will work and this is a good sign. I hope that you did decent market research to check that there is a serious need for the product as otherwise there is a risk that you wasted that money.
2) If everything goes well you aim to sell €5 million of the product within 5 years. When does everything go well? Did everything go well when you were creating the prototype? There is a saying we Maltese believe in; “man plans and God laughs”. You can speak with certainty about the past and somewhat about the present, but you cannot foretell the future.
Keeping these points in mind, I would recommend a potential base valuation of €30,000-€50,000 simply because there are no sales, no profit and although you invested €100,000 to create the product, you made losses through trial and error, mistakes and delays.
Start Up Stage 1 Valuation
You have a product (or service) set up and you have been operating for 15 months. You made sales totalling €150,000 with a profit, after overheads of €50,000. The business is made up of yourself and your partner and you both own 50%. You are not currently paying yourselves a salary as you want to re-invest your profits to grow the company. In the next 12 months you expect sales to reach €300,000 with a profit of about €120,000. You are still working out of your garage.
This scenario brings new things to consider:
1) Having a high number of sales shows that your product is wanted by your customers and the price is right for them. This number looks nice because it’s usually high, but the investor wants to know your profit as this is the number that will eventually give a Return Of Investment (ROI) to the investor.
2) Most start-ups are hard and need cash. Not paying yourself a salary makes a lot of sense and shows that you are dedicated and willing to sacrifice now for faster growth. These are qualities investors look for in start-ups. However, be careful about saying that your profits are €60,000 when you are not paying yourself. The profits would quickly dwindle to a break even if you decided to pay yourselves a decent salary. No business operator can continue to work for no money, therefore you need to set a target date by when you either start getting a salary or consider other businesses.
This business appears to be heading in the right direction but needs to become more profitable. Probably by increasing sales the cost per product would decrease so the profit margin would also increase. I would recommend a base valuation of €70,000 – €100,000, slightly more if you are getting orders you cannot satisfy as you are working at full production capacity.
Start Up Stage 2 Valuation
Your product has grown and your annual sales are now averaging €500,000 a year with a profit of €100,000 after overheads, including your salaries. You’ve moved production to a small production plant you rent and employ 2 people to help you satisfy orders. You forecast sales for next year to reach €750,000 with a profit of about €150,000.
Also this scenario brings new things to consider:
1) If you have an automated production plant and employees then it’s fair to say that you have tangible assets, including machinery, equipment, etc. This increase the valuation to the business but you cannot simply consider the equation, “equipment cost €20,000 = added valuation to the business €20,000”. Depreciation and their importance to the company alters their real valuation considerably.
2) Your projections start to have a little more substance as you have numbers from previous years to back you up. However, they are still projections and things can still go terribly wrong.
The base valuation in this case would be about €300,000 – €400,000 considering that your business has been successful with customers for a good number of years and the pricing and profit seem to be calculated well.
I will repeat what I said at the beginning; valuation is subjective and hard to be defined. If, for example, your business solves a problem that no other competitor can solve then your valuation dramatically increases. The base valuation does not consider certain important factors such as company debt, other investors and market prices.
What you are seeing as potential, the investor is seeing risk. If the valuation you give to your business is bloated with future projections, then first get those projections to be real numbers and then you can offer the business at that price. If you need money now until you grow and then you would become self-sufficient, then take out a bank loan. If this idea worries you due to the risk, then, well done, you are now starting to realise just how the investor feels.
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24 thoughts on “Company Valuation – How To Calculate It Correctly For Equity Investors”
Very interesting info!Perfect just what I was searching for!
Glad you’ve found the article interesting, Gabrielle. I invite you to share it with your friends who might also find it interesting.
I appreciate you sharing this blog article. Much obliged.
You’re welcome, Ehtel
Keep this going please, great job!
We will, Sarah, thanks to the support of readers like yourself!
Thanks for writing this informative article.
You’re welcome as always, Bobby.
Thanks to the great guide
You’re most welcome, Ethan.
thq u so much for ur information and helped a lot
Glad to be of help, Kris!
Company valuation is a very delicate subject and you give a very good first explanation about it. Thank you for your article.
It’s my pleasure, Stephen.
An intriguing topic. In my opinion you need to write more about this subject. Best wishes!!
We do have an upcoming article on seeking investment this week. Thanks for your comment, Ned.
Thank you, Bianca.
Thank you, I have been looking for info about this subject for ages and yours is the best I’ve found out till now.
Thank you Willy. Valuation is a very important step in selling your company and it is important that you are confident before agreeing on a price.
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Thank you Paris for your comment. I invite you to subscribe to stay up to date with my latest posts.
Thank you for some great advice on valuation. I am researching the best value to give my company before speaking to investors and your article really made me think.
Looking forward to your next post!
Thank you Sam for your comment. It is always nice to be appreciated and encouraged. I wish you best of luck with your negotiations and always think well whether you need an investor or not.
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