Do You Need a Business Valuation?
A business valuation is essential for capital raising, mergers & acquisitions, and strategic planning:
- When negotiating any transfer of business ownership – whether you’re bringing in new investors, selling a business, or buying into another business – the fundamental question is: How much is its market value?
- When building a business, you must regularly ask: How can I maximize its worth over time?
Let’s consider these two common uses for a business valuation.
Valuation for Capital Raising
You’ve reeled the investors in. You’ve wowed them with your unique vision and strategy. You’ve established that the target market is massive, and that you know just how to secure a big chunk of it. You’ve convinced them that you’re the right horse to bet on. They’re itching to get a piece of the action. But before writing the check, they need to know:
- How much money will the company make?
- How much outside investment is needed, and when?
- How much of the company do the investors get?
All three questions are inseparable from the million (or billion) dollar question: How much is the company worth? In other words, what is the valuation?
Show them the money: It all starts with the financial model
Investors are in it for the money – specifically, the future cash flows. So, before buying in, investors must assess the magnitude and timing of those cash flows. You, the entrepreneur, must show them the money (well, the potential money). How? With a robust, user-friendly financial model.
Cash flows are a function of many factors:
- Revenues: Money received from customers in exchange for goods and services
- Expenses: Money paid for product inputs, employees, supplies, leases, research & development, interest, taxes, and anything else needed to produce goods and services
- Capital expenditures: Money invested in long-term assets – factories, trucks, machinery, servers – needed to produce goods and services
- Working capital: Money tied up in short-term assets – inventory, accounts receivable, petty cash – needed for operations; money accrued – accounts payable, taxes payable – by deferring payment to suppliers and other payees
- Non-cash items: Depreciation and amortization of long-term assets
- Debt: Money borrowed from, and repaid to, banks and other lenders
Sound complicated? It can certainly get that way. That’s where a robust, user-friendly financial model comes in. A financial model is a custom-built spreadsheet that takes all relevant inputs specific to the business, performs calculations specific to the business’s unique economics, and generates outputs critical to assessing the business’s potential, such as:
- Financial projections (“proformas”): Standard accounting statements: income statement, balance sheet, cash flow statement
- Funding needs: Projection of how much outside investment is needed, and when
- Net cash flow to equity: Projection of how much cash will be returned to investors, after consideration of all cash inflows and outflows
From the financial model comes the valuation
Once you’ve shown them the money – the future cash flows – it’s time to show what that money is worth today – the valuation. (Side note: Many people search online for “business evaluation services” when what they are really looking for is “business valuation services.” This is a very common mistake!) To determine what percentage of the company investors should receive for a given amount, you must first estimate how much the entire company is worth. Let’s say the financial model indicates that $2 million in outside investment is needed. If the company is worth $10 million, investors get 20%; if it’s worth $5 million, they get 40%.
There are many valuation methodologies, but fundamentally, any income-producing asset – a business, a rental property, a patent – is worth precisely the present value of all future cash flows accruing to its investors – its owners. The present value of a cash flow is the amount that an investor is willing to pay today for the potential of receiving it in the future. Present value is always less than future value since investors must be compensated for inflation, delayed consumption, and the risk that the payoff will not occur as projected. How much less depends on market and economic conditions and the degree of uncertainty surrounding whether projected cash flows will materialize.
Valuation for Strategic Planning
Value creation is the goal of any entrepreneur. Whether investors realize their payoff in the form of dividends, sale of the company, or initial public offering, maximizing the present value of future cash flows – maximizing valuation – is the ultimate objective. Any strategic initiative under consideration – a new product line, geographical market, marketing campaign – must be assessed based on how much value is added.
As with capital raising, it all starts with the financial model – a robust, user-friendly financial model is an indispensable tool for strategic planning. Users can test different scenarios, adjust inputs, and activate/deactivate strategic initiatives under consideration, and instantly see the effect on financial projections, funding needs, and valuation. Through that iterative process, decision-makers identify courses of action that optimize financial performance, allocation of funding resources, and, ultimately, valuation.
Where Cayenne Comes In
Cayenne Consulting provides business valuation and financial modeling services to help position ventures for successful capital raising and effective strategic planning.
Negotiation is central to capital raising. Buyers and sellers of equity – investors and entrepreneurs – differ on financial assumptions, such as projected units, pricing, cost of goods sold, staffing, long-term assets, working capital, and required rate of return. Any change in assumptions affects valuation. Cayenne focuses on developing financial models and valuation analyses to serve as negotiation tools, helping ventures approach investor discussions from a position of strength.
An independent, third-party valuation opinion is generally not necessary for raising capital. To render such an opinion, the valuation professional must perform extensive due diligence, and since investors do their own due diligence as part of the decision-making process, there is no need for the venture to pay for it.
Instead, entrepreneurs must demonstrate that critical economic drivers have been identified and considered – that they’ve done their homework. Negotiations should start with, “Based on our research and analysis, our comprehensive model indicates that the company is worth $XX,” rather than, “The valuation professional we hired says you need to pay $XX.” Demonstrating knowledge and preparedness goes a long way toward ensuring that you raise capital, and raise it at a valuation that reflects the venture’s true potential. By developing robust, user-friendly negotiation tools – financial models and valuation analyses – that clearly and credibly communicate thorough analysis and reasoning, Cayenne helps ensure a fruitful capital raising process.
Cayenne Consulting custom develops financial models and valuation analyses that capture the unique dynamics of each venture. Key objectives include:
- Creating user-friendly, logical interfaces for management and investors to modify inputs (assumptions) and test multiple scenarios quickly and easily
- Communicating financial potential to investors and other stakeholders clearly and credibly
- Equipping management with a robust, user-friendly strategic planning tool
- Providing insights to help further improve the business model
- Preparing entrepreneurs to enter investor discussions from a position of credibility and strength
Drawing on real-world and academic valuation experience, we take a bottom-up approach that incorporates the economic dynamics specific to the company and sector. Functionality and user-friendliness are paramount. The user – whether the entrepreneur, investor, or other stakeholders – can adjust assumptions quickly and easily. Clearly understandable exhibits present the most pertinent takeaways. Formulas performing the gory calculations are kept behind the scenes.
Meet Our Business Valuation Specialist
George Papaioannou, CFA, MBABusiness plan consultant in Los Angeles, CA & Princeton, NJ
George Papaioannou has three decades of experience in developing, analyzing, evaluating and executing upon business models, from an investment as well as an operational perspective. He is one...
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