If someone asked you how much your business is worth - and they will if you're trying to raise equity - could you provide a confident answer? Determining the value of a business is difficult, because there’s much more to a business’s worth than cash flow. Even if you’re regularly turning over a healthy profit, this is no guarantee that your business is worth more than another business that is just breaking even.
If you’re financially savvy, you will be able to crunch some of the numbers yourself. And with the help of an accountant, you’ll probably come up with a figure that’s close to the mark.
However, potential buyers will be looking for much more than a ‘close estimate’. They will understandably be sceptical of any of the numbers you come up with on your own. Therefore, it often pays to arrange an external valuation from a qualified valuer, so that you and any potential buyers are confident the price is right.
Of course, a professional valuation won’t necessarily determine the final sale price – this will come down to how much a potential buyer is willing to pay for it (and how much you’re willing to sell it for). But a valuation serves as a good base from which to start negotiations.
Professional valuations are based on three key components:
- Asset valuations take into account your business’ tangible assets (for example, machinery or vehicles), intangible assets (for example, intellectual property), and stock. Some businesses are made up of mostly tangible assets, while others are made up of mostly intangible assets. An asset valuation is calculated by determining the value of the assets minus any debts.
- Cost of entry comparisons are an important consideration when it comes to undertaking a valuation and factors in the cost of starting a business from scratch. Anyone can have a business idea, but turning an idea into a profitable company costs money, and this will be covered in the cost of entry comparison. Often, both the buyer and seller will conduct their own comparisons and then come to a compromise.
- Price-earnings ratio valuation (otherwise known as P/E ratio) calculates a business’ future earnings based on its net profit. If your potential for future earnings is high, then you could secure a very good price for your business – one that far exceeds your latest profit statement.
The importance of calculating ROI for business investors
In addition to your business’ valuation, most venture capitalists and angel investors will expect a minimum of 30% before they even consider investing. Anything less and they may not deem the risk of investing in your business as worthwhile. If you can only offer a low ROI, investors may be better off putting their money in the bank.
We’ve outlined a few things you should keep in mind when calculating ROI:
Is your current growth maintainable and scalable?
Does your business have the potential to keep growing or is it likely to hit a ceiling, and if yes, when? Be wary of using current trends to predict future ROI, as there are no guarantees you will be able to sustain your current pace.
Potential growth depends on a variety of factors such as market conditions, competition, and your ability to finance growth. Make sure you’ve conducted extensive research and know where your business stands in the market.
Another thing to consider is scalability. Can your business model or system continue to cope and perform under an expanding workload? To scale successfully, your business needs to increase performance and efficiency as it adapts to larger operational demands so that you can maintain profit margins and continue increasing sales volumes.
Learn more: Preparing to Raise Capital Workshop
Have you factored in future compliance and regulatory costs?
It is important to forecast potential compliance and regulatory costs as they may have a significant impact on your business’ future growth plans. Business investors will want to see this. For example, you might intend to expand overseas, but have you considered potential tariffs and quotas that may arise in certain markets? Or what about the other various costs of growing, such as international tax obligations or quarterly reporting for an IPO?
These costs will impact profit margins and may erode the benefits of expansion. You may have to adjust your prices accordingly.
Are you solving a problem people will pay money for?
This is a question you should ask at all phases of your business journey, not just when you’re trying to raise money from investors. Are people willing to pay money for the solution you’re providing? Just because you’re solving a problem or fulfilling a perceived need doesn’t necessarily mean people will want to part with their cash (especially if there are free alternatives available).
The best way to ensure people are willing to pay for your products or services is to build a must-have offering, not a nice-to-have offering. In today’s competitive marketplace, consumers are overwhelmed with choice, which means not every product or offering gets attention. To get noticed, you need to be doing something different and better than the rest. Your competitive edge will be attractive to potential business investors and give them peace of mind that your idea is likely to generate your forecasted ROI (and therefore carry less risk).
This blog was written by Aaron Wallace from Bellingham Wallace, a Chartered Accountancy firm based in Auckland. Since 2013, The Icehouse has worked with Bellingham Wallace to provide financial management capability workshops for business owners and leaders.