If the M&A market after the pandemic has taught us anything, it’s that there’s a lot more variability in valuations between the top, the middle, and the bottom of the market.
Often owners of businesses are hesitant to engage an outside analyst to evaluate the value of their business or company thinking that they already know the value of their business. Moreover they view the process as an unnecessary expense to accomplish their goals. But when they are contemplating an M& A process they realize that a business valuation engagement is a very necessary and valuable exercise.
Business owners who take their business valuation process seriously and engage in the project, ultimately realize that a business valuation report is more than just a number; it’s a powerful document that provides deep insights into the inner workings of their company. And had they engaged in a valuation process sooner, they may have been able to maximize their company’s value.
The first thing to keep in mind regarding the valuation of a business is that there are many different methodologies for valuation. Some methods may weigh income, while others may look more closely at “market value” based on other similar assets that have been sold recently.
A company’s valuation could be radically different depending on who actually conducts the appraisal, but the hard fact and truth is, that your business is worth whatever someone who is interested in acquiring it is willing to pay for it.
However, there are a number of factors that are traditionally considered when calculating the value of an existing business. Below are some of the most common:
- Industry Demand. The industry in which a company operates is extremely important in determining valuation. If a company operates in a “hot” industry sector, like IT for example in the current times, then it is likely that it will be able to achieve a higher valuation compared to another company in a different industry segment at the same stage of development. This is because in a “hot” industry there will be a greater demand to make investments and more people ready to invest resulting in higher industry average entry valuations.
- Market Size. The larger the market in which a company operates, the bigger the potential upside of an investment. Therefore, the bigger the market, the bigger the potential valuation a company can command and vice versa. If your product lies in a high demand industry with low market supply, investors will come knocking at your doors with plenty of offers. But if you operate in an overly saturated market with numerous competitors, then your chances of attracting investors are slim unless you have a distinct competitive advantage. Investors will get a glimpse of your business’ value by assessing your earning capacity based on market demand.
- Stage of Development. If a business is still just an idea then it is not likely to get the same valuation as a company that has an established product in the market with customers or user base.
- Margins and operating expenses: Developing a revenue growth strategy helps business owners fill in gaps for the rest of their financials. If a new product or service is a part of the growth strategy, then how will the new mix affect margins? Are current employee levels and facilities enough to absorb anticipated growth? What new selling and marketing expenses are required to help drive the revenue growth to achieve the desired goal? Thinking along these lines will help business owners manage their net income and make changes necessary to help the bottom line increase.
- Growth Prospects: This factor looks at how much potential the business has to grow in the future. Thus, If a company has evidence that it is gaining amazing traction with really high growth rates or if you are in an industry that will likely see significant growth, these factors could increase the value of the business.
- Earnings history: Income is a major factor in the valuation of any business. Particularly, some investor appraising the value of your business will look at the historical trends of your earnings. An increase in gross income over the past few years will have a positive impact on the valuation, while a downward trend in income may serve to devalue the business.
- Talent Potential: Besides the market potential, your company’s talent also plays a considerable role in valuation of your business. The more relevant experience your company’s leadership has, the more likely you’ll achieve product/market fit. Since most investors prefer to see early evidence of market traction, your talent plays a pivotal role in establishing that early traction and in turn attracting investors. An amazing team with high profile or experienced key members will be able to command a higher valuation as the higher the quality of the team, the more likely they will be able to build a successful company. For many investors the team is the most important factor in determining whether or not to invest.
- Reputation: Your company’s reputation and goodwill within the business circle can be incredibly valuable. It can be relatively difficult to place a number value on this type of intangible asset, but it is nonetheless incredibly important. An overwhelmingly positive reputation could significantly boost the value of your company, while a negative reputation could be detrimental to your prospects for selling your business.
Business owners, especially ones planning to sell their business, need to ensure that they have historical financial statements supporting their growth story, a documented growth strategy, and a plan to mitigate any potential risks along the way. Understanding all the levers of value and their effect on the business valuation will provide them with the insights necessary to strategically drive more productive conversations, change operational strategy, and ultimately, realize more value for their business.
The DocullyVDR team is a provider of a new generation secure data sharing platform designed for businesses. The team has extensive experience in working with document sharing platforms and has been assisting the Virtual Data Room community since 2019 by providing users with free information.