Valuation is probably one of the most personal aspects of a business, often clouded by emotion and just plain wishing. But even if valuation is in the eye of the beholder, we still need to approach it in a systematic way, looking first at why you need to have it done.
It may be transactional, for the purpose of selling, financing or obtaining a new partner; for tax reasons, for gifting all or a part of the business or for estate purposes; or for financial reporting, to establish its “fair value” for an acquisition.
The purpose and the available information drive the valuation approach, which will be one of these three options:
- Cost approach, which values an asset or business based on avoided cost or cost to reproduce. This may come into play with a pre-patent idea that is pre-revenue and/or without revenue projections. However, if you want to license the idea or need to value it for other reasons, valuation may be based on how much you have spent to date. This is usually the least desirable option because it does not include any value for future success.
- Market approach: This is similar to looking at the “comps” when buying or selling a home. By applying comparable market data for publicly traded companies (since that will be public record), we can develop appropriate multiples. This approach is of limited value for smaller businesses because meaningful comps are typically not available.
- Income approach: Valuing the business based on its expected future cash flows, this takes into account discounted cash flow (i.e., the present value of the expected cash flows discounted at a rate based on the company’s weighted average cost of capital) and the residual value at the end of the forecast period.
Here are a few points to consider when applying valuation concepts to technology companies:
- After identifying why the company is being valued, understand how company valuation is applied – whether it is a cost, market or income approach.
- Address the key value elements and concerns, including financial statements, internal controls and the interests of strategic and financial buyers.
- Recognize where your company is in the business life cycle.
Each valuation project is unique, but generally for tech companies:
- Startups will often be valued on a cost approach if reasonable cash flow projections cannot be developed. If supportable projections can be developed, investors may pay you for the upside (i.e., reasonably discounted to reflect risks and uncertainties) rather than the value at the outset (i.e., costs incurred). The more you can prove the value of the concept (e.g., by developing customers, by getting a patent, etc.), the more you may get.
- Early stage companies will often be valued using the income approach. Having proof of concept is key.
- Post commercialization/mature stage businesses may be valued using either the income or market approach.
As you can see, there are a number of variables involved in valuation and business owners must be able to detach themselves from their emotional connection to the business to look at the business from the point of view of the prospective buyer – and then provide the right information to get the best possible results.
Steve Schuetz is managing director for Valuation Research Company’s Tampa, Florida office, specializing in the valuation of business entities and intellectual properties. He also provides opinions of value for solvency, capital impairment and fairness. Steve is an Accredited Senior Appraiser (ASA), Chartered Financial Analyst (CFA) and former board member of the Tampa Bay Chapter of Association for Corporate Growth. He can be reached at firstname.lastname@example.org.