(Note: I posted this on Up and Running yesterday. I’m crossposting it here for reader’s convenience. – Tim)
I really don’t like the word "valuation"; it sounds too much like an MBA buzzword. But I like even less the general confusion about the concept. We talk about starting businesses, we talk about running businesses, getting investment, getting financed, and we should take discussion of valuation for granted. Valuation is at the same time frequently necessary, obvious and extremely arcane. It is nothing more than what a company is worth. It becomes necessary more often than you’d realize, with buy-sell agreements and tax implications after death and divorce, plus financing and investment. It’s obvious because a business is worth what a buyer will pay for it. And then it breaks down into complex formulas and negotiations.
So here are 10 (I hope simple) rules for valuation.
- Valuation is what a company is worth. It’s like what a house or a car is worth–less than the seller says, more than the buyer says.
- A company’s ownership is almost always divided into shares. Let’s say your company has 100 shares, 51 yours and 49 your co-owner’s.
- Valuation equals shares outstanding times the price of one share. If the company is worth $500,000 and there are 100 shares, then each share is worth $5,000. (OK, there are exceptions, preferred shares and such, but leave the fine tuning for later.)
- Tax authorities say the price of a share is whatever it was at the last transaction. (There, too, there are exceptions, but let’s keep this simple.)
- When startups offer shares–equity–to investors, then that, too, is simple math. If you sell 20 percent of the company for $100,000, that means the company is worth $500,000.
- Investment deals frequently revolve around valuation. When investors question your valuation, they’re saying they want more ownership for their money, or want to invest less money for their ownership.
- Analysts often apply formulas. The most common formula is called "times profits" because it multiplies profits times some number. Another common formula is "times sales." Companies might be worth two times sales or 10 times profits. There’s also book value, which is assets less liabilities. And there’s the estimated sale value of assets.
- Privately held companies are worth less than publicly traded companies. They get discounted for the disadvantage of not being able to convert ownership to cash easily.
- Growing companies are worth more than stable or declining companies.
- As with real estate, comparable sales matter. Analysts look for recent transactions involving similar businesses.