Russell Smith, managing director at Leeds-based accountancy practice Russell Smith Chartered Accountants, takes Business Advice readers through the correct way to value a startup.
The popular BBC show Dragon’s Den is a masterclass in how not to approach investors.
You’re probably familiar with this recurrent segment of the show, where the anxious-looking pitcher is asked by the fearsome dragons how much their business is worth.
They will often give one of two answers: “I don’t know” or a widely outrageous sum. When the Dragons press them on how they got to this sum, it inevitably comes round to that same “I don’t know”.
A common mistake for startups and small business owners is not getting a proper evaluation on how much their business is actually worth.
Knowing the value of a business is vital. At the end of the day, for investors, cash is king. They want to know exactly how much the business is worth and how much the projected profits are.
If you can’t give them a reasonable business value estimate, they can’t weigh up that appropriate risk-to-gain factor so important to investors. And if they can’t make such a fundamental assessment, they can’t invest in your business.
You need to know how to value your business. But how?
Your business is not worth your capital assets
Many newcomers to the business world make this fundamental mistake. When asked how much their business is worth, they look at their stock, their investments, and other assets, before tallying the results.
This is not how much your business is worth; it’s how much money is in your business. Investors don’t care if you have £100k of stock waiting to be shipped. They care about how much it has sold for.
How to value your new business
To value your business, you need to consider a number of variables. Simply put, your business is worth its profits. When investors — and potential buyers of your business — ask what the value of your company is, they mean how much profit are you making.
The value of your business is not simply one year’s profit, though, nor is it your exact profit margins. It is more complicated than that.
When calculating the value of your business, you need to look at a few different financial aspects:
- Gross Profits
- Your Salary
If your business is not profitable yet, keep reading, we’ll talk about this later.
Calculating the value of your business
First, you look at profits. Let’s say you earned £100k last year. This is your base to start working from.
With that £100k, we now look at expenses. Let’s put a guess in at £30k for equipment, tax, travel costs, rentals, etc. Now, we’re at a value of £70k.
Next, we have to consider you. Many valuations don’t consider the individual running the business. But if you sell up, somebody else is going to be taking profit and if you stay, you’ll still be taking profit.
You take a £20k salary from your business. The rest is taken as dividends or reinvested into the business, but this is your official salary. Now, the value of £50k.
Now you have to look at projected profits. Your business isn’t worth one year’s trading – most investors assume it will continue to trade into the future.
For small businesses, owners can usually expect to multiply value by five or ten. The smaller, riskier, and more niche your product market is, the smaller multiple you’ll be able to use. Let’s “low-ball” and say it’s five. Now we’re at £250k.
But we aren’t done yet. This is the complex part. You have to look at your competitors, the market you are in, your investments, and the resources at your disposal. This allows you to make an evaluation based on potential growth.
For most businesses, it is unlikely your profit margins will stay level. If you’ve just started out, you’ll be hoping for rapid expansion.
For startups with no profits yet, the only thing you can do is look at the variables and your competitor’s profitability, making educated guesses based on these factors. Based on projected growth, you can usually multiply your business value again.
This sort of valuation requires in-depth analysis and it is recommended you get in financial experts to consult you, such as a chartered accountant or investment expert.
In this example, our business is entering a strong market. We’ve got sound business acumen, strong investment, and our competitors are all growing. Our financial expert advises our business be valued at four times its base valuation.
Our valuation going into business meetings to sell or gain more investment is £1 million, based on our projected profits for the upcoming five years.
You don’t need a financial expert to assist you in this, but you must find evidence to back up your claims. Be realistic, look at aspects like previous profit increases, profit to investment ratios, market expansion, and competitor success scaled to your budgets.
The market valuation is your business’ value
After working out a calculation of your business’ worth, you can now face investors. However, don’t take your valuation as gospel. Take theirs.
Let’s say, after your evaluation, you value your business at £1 million. You face investors or buyers time and time again, but can only secure £750k.
Your business isn’t worth what you projected – it is what they will offer you.
At the end of the day, these people are your financial backing. If you reject their offers because you think your business is worth more, but cannot survive without them, it is actually going to be worth nothing very soon.
Use your own business market valuation as a base to entice investors and buyers, but be flexible and accept what other financial experts are telling you.
Russell Smith is managing director at Russell Smith Chartered Accountants
Read our expert’s six tips to perfect pitching, here.
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