How much is a business worth?

How much is a business worth? [Photo: Courtesy]

It is often said a business is only worth what someone is willing to pay for it. But that doesn’t mean you can’t come up with a sensible figure.

The process of valuation can get complicated given it attempts to measure how much a business will eventually be worth.

Most people start by calculating how much they need in investment and working backwards from there to land on a good valuation.

In an article, analysts Stephane Nasser and Augustin de Cambourg describe a start-up as a very special box.

The box has a value. The more things you put in the box, the more its value increases. Add a patent in the box, the value increases. Add a stellar management team, the value increases.

The box is also magic. When you put Sh100 inside, it will give you back Sh200, Sh300 or even Sh1,000. The problem is, building a box can be very expensive.

So you approach an investor and offer them a deal that sounds a bit like this: “Give me Sh1 million to build a box, and you get X per cent of everything that comes out of it.”

But how much should ‘X’ be? Here’s an overview of eight valuation methods you can borrow from.

1. Berkus Method

The Berkus Method is a simple and convenient rule of thumb to estimate the value of your box. It was designed by Dave Berkus, an author and angel investor, and aimed at pre-revenue start-ups.

He proposes that you first be sure your box can rake in money over its first five years of business. You assess your business against five key criteria: sound idea (basic value), prototype (reducing technology risk), quality management team (reducing execution risk), strategic relationships (reducing market risk), and product rollout or sales (reducing production risk).

This will give you a rough idea of how much your box is worth, and more importantly, what you should improve.

2. Risk Factor Summation Method

With this, you first determine an initial value for your box, and then you adjust the value against 12 risk factors inherent to box-building.

The initial value is determined as the average value of similar boxes in your area. The risks, on the other hand, include the stage of the business, political risks, capital-raising risks, competition and management risks.

3. Scorecard Valuation Method

The Scorecard Valuation Method starts with a base valuation for your box, and then you adjust the value against set criteria.

These criteria are themselves weighed based on their impact on the overall success of the business.

This method, also called the Bill Payne Method, considers six criteria and weights them thus: management (30%); size of opportunity (25%); product or service (10%); sales channels (10%); stage of business (10%); other factors (15%).

4. Comparable Transactions Method

Depending on the type of box you’re building, you can find a number that you can use as a good indication of the value of your business.

This number can be specific to your industry. Some of the indicators you can use are average monthly revenue, number of outlets or weekly active users.

5. Book Value Method

This method relies on the net worth of the company – that is, the tangible assets of the box; the ‘hard parts’.

This method, however, isn’t very relevant to start-ups that rely more on intangible assets, such as user base or the software they’ve developed.

6. Liquidation Value Method

As implied by its name, the valuation is applied to what you’d get from a company when it’s going out of business.

Things that count in a liquidation value estimation are all the tangible assets, like real estate, equipment and inventory. The intangibles, like patents, copyright and any other intellectual property, are considered worthless in a liquidation process.

7. Discounted cash flow

This technique is suited to mature businesses with stable, predictable cash flows.If your box works well, it brings in a certain amount of cash every year.

Consequently, you could say that the current value of the box is the sum of all the future cash flows over the next years.

You discount the amount, though, to account for any risks and the time value of money.

After all, Sh1 is worth more today than Sh1 tomorrow because of its earning potential. The discount rate can be anything from 15 to 25 per cent.

8. First Chicago Method

What if your box has a chance of becoming huge? How do you assess this potential? This method addresses this by making three valuations: a worst-case scenario (tiny box), a normal-case scenario (normal box), and a best-case scenario (big box).

Each valuation is made with the discounted cash flow method. You then assign a percentage reflecting the probability of each of the three scenarios happening. Your final valuation will be the weighted average of each case.