WHY PRIVATE FIRMS SHOULD BE VALUED BEFORE LOOKING FOR FUNDING|Investment Tips by IDIKA AJA – National Business Extra Newspaper of Feb, 10, 2020

As an entrepreneur, owner of a business or intending to own a business, at a point you may need to have other people invest in your business or borrow to expand and grow the business.  Apart from having certain structures, another important thing, you need to do, is to know the value of your company.

For listed companies, valuation is a bit easier, but valuing start-ups is a bit tricky and difficult, though, the valuations fundamentals are still the same and do not change. Even some analysts believe start-up firms should not been valued because of some inherent and fundamental challenges, such as lack of or limited information on historical financial statements and valuation of comparable company, no products or services to sell, are dependent upon equity from private sources and particularly susceptible to failure.

Notwithstanding, the value a company; start-up, growth or quoted, is the present value of the expected cash flows from its operation.  You discount those earnings to get the present value.   Because, value is based on capacity to generate cash flow, more profitable firms are valued more highly than less profitable one.  But, because, start-ups are untested with, no history, no market established, no comparable firms, the value rests entirely on its future growth potential, and as such all inputs have to be estimated, which are likely to have considerable error associated with them.  Therefore, in most cases, the discount rate for start-ups and small businesses can be as high as 60% or 70% and so a contentious issue.  There is a disconnect as the investors can say your company is worth N1,000,000, while entrepreneurs can say, oh! No, the business is worth N5,000,000.

To solve this disconnect, therefore requires appropriate valuation or the entrepreneur can sit down and agree with the investors.  Maybe offer high-liquid convertible financial assets to securitize the investor’s investment.  When valuing your start-up, look at your firm’s current or projected financial statements, past history or history/performance of comparable firms in the same industry/sector or competitors or peer group. While peer group helps to get a measure of how much better or worse a firm is than its competitors, current financial statements help to determine how profitable the firm’s investment are or have been, how much it reinvest back to generate future growth, and the firm’s past history in terms of earnings and market value/prices help to judge on how cyclical a firm’s business has been and how much growth it has shown and the risk.  Though in most cases, this information is hardly available and easy to get.

There are different ways or methods a company can be valued, whether a public, start-up or growth company. The choice of method may depend on the type of company (start-up, growth or quoted).  Irrespective, valuation methods include intrinsic discounted cash flow, relative valuation, market multiples, cost-to-duplicate.

First, let us look at this simple valuation.  Assuming your company generates or is expected to generate N10,000,000/annum.  N8,000,000 is expended or expected to be expended to generate the N10,000,000.  That means you have profit before tax of N2,000,000.  Take away N600,000 as tax leaving you with N1,400,000 net income/year.  Assuming you would need to do anything, what would you be willing to pay to buy this company? Assume the business has no risk.  Let us use three different purchase prices:

  1. Purchase price of N6,000,000  =       23%
  2. Purchase price of N4,000,000 =       35%
  3. Purchase price of N2,000,000 =       70%

From above, it means, if you buy the business for N6,000,000, you are going to make 23% and so on.  But the important thing to note is that the business does not change, it generates N1,400,000/year.  Therefore, the name of the game is what the company really worth.  If you pay higher the yield will go down.  On this note, the value of a company is what you will be willing to pay for.  If you are happy with estimated return of 23%, you then pay N6,000,000.

Remember, from above, the assumption is no risk. Where there is a risk, Discounted Cash flow will be used to calculate the present value of the earnings. DCF involves forecasting future and using a discount rate discount the future earnings.  To be able to use DCF, you have to be able to forecast future market conditions and make good assumptions about long term growth.  Also the appropriate discount rate has to be used.  A higher discount rate is usually used for companies with high risk such as start-ups. In estimating discount rate, you need to estimate your cost of debt and equity.  I have treated how to estimate the cost of equity in “Cost of equity and Return on Equity” Not minding, you can estimate your start-up’s cost of equity by looking at the beta (or betas) of comparable companies, get the market return and return on risk-free asset and use the Capital Asset Pricing Method to arrive at your cost of equity

The beta element of the CAPM model can be estimated by regressing returns on the stock against return on a market index and the cost of debt by looking at the current market prices of publicly traded bonds.

You can also use ‘Valuation by stage or development stage valuation.’ This model uses ‘rule of thumb’ and in line with the values typically set by investors, depending on the firm’s stage of commercial development.  The further the firm has progressed along the development pathway, the lower the company’s risk and the higher its value.  Angel investors and venture capital firms usually adopt this model, when valuing start-ups to invest in.

Market multiple can also be used.  Market multiple entails determining what the sales or earnings of the business will be once it is in the mature stage of operation.  Usually venture capital investors use and prefer this method because it gives an indication of what the market is willing to pay for the company.  The market multiples arguable delivers value estimates that come close to what investors are willing to pay.  It also values the company against recent acquisitions of similar companies in the market, but comparable market transaction can be very hard to find, especially in the start-up market.

Cost-to-duplicate is another method you can use to value your start-up.  It involves calculating how much it would cost to build another company just like from scratch.  Usually the physical assets are used to determine the fair market value.  It is often seen as the starting point for start-ups, since it is fairly objective after all; it is based on verifiable historic records.  But the challenge is that the estimates of the future growth are often based upon assessments of the competence of existing managers and their capacity to convert a promising idea into commercial success.  Therefore, investors, such as angel, private equity or venture capital firms, will consider the quality and strength of your management/managers; whether they are successful, have a track record in converting ideas to Naira.

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