The process of business valuation takes time and requires you as a business owner, to understand your company inside out to ensure a solid foundation when looking to grow or exit your business.
Knowing the value of your company can assist you in:
- raising debt or equity for your business;
- a merger or acquisition; or
- issuing shares as a form of remuneration to employees.
There are multiple valuation methodologies that can be used for business valuation, and it is important that the most appropriate method is chosen to ensure that the valuation is robust by taking into consideration both the current and potential profitability of the business.
A high percentage of startups are capital intensive and/or loss-making in nature, therefore it would be inappropriate to rely on historical earnings in order to determine their value.
Startups are also likely to experience high growth during their early years as they expand operations, generate revenue and expenses become more stable. The discounted cash flow methodology is a widely accepted approach in valuing a startup business expecting to experience significant revenue growth in the future.
As a cross-check to the discounted cash flow methodology, business owners who own startups that aren’t at a scale to generate sustainable profits may look at revenue multiples (enterprise value divided by revenue) of comparable transactions or comparable companies listed on the Australian Securities Exchange.
Below, we discuss four critical items that a business owner should consider when looking to assess a realistic value of their business using the discounted cash flow methodology:
1. Be able to determine an appropriate forecast period
Having an appropriate forecast period is important in preparing a discounted cash flow, as it should incorporate the period where there are changes expected to revenue and expenditure assumptions.
For example, a startup may rely on market penetration as one of their revenue assumptions and should incorporate the growth in market penetration over the forecast period to the point where they expect growth to continue at a constant rate.
It is important to note that longer forecast periods are generally less accurate, due to the difficulty of estimating revenue and expenditure assumptions.
2. Understand the key drivers behind revenue and expenses of the business
A business owner should be able to understand what drives the revenue and expenses of their company.
For example, a retail clothing store will typically be able to calculate revenue by multiplying the price of each item sold by the total volume of items sold. For other sectors and businesses, the key drivers may be less tangible such as technology take-up. Furthermore, the owner should be able to identify the variable costs of the business that will change as a result of a change in operations.
3. Ensure all assumptions are supported by market research
Assumptions used in a discounted cash flow model should be backed by sufficient market evidence or supporting documentation. If requested, the owner of the business should be able to readily provide the user with information as to how a forecast revenue or expense item was derived.
Being able to support revenue and expense assumptions is a critical step to completing a discounted cash flow and is frequently requested by investors, banks and potential buyers of the business.
4. Know the capital requirements of your business
Startups can be capital intensive in nature. As a business initially grows, there is usually a requirement for new property, plant and equipment to provide capacity for the next phase of growth. A business owner needs to be able to identify which growth capital expenditure items are required for their business and to incorporate these costs into their cash flows at the appropriate dates.
The forecast period of the discounted cash flow should continue to the point where capital expenditure incurred by the business is at a sustainable level and no longer attributed solely to the growth of the business.
It is important to understand that the derived value of your business startup will not necessarily be equal to the value placed on it by other parties.
For example, a bank that provides a debt facility to a business will want to ensure that the business will generate sufficient funds to repay the outstanding loan and any interest accrued, therefore it is unlikely that they will consider the full growth potential of a business when assessing its value. On the other hand, a potential buyer looking to add a service line to their existing business or gain from synergies through a merger or acquisition may pay an additional premium to acquire your business. Sophisticated early-stage investors may adopt a venture capital valuation method which is primarily driven by their desired exit return.
Completing a valuation can be a complex process and often there is no simple or single answer, however, the four key considerations above will assist you in focusing on the important areas of a discounted cash flow valuation. If the task of completing a business valuation is too daunting, reach out to a professional who can assist you in assessing the value of your business.
How can RSM help you?
If you require further information, please contact your local RSM adviser today.
This article was originally published on Startup News on 11 February 2021.