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Business Valuation: How Do Investors Determine Business Value?

| May 24, 2022 | By

Are you planning to sell your business soon? Then, you must know how investors do a business valuation, so you get top dollar for your company. Whether you’re looking to sell to fund your retirement or invest in a new company, let’s break down the basics of the business valuation process

Business Valuation Key Terms

There are three key terms investors use when determining a business’s value:

  • Pre-money valuation — The company’s value before the investment. 
  • Amount invested — The price investors must pay to realize a positive ROI. 
  • Post-money valuation — Value of the company after the investment. 

How these terms work together in the business valuation process

Essentially, the pre-money valuation and the amount invested equal the investors’ ownership percentage after VCs invest in the company.

For example, let’s say you have a company with a pre-money valuation of six million dollars. The amount invested is one million dollars. The mathematical formula for how investors calculate their percentage of ownership is:

  • The equity investors owned equals the amount invested, divided by the pre-money valuation, plus the amount invested.

In this particular example, determining the percentage of ownership would look like this:

  • $1M ($6M + $1M) = 14 percent 

Now, the post-money valuation mathematical formula is: 

  • Post-money valuation equals pre-money valuation plus the amount invested.

In this case, the post-money valuation would equal seven million dollars. 

Other factors to consider in a business valuation

However, you can’t analyze the pre and post-money valuations in isolation when trying to determine a proposed valuation’s financial merits. You’ll also need to consider dividends and liquidation preferences to decide if the proposed valuation is a good deal for you. 

Investors also use other factors such as market share, gross margins, and predictions of market growth rate to determine a valuation range. 

Top Methods Investors Use to Determine Business Value

Remember that the most common business valuation methods aren’t always conducive to determining the value of startups and early-stage companies. 

The results are often questionable for startups since many factors used to determine business valuation, like assumptions about market growth rates, can’t be accurately predicted. 

But for established companies with a good history of revenues and costs, discounted cash flow, or DCF is the most common methodology used in the business valuation process. Price/earnings multiple, or P/E, is another adequate valuation methodology for established businesses. 

When venture capital funds invest in startups, they typically use two business valuation methods to establish an investment price. 

Business valuation methods for startups

  • Recent comparable financings — Investors use companies in similar sectors and stages to determine the investment opportunity. Databases like VentureSource and VentureXpert provide the information investors need to establish a valuation range for a similar startup. 
  • Potential value at exit — In this method, investors already have a good idea of the company’s exit value based on recent mergers and acquisitions (M&A) in the sector. Or they use the established valuation of similar public companies as a baseline. 

Usually, early-stage VCs look for 10 or 20 times the ROI on their investment. In contrast, VCs for established companies look for three to five times ROI within two to five years after investment. 

Business valuations for established companies 

  • Earnings multiples (P/E) — In this method, investors estimate the company’s earnings over several years, called the price-to-earnings (P/E) ratio. For example, if a typical P/E ratio is 15 and investors predict the company will earn 200K per year, the business is worth three million dollars. 
  • Discounted cash flow analysis (DCF) — This somewhat complex formula looks at the company’s annual cash flow and projects it into the future. The projected future cash flow is then discounted to the cash flow the business realizes today via a net present value calculation. 

Maximizing Your Business Valuation

Getting top dollar for your business boils down to two things — numbers and persuasion. Ultimately, you’ll need to make a good case with the investors to maximize your business valuation. 

Show them the maximum potential exit value of your business. Remove any obstacles an investor might see as a possible limiting factor in the company’s worth, such as issues with the management team or sales process in your business. 

Another effective way to maximize your business valuation with investors is to do your research. Look into how much investors have valued other companies in similar industries and slightly later stages than yours. Use these established valuation ranges to identify any commercial or technical gaps your company may have and close them before undergoing the business valuation process. 

Determining Business Valuation: The Bottom Line

After an investor gives you an initial valuation number, don’t be afraid to push back and ask for a higher valuation. Provide evidence and a persuasive counter-argument for why you think the business is worth more. A good rule of thumb is to ask for a valuation that’s 25 percent higher than the initial offer. 

Ready to find out how much your business is worth and confidently negotiate the highest price possible with investors? Get in touch with us today at (508) 797-5003 for your free business valuation consultation.