If you’ve successfully walked through the door of a VC firm and given a presentation, your next step may be having the VC firm perform a valuation on your business. A successful presentation is indeed a commendable feat, but before you receive a check from a VC firm, they will do their due diligence and valuate the true potential of your business.
Some call the process of valuating a business an art rather than a science. The results can be highly subjective rather than objective when considering the value of an untested business idea or process. Particularly the entrepreneur’s opinion of his business may be inflated due to the enthusiasm that clouds better judgment. But conversely, a VC may undervalue a business to be ultra-conservative in estimating potential losses.
A VC business valuation must take many factors, including:
- Risk vs. Reward – A VC firm must evaluate a company from the viewpoint that it is risking its own capital to capitalize another company. And for that risk and use of money, they deserve a reward. The higher the risk of financial loss, the more reward will likely be asked of a potential portfolio investment company.
- How Much Capital is Needed? – A VC firm will try to assess the amount of capital that a business needs in order to succeed. Too little capital and the business risks failing. Invest too much capital, and the VC firm has tied up more money than it needed, thus losing other potential investment earnings.
- How Fast Will Revenues Grow? – Another factor that venture capitalists must consider is the rate at which revenues are predicted to increase until they can take out their “reward” or financial return. Some companies may take up to five years or more before they even see a profit and are able to incorporate with an IPO. The longer that VC money will be tied up, the more return they will ask for at their exit point.
There are many methods a venture capital firm may employ to valuate a startup business. Most of these methods are subjective since the future is always unknown. Here are a few of the most common methods:
- Cost Approach – This is also known as book value. The cost approach tries to determine the future book value of a business at the exit point after liabilities are subtracted from assets.
- Market Approach – A market approach to business valuation would try to determine what the business would be sold for on the actual market. Sometimes this means comparing the actual recent sale price of a similar sized business in the same industry.
- Income Approach – An income approach uses a capitalization rate, or cap rate, to determine a subjective valuation. The cap rate is divided by the net income of a business at a particular point in the future to calculate the valuation. For instance, if a startup company expects to have net earnings of $10 million at the projected exit point in eight years, and a 10% cap rate is used, the business valuation would be $100 million.
Business valuation is an important step for VC firms and entrepreneurs. It must be completed to reconcile the valuation between what the business owner thinks the company is worth, and the conservative estimates of a VC firm. If you’ve reached this stage, you’re well on your way to receiving VC funding, but be prepared to cooperate fully with a VC firm in their requests for valuation information.