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Back to About the In This Issue:Cover Story Why Manage More Than One Incubator? Feature Stories The Value of a Business Valuation UK Business Incubation Strives to Meet Challenges U.S. Venture Capital Investments Down in 2002 Evaluations Can Improve ED Efforts Europe Seeks Departments
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by Brian Walker There’s really no way around it: Judging value is a subjective
process. Whether you’re shopping for a new television set or
helping a client seek investment for a start-up company, it all comes
down to perceived value. In the case of television shopping, you can
quiz salespeople or read Web sites to compare features, brand names
and other factors that play into product value. But what factors affect
the value of a small company and how do you assess those factors?
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Can every company be valued in the same way? |
Wierwille: Absolutely not! Valuation methods depend on the company’s
stage of development, its product or service, and its ability to make
valid projections. Some companies will be difficult to value at any
stage of development. This is often the case for a company that is
developing technology for which there is high market potential but
no demonstrable cash flow forecast, such as a new pharmaceutical compound.
Others will be easy to value because they produce a common good/service
that can be easily compared with existing markets. Sometimes a company
might be near death and looking for ways to cut its losses and sell
the pieces. For instance, a company might have an obsolete product,
but still have a valuable trade name or assets in a manufacturing capacity
[that could be] easily adapted to an alternate use. In those cases,
the parts must be examined separately to obtain the value of each asset
and how they contribute to the whole.
At what stage of development can a company undergo a valuation?Wierwille: A valuation can take place at any stage of development,
but an early-stage company’s value is often dependent on the
eyes of the beholder. A young company may have a good idea for business,
but little data to support it, leaving much of the valuation to speculation.
For this reason, many investors may not require a valuation for younger
businesses, but simply put up the required seed or ongoing capital
needs in return for a significant stake.
Once the company moves on to later stages, valuation becomes more quantifiable
and less speculative. There is a history to reference along with a more grounded
business plan. The need for a solid valuation becomes even more critical as
the company moves through these later stages of development. It is arguably
more valuable, but at the same time, these companies often have a greater need
for investment to make it to the next level.
Who should an entrepreneur contact to perform the valuation?Pastor: There are business support firms that specialize in valuation.
Generally these folks have a good understanding of finance and may
include accountants and lawyers. Referrals from other emerging firms
and from folks who have invested in other emerging firms are very helpful.
Valuation is an arduous process. It is important to have someone who can work
closely with management and who is willing to work iteratively as new information
becomes available. You should make sure that whoever you hire is familiar with
valuing early-stage firms, and that they have a good understanding of your
product or service. Companies that are based on tangible products have different
issues than companies that sell intangible services or whose competitive advantage
lies in intellectual property.
A good valuation professional will not only provide his or her clients with
a valuation report, but will provide the entrepreneur with new insights into
improving the company’s business model, which should result in a higher
valuation.
It is imperative that whoever performs the valuation remains independent so
that outsiders can rely on the valuation during negotiations.
Is it necessary to hire a third party to perform a valuation? Or can
an entrepreneur obtain similar results with the help of an incubator
manager? Wierwille: Incubator managers and clients
can and should use valuation techniques for self-monitoring purposes
(see Ratio Analysis 101), but they should be aware that some investors
prefer third-party
evaluations. Entrepreneurs are very close to their “offspring” and
will often not have a realistic value perspective. Investors are by
nature cautious and skeptical. The external valuation process can serve
as a mechanism to bridge the resulting value gap.
Also, incubator managers may elect to use valuation techniques for their own
purposes. When choosing from a pool of applicants, an incubator manager can
use valuation-type techniques to distill the applicant pool down to those that
are most likely for success. In many ways, a manager is looking for a good
company to invest in.
An incubator manager can also use valuation techniques to estimate the value
of the services an incubator provides for the purposes of attracting clients
or negotiating equity agreements. (See The
Value of Incubator Benefits.)
What preparation is required of an entrepreneur who wants to determine
company value?Pastor: Entrepreneurs should begin to gather information, both financial
and marketing, on competitors and any firms that they believe have
analogous products and services. The management team members need to
understand who their customers are, the value that their product brings
to those customers and how much the customers are willing to pay. They
need to have a good understanding of the costs related to producing
and promoting the product and the costs related to running the company.
And they should have information about the growth of the industry,
the general outlook of the economy and how it will impact sales, and
the ability of the company to sell equity. Also, it is very important
that whoever is doing the valuation fully understands the company’s
business model, so it is critical that the entrepreneur is able to
communicate that clearly.
For example, several book companies may offer similar products but have different
distribution channels. For people who do not want to spend the time to go from
one bookstore to another, online shopping provides added value to those customers,
for which they may be willing to pay. The cost structure as well as the marketing
strategy will be very different depending on the business model. An expert
who understands “bricks” but not “clicks” may not be
able to address all these differences efficiently.
What aspects of a company are examined during a valuation?Pastor: There is good bit of research and due diligence involved in
performing a valuation. The results can be put into a set of projected
financials so that the level and timing of profitability and cash flow
can be evaluated. Some of the most important assumptions made in producing
the projected financials are:
If multiple entities, such as an incubator and investors, have equity
in a company, how does that affect a company’s value?Wierwille: If someone has already made an investment, whether it is
monetary or through services provided (such as an incubator), you’re
already dealing with a post-money perspective. The company’s
chances for survival are greater because of that investment and it
becomes a benchmark for the company to use in future valuations. An
entrepreneur can point to this instance and say that the company received
this much money, for this much equity, at this point in the company’s
maturity.
Pastor: The amount of equity given up early in fund raising may affect
the ability of a firm to raise capital in the future. As more shares
of equity or stock are issued to new investors, the percentage ownership
of the earlier investors is reduced or “diluted.” Major
investors such as venture capitalists may require that the entrepreneur
buy back some or all of the early shareholders’ stock. One of
the reasons for this is that a major investor would expect to have
significant input into how the company is run and would not want to
have to negotiate with a block of minority shareholders in influencing
management. On the other hand, without early-stage financing and the
use of equity to lure talent, most companies would not get to a stage
in development that a major investor would be willing to provide a
cash infusion.
What role does intellectual property play in a company’s valuation?Pastor: Intellectual property provides a barrier to entry for competitors.
This is very important for any firm. It provides the firm with protections
from competition so that it has enough time to develop and market its
products and services. Then, once in the market, the company is the
single source for its customers, allowing the company to control prices
and realize higher profits. This market control is true of any barrier
to entry, such as cost advantages or trade regulations, not just intellectual
property.
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How much does a valuation cost? |
Wierwille: An average appraisal by a relatively small valuation firm
would cost $10,000-$15,000. A fairly rigorous valuation by a larger
firm would cost $25,000-$35,000 and up. Unfortunately, a company’s
stage of development doesn’t generally have an effect on the
price of a valuation, even though a start-up company may be more difficult
to value than a later stage company. The choice between types of valuations
is a personal one. Some entrepreneurs choose a smaller valuation firm
because of price concerns. Others choose larger firms because those
firms may be able to incorporate the valuation of the company’s
individual assets, both tangible and intangible, or specialize in valuing
specific types of firms, such as biotechnology companies. Something
to consider is that a prospective investor might foot the bill for
valuation in order to gain a better investment position. In those cases,
the appraiser can even be jointly retained by both parties, which is
good because it synthesizes both parties’ specific and opposing
views and goals.
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How much time does it take to complete a valuation? |
Wierwille: The
time required is relatively straightforward once the company gathers
the required information. If it’s all there it can be completed
in a couple weeks. If not, there’s a back and forth between appraiser
and entrepreneur to synthesize the information. Three to four weeks
is a typical valuation
period – 45 days is considered a long time.
Does the fact that a company resides in an incubator increase its
value?Wierwille: Yes and no. The analogy is like a child still residing
at home. The child has support systems in place that can ameliorate
some of the risks of being out in the world. At the same time that
those risks are reduced, costs may not reflect what it’s really
like in the real world. For this reason, the value of a company once
it’s outside the incubator might be different than while it’s
inside. But in the end, the assistance an incubator provides should
add an intangible element that would ultimately benefit a company’s
value.
It’s also good to note that even with all these considerations, a company
in an incubator is not harder to value; an appraiser just has to appropriately
account for these other factors – something that an incubator manager
might assist with during the valuation process. (See The Value of Incubator
Benefits for tips on assessing the value of incubator
services.)
Pastor: Since
a lot of money can be wasted in the early days of a company on “trial
and error,” the expertise and experience that companies have access to
in an incubator will allow companies to develop further before needing to begin
raising funds. Both the expertise as well as the higher level of development
reduce risk and therefore increase the firm’s value. Additionally, investors
must rely heavily on the management team to make the business model work. Therefore,
choosing the right management team and the right service providers will increase
the value of the firm. Most incubators provide services to help companies identify
and recruit these critical skill sets.
What are some ways that an incubator manager can assist a business
in increasing its value?Wierwille: Incubator managers can assist mainly by understanding what
goes into a valuation. A lot of companies working with incubators have
great ideas and believe that their products/services have tremendous
opportunities for success. The critical component for the manager is
to get that notion to a point where it’s believable to others
through hard facts and numbers. Incubator managers and their clients
must pinpoint the milestones needed for success and the hurdles along
the way so that there is an achievable plan that is credible, not only
in terms of funders, but for those ascertaining value. It must always
be a team effort between the manager and the entrepreneur to be realistic
for these estimations, because in the long run, untruths are only going
to hinder the company’s growth and reputation.
But when it comes down to it, the whole purpose of an incubator manager is
to help his or her clients succeed, thus contributing to the client’s
value. So helping a company increase its value is second nature. Ultimately,
an incubator manager increases a client’s value simply by doing his or
her job.
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NBIA asked Michael Wierwille, managing director at Standard & Poor’s
in Los Angeles, for some ways that incubator managers can use
these ratio analyses for client-monitoring purposes. Here’s
what he had to say: |
When a company undergoes a formal business valuation, experts examine similar
factors, including the company’s history of operations, the growth history/potential
of its target market and its business environment (including the benefits that
an incubator provides). The valuation process results in a final appraisal that
entre
preneurs can use when negotiating investments and loans, selling a company,
creating compensation packages and more.
It can be difficult
to put a precise value on the many benefits that incubators provide
their clients. But following the lead of valuation experts can
make that task a lot easier for incubator managers. The valuation
techniques that experts use can help managers arrive at hard
numbers for use in attracting clients or negotiating equity agreements.
Ratio analysis is a technique that valuation experts often use
to assess a company’s financial health. It’s a benchmarking
method that uses proportions to detect financial strengths and
weaknesses. Incubator managers can use this same technique to
monitor clients’ stability. Some common ratios include: