Revenue doesn’t always equal success in the eyes of investors

Startup companies that seek funding for growth are not the type of companies banks tend to see as the best candidates for loans.

“Banks know that most startups fail,” says Michael Stevenson, managing partner at Clarus Partners. “Startups and small businesses tend to have little capital at the outset and banks are leery of lending money that might not come back.”

Investors are experienced business people who are looking for specific metrics to determine a valuation. That often surprises most entrepreneurs who rely too heavily on revenue projections to generate a value.

Smart Business spoke with Stevenson about the importance of an accurate business valuation and what investors look for in early-stage companies.

Why does a business valuation matter?

For a startups looking for capital, a valuation determines the share of the company they have to give away to an investor in exchange for the money they need for growth.

There are three common valuation approaches: asset-based approach, market approach and income-based approach.

Asset-based valuations are based on the assets a company holds — real estate, inventory, or machinery and equipment, for instance.

Market approach uses proxies, which are comparisons of similar types of companies and what those have sold for in multiples of revenue or EBITDA.

Income approach uses a company’s historical or projected earnings to make assumptions about future earnings.

The income approach is the most common, but often two of the three approaches are used to determine a company’s value.

Who should perform a valuation?

Independent valuation companies and most larger accounting firms will perform a business valuation.

Accounting firms can help companies develop an investor deck that lays out its value, its growth history, key staff and their influence on the company, the market and direct competitors, competitive differentiators and strategies for future growth.

It’s usually the entrepreneur who has a valuation performed on his or her business. A potential investor will ask to see the assumptions used to make the valuation, typically looking at revenue, net income and gross margin growth.

Investors like to see valuations put together by experienced professionals as it gives credence to the numbers. CPAs are particularly valuable for this reason. Investors are more confident when they see that a CPA with experience making projections and modeling has helped the entrepreneur create a forecast. It can be beneficial to have that person on hand when pitching to investors to explain the numbers and how they were reached.

What numbers should entrepreneurs watch to get the most accurate sense of their company’s value?

Gross margin, net income and cash flow are the more important figures. Many startups think sales are the only measure, but if those sales don’t make any money, they don’t matter.

If a startup is seeking funding for more inventory, economies of scale suggest that buying more will drop material costs and improve gross margin. That’s often seen as a good investment.

But looking purely at a revenue increase and ignoring gross margin, which could go down and create ‘empty calories’ rather than generating cash, is a red flag and investors will balk.

How can advisers help business owners understand their business’ value and help improve it?

Most of the time business owners think their company is worth way more than the valuation, so an adviser has to explain how the value was calculated and how the owner can get to where they want it to be, often by devising strategies to increase profitability.

Before approaching investors, entrepreneurs should know their business and industry inside and out, have a realistic value of their business and understand that an investor’s primary concern is to make money. Otherwise, they’re in for significant disappointment when no one is interested in funding their venture.

Insights Accounting is brought to you by Clarus Partners