Why valuation matters

Many entrepreneurs wonder about value of the enterprise they have so carefully built. The most important thing to remember is that when a liquidity event occurs, it is the market that will decide your valuation.

The publicly traded capital markets buy and sell stock at a certain price. If your business is a publicly traded entity, then a market capitalization is determined by the number of outstanding shares multiplied by the market price.

But what about privately or closely held enterprises?

Business valuations are done all the time and for different reasons, such as estate planning, raising growth equity capital or preparing for a merger or acquisition. Determining the enterprise value can be done by using various methodologies, including comparing companies within the industry to see how they are trading, as well as the traditional valuing-of-assets approach. You could also combine different methods to reach an estimated range of value.

EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) multiples are crucial in the analysis. An EBITDA multiple determines the trading level of enterprise values. A similar measure with publicly traded companies is the PE (price-to-earnings) ratio.

If you own a privately held company and are seeking growth equity capital from the investment community — either by angels or institutional investors — here are some important terms to keep mind.

Pre-money valuation is the valuation determined prior to an investment.

Post-money valuation is the valuation after an investment has been made.

Valuation fraction is as follows:

* The investment amount = the numerator

* The investment amount + Pre-Money Valuation = the denominator

The more investors you have looking at the transaction, the higher likelihood of a competitive and favorable valuation determination. Refer to your Economics 101 textbook regarding supply and demand principals.

Company valuation example

XYZ Corp. is an early stage company with top line revenue of $5 million and EBITDA of $500,000. XYZ is looking for $2 million of growth equity capital in order to complete purchase orders and increase staffing, round out the management team, and for general working capital purposes.

After aggressive marketing efforts that utilize a top-notch investment banker, there are four interested parties. Each has a different valuation proposal for the target company.

* Investor A — A $3 million pre-money valuation and a $2 million investment. The investor would own 40 percent of XYZ Corp.

* Investor B — A $2 million pre-money valuation and a $2 million investment. The investor would own 50 percent of XYZ Corp.

* Investor C — A $1 million pre-money valuation and a $2 million investment. The investor would own 67 percent of XYZ Corp.

* Investor D — A, $8 million pre-money valuation and a $2 million investment. The investor would own 20 percent of XYZ Corp.

All other things being equal, the management team would reject Investors A, B and C and accept the proposal from Investor D because this is the most favorable valuation presented to the company.

So why the difference in valuations? Everyone has a different view of the world. It could be a strategic partner, who loves leveraging synergies; it could be economies of scale; or it could be something else entirely. The important thing is that the process is competitive and no stone is left unturned. The more investors that look and express interest, the better for the entrepreneur.

Using an investment banker in this process puts the entrepreneur in an auction environment and generates competition for the deal, hoping to attract the best investor at the best possible terms.

John Bintz is founder and president of Apple Tree Investments Inc., an investment bank dedicated to middle-market transactions. The firm raises growth equity capital, sells middle-market businesses and assists entities with strategic business planning. Reach Bintz at (312) 243-9694 or [email protected].