Businesses often sell equity in their company or sometimes, sell the company as a whole. So how exactly do companies determine how much their equity or their business is worth. Sometimes, this is an easy process. For example, publicly traded companies allow the market to set the price on their shares. Some businesses are very asset intensive, such as manufacturing companies. In this case, the value of the company can usually be approximately determined by the value of the assets; i.e. factories, equipment, etc. Technology based businesses may base their value on intellectual property such as patents or trademarks. Finally, one other way businesses value themselves is based on revenues and earnings. For example, if a company has one million dollars in receivables, the company must be worth at least that much.
These examples highlight businesses where there is a solid basis for valuations. What about companies that don’t have any revenue or assets, yet they are looking to raise capital? How do they value their company? A common example is a young technology start-up that has a new application or software product in development. They may or may not have intellectual property associated with the product. They likely have little or no revenue, minimal assets (usually a few computers and a lot of brain power), and a young, promising team, yet with little experience. How can they value their company when trying to find outside capital to get the company up and running? Companies also need a certain amount of equity in order to get debt financing as few debt providers are willing to issue debt to companies with minimal equity investment. Ideally, companies can raise just enough money through equity to convince debt providers to issue additional capital. Debt is both cheaper than equity and allows the founders of the company to retain more control and interest in the company.
Valuation is a bit of an abstract process. Companies such as the one described above need to balance how much money they need, making the price attractive to investors, and retaining an amount of equity they’ve identified as being necessary for the financial and operational success of the company. A good strategy is to speak informally with investors, attorneys, and accountants. Gauge interest in the company, ask accountants to assist with valuing any assets, and speak with an attorney to help develop a long term capitalization plan. There is no right or wrong answer when valuing your company. The value that a business places on itself at the beginning may change dramatically once they go out to raise capital. It may change dramatically after a successful capital raise, after revenues start coming in, after assets are acquired, permits are issued, etc. The value of a company is constantly in flux and consulting with experts such as venture capitalists, accountants, and attorneys can be useful for businesses struggling with this issue.