When raising capital for a business or business venture, most do it yourselfer’s leave out several key tools that drastically increase their chances of obtaining capital and making their dream a reality.   Why? I ask myself that every time a client says “I don’t need a business valuation to raise capital”.  Or they say, “I’m not paying for that,” they do it their way and a year later are still in the same rut when we first met.  One thing I’ve learned from this business, the really successful entrepreneurs know there are costs to raising capital.  As a result, they hire the right team of professionals and surround themselves with advisors to drastically increase their success rate.

Mistake #1 – Valuing Your Business Too High

One of the biggest mistakes many business owners or would be business owners make is valuing the business too high.  As a result, when they try to sell the business, they find out it’s not anywhere near what they think it’s worth.  They use wrong criteria for evaluating it’s value.  This is a very general description of what a business valuation is, what is involved in valuing a business and some common mistakes many business owners or entrepreneurs make when starting a new business venture or trying to sell a business.  I’ll also discuss possible solutions to increase your chances of a successful capital raise.

What is A Business Valuation?

‘Shark Tank’ is a TV show in which budding entrepreneurs take their ideas to a panel of Venture Capitalists (VC’s) and “pitch” them on investing in their business.  One of the biggest reasons the entrepreneurs fail to gain capital is common, “I can’t get my hands around the valuation” one of the sharks states.  The entrepreneurs have not properly done their homework, and most of the time, overvalue their business.  A typical request would be to give up 20% of the business for $50,000.  Simple math tells us they are valuing their business at $250,000 (20% x 5 = 100% // 5 x $50,000).

The panel asks the potential partner – “Do you have any patents?  Do you have any orders to fill?  How much revenue did you generate last year and through this year?  Where are your sales coming from?  Do you own any assets? How is your business structured (LLC, Partnership etc.)” and many other questions designed to determine a value of their business, their market and reason for the request.  Most contestants fumble through this questioning because they don’t have solid proof what their business is truly worth, they guessed.

A business valuation is not an appraisal.  An appraisal involves physical or tangible elements, jewelry, real estate, a classic car or inventory – something that can be touched.  An appraisal can be part of a business valuation, the physical assets, but there is more to the value.

Three Common Methods to Value a Business

1)    The Income Approach: Also known as a valuation approach, this method takes into account the annual income a property or business generates to produce revenue.  Revenue or Net Operating Income (NOI) is determined by adding all the revenue a business generates minus all operating expenses.  However, income taxes, interest and servicing debt are not deducted. Many models may call this EBITA – Earnings Before Interest, Taxes and Amortization expenses.

In the simplest form, the process works like this – assume our business is an antique store and has EBITA of $1,000,000 annually. A valuation multiple is applied to the EBITA.  Many times it’s based on the discretionary earnings of the business.  Assume that after interest, taxes and depreciation there is $500,000 profit. The sales price would be calculated on that amount – a common factor is 2 ½ times earnings or $1,250,000.  Of course there are other things taken into account the inventory, furniture, fixtures or equipment, accounts receivables or the real estate (if we own the building) – but you get the idea.

2)  The Market Base This approach looks at comparable sales of similar businesses in your area.  Every industry is classified into a Division, then a Major Group, and finally a class.  This is known as the Standard Industry Code or SIC.  The Bureau of Labor and Statistics is a great resource for this information www.bls.gov.

Using our Antique Store, we are grouped in with Retail Stores, under Retail Trade and Used Merchandise. Comparable stores would be Second Hand Stores, Pawnshops, used Furniture even used book stores.  The value is based on how these   businesses sold for in our community or a general geographic area. This is not an apples to  apples comparison – it’s similar to a home appraisal. If a comparable business or a home, was sold due to illness or some other issue where the owner was forced to sell  below market value, that affects the sales price of your business, or how much an investor may be willing to invest in your endeavor.

3)  The Asset Base This approach bases the value of the business on the overall assets that are in inventory when the business sells.

For our antique store, that could be a pretty good deal – especially if we are selling high end antiques or old jewelry. If we have $5,000,000 worth of inventory at wholesale and the retail value was $10M, we would anticipate a sales price somewhere between the two. If we own the building and real estate, that could be a nice thing for us.

Which Method is Best?

So which one is best?  A combination of all three. Together, they look at ALL aspects of the business – not just the assets or the revenue.  But there is one element many entrepreneurs forget to take into account when valuing a business – the key people running the operation.  Does that team come with the sale of the business?  If the answer is yes – that can add a tremendous value since those folks know the client’s, they understand the market and were most likely instrumental in making the business what it is today. If not, then you need to rely on the above.

Mistake #2 – Why Not To Do it On Your Own

Another mistake when selling a business or seeking funds for a venture is trying to do it on your own.  A project I recently reviewed was amazing. The conservative numbers show a great return on investment, there is a need for this service, the client has the market locked up and has created a virtual monopoly. He did his own market research, he’s buying the primary business asset at a great discount – so in his mind there is equity and he thinks this deal is a no brainer. Here is the problem, he refuses to accept anyone’s word that the money sources need an independent third party valuation and market study done for his business. He comes back with “The asset is worth X but I’m only paying Y” – exactly, if that’s what you can buy it for, that’s all it’s worth.  “But I’m insuring it for X” That’s nice, how much did you pay for it?

Here is the dilemma, the capital sources are impressed with his credentials, he’s extremely qualified to run this operation. He’s recognized as one of the top 5 professionals in his field in the world and is uniquely qualified to provide all this information – for someone else. The capital sources could care less who he is – they won’t “take his word for it” – they want an independent study conducted to verify the information on their own. So here we are, a client who refuses to pay for an independent study and money sources refusing to give him a dime until he does.  So next year, I’ll let you know that someone else paid for a study, took his business idea and is making millions, while this “expert” is sitting in the wings.

Mistake #3 – Why Do I Need a Market Analysis?

Which leads me to another major mistake – many entrepreneurs don’t understand why they should have a Needs and Necessity Study /a Market Analysis done.  This is probably the most critical piece of the business valuation.  If the person putting a value on your business does not know what the local market is doing, how can they provide a legitimate value?  If you are getting into an industry that is in a downward spiral, who is going to invest in it?

Doing It Right The First Time Saves Money and Time

So what does all this mean?  Hire a qualified source to help you raise capital.  Make sure it’s a reputable institution or individual with a proven history that will require a market study and a valuation done on your venture.  This protects you both – the entrepreneur won’t get stuck giving away more of the company then they should. The investor is going to know the value of the company and the market is there so you both have a legitimate chance at success.   Yes, it is going to cost you some money you may not have been expecting to spend right now.  It’s important to understand, a group that works with you to raise capital is going to do the majority of the work for you now, so in the future, when you come back – the paperwork and bulk of the work will be done for future equity raises, it won’t take as much to do it again.

Many budding entrepreneurs are not willing to spend the money to do it right the first time; they are looking for “the deal” and want immediate satisfaction.  They don’t consider the long term consequences of their decision or the additional time and money it’s going to take to achieve success. It’s like the man who was aimlessly wandering through the desert, dying of thirst.  He came across a shack, upon entering, sees a sealed glass container of water on a shelf.  Next to it is an old fashion water pump secured to the floor and a sign above the water container saying “Don’t drink the water – unscrew the cover, prime the pump and you’ll get all the water you want – Don’t forget to put a full jar back for the next guy”.  Do you want to drink the water?  Or prime the pump?

Jim Alafat, CMPS

August 2011