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Valuing Business Ventures
Updated: Aug 25, 2023
Foreword:
Board members are recognized for having the duty of managing the entire company, but they also need to be able to comprehend the idea of business appraisal. Entrepreneurs typically want a high value for their business; however, investors want the contrary because it limits the risks that both the business and the entrepreneur might encounter.
Mr. Cacaho highlights the necessary rates of return, which include return multiples in number of years and internal rate of return, to demonstrate the projected usual returns required by private investors and venture capitalists for investing in emerging business ventures.
This article first appeared in the Q3 2023 issue of the SID Directors Bulletin published by the Singapore Institute of Directors you can read and download Mr. Cacaho’s as a PDF file at the bottom part of this article.
A successful venture requires more than a great idea. It requires convincing others to obtain the resources needed to execute the idea. Business valuation is a key requisite for obtaining the venture’s appropriate capital.
While board directors have oversight responsibility, it is also important they understand the concept of valuing a business. Hence, knowledge of the basic methodology of business valuation is useful.
The entrepreneur usually wants the highest valuation for his company. In contrast, the investors want a low valuation to mitigate the risks and hurdles the entrepreneur will likely encounter.
One of the first steps is to build a financial model so that an investment’s true sources of value stand out. This will enable an efficient allocation of resources within the organisation and highlight the dynamic consequences of decisions through sensitivity analysis.
Rates of return
The rate of return on investment required by an investor depends on the type of investors and the perceived risk of the business opportunity. The box, “Required Rates of Return” shows an estimate of typical returns required by private investors and venture capitalists for investing in new business ventures.
Venture capitalists and angels financing early-stage startups require an annual rate of return of greater than 50 per cent to compensate for the high level of risk involved at that stage of the company’s journey. For later-stage financing, when the venture becomes more mature (i.e.lower risk), investors require an annual rate of return of between 30 and 40 per cent.
Factors affecting valuation
Some of the risks that investors evaluate are: the market, team, product, technology and business model.
The potential rate of return for the investor must compensate for these risks. The higher the perceived risk, the higher the rate of return that the investor requires.
Apart from the business fundamentals and potential, the external business and economic environment also affect funding support. It is easier to raise money on favourable terms if, for example, the state of the economy, the condition of capital and venture markets, and the specific industry vertical are good.
Valuation methods
There are several valuation methods to estimate the value of a company. A simple and common method is to apply a price-earnings (P/E) multiple to a business’ future earnings. (See box, “P/E-based Valuation Method”).
The methodology and case example can provide a benchmark. The final deal between the entrepreneur and investors is the result of negotiations between the two. And much of this depends on the amount of money an investor is willing to pay for a certain percentage of ownership that an entrepreneur is willing to sell to the investor.
Armand Cacacho is an Adjunct Professor at the Asian
Institute of Management (Philippines) and a faculty
member of the Institute of Corporate Directors Philippines.