What is EBITDA? Must read for entrepreneurs
Evaluating a startup is an extremely taxing procedure. Among all the dynamic solutions available for quality startup valuation, EBITDA and DCF are two accounting methods used by companies
#EBITDA article series
Evaluating a startup is an extremely taxing procedure. Among all the dynamic solutions available for quality startup valuation, EBITDA and DCF are two accounting methods used by companies. Between the two, the former is a useful formula to measure the long-term growth potential of startups. Investors use the result to influence their decision to invest in a particular startup and compare different businesses. These metrics deliver on mapping the financial health of an organization.
Additionally, in the corporate world, EBITDA is a popular calculation metric to measure a company’s profitability. It gives a reasonable estimation of actual profit trends. It does not consider the extraneous factors to provide accurate results that are used to compare different companies. Furthermore, the metric is also used as a shortcut valuation method to find out the cash flow available required to pay off the debts of long-term assets. So, industry averages can easily be measured through the method.
Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA measures your business’ scale. By using this metric, you can have an estimation of the financial status of your company.
What is EBITDA?
Besides startup valuation, it is also used as an alternative for calculating net financial income. Even though it is a fairly common procedure to measure a startup’s valuation, it is not absolute. It does not take into account expenses of other investments like equipment, plant, property, etc.
Along with the above, the metric does not include debts by the company because the method adds up interests and taxes to the earnings. Because of this, the calculation metric could be misused to produce company earnings higher than the actual figure.
However, even after deducting debts from the calculation metric, the metric is a precise calculation method for corporate financial reports as it can show earnings before accounting and financial deduction’s influences. Also, the metric helps business owners understand the extent of profitability and the growth opportunities of their businesses.
What is a good EBITDA?
A good EBITDA helps sense a company’s financial prowess. Naturally, a higher value signals better financial health of a company than relatively lower values. However, various companies and industries of variable sizes in different sectors have different values. The valuation of a startup is dependent on the kind of services it provides and its size. Therefore, a good practice would be to find companies in the same industry and sector and of the same size to evaluate the strength of a startup’s Earnings Before Interest, Taxes, Depreciation, and Amortization metric.
Importance of using EBITDA
The metric is popularly used to find out a company’s cash flow. For an analyst, the calculation method provides a quick understanding of a company’s value. It also gives a valuation range to an analyst by multiplying the company value by a valuation multiple evaluated from equity research reports, M&A, or industry transactions.
Besides being a helpful metric to financial analysts, companies turn to EBITDA to understand their economic progress with respect to their competitors. It is an excellent indicator of the financial status of a company in a familiar business sector.
Also, the tool helps business owners make the right policy or business changes when they are not running in profits. Aside from being an excellent comparison tool, the metric works as an indicator to show business owners and associates the performance probability of the company in the short and long term.
Limitations of EBITDA
Even though there is no legal compulsion to disclose a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization values, the method is not accepted by GAAP (Generally Accepted Accounting Principles), a standard financial performance measure. The metric does not qualify for GAAP as its evaluation is not consistent between companies.
It is not uncommon that companies prefer EBITDA over their net income because it is more flexible than other metric systems. Also, the measurement method can be quite distracting as it does not emphasize other problematic areas in a company’s financial statements.
Ignores costs of assets
The metric does not represent the cash earnings of a company. Also, it does not see the asset costs, like that of free cash flow. Calling it a true representation of the cash earnings of a company will be inaccurate.
Another common criticism that the metric faces is that the metric understands profitability to depend on sales and operations only. A company is survived by assets and finance too. But the metric does not take company profits to be a function of financing and investments.
Ignores working capital
Among all the parameters that the metric leaves for calculating profitability, one is the crucial element of the money required for funding working capital. Another element is the expense related to old equipment replacement. The profit calculation is only concentrated on sales and operational costs.
For instance, even though a company sells its product for a sizable profit, the question remains which resources are utilized to acquire the inventory required to charge its sales channels? Furthermore, the metric ignores the costs related to developing the latest software versions or future products in the software industry.
Varying starting points
Various companies use varying earning figures as the starting point for calculating EBITDA. Because of this, the calculation metric opens the scope of tricking the company account calculations on the income statement. For example, while deducting tax charges, interest payments, depreciation, and amortization from earnings may appear to be a simple process.
Still, different companies produce different figures by starting from varying starting points. Even if the discrepancies from interest, depreciation, taxation, and amortization in EBITDA are considered, it still fails to produce reliable earning figures for a company.
Obscures company valuation
The metric may make a company look less valuable than it is in reality. This may happen when analysts look at its stock price multiples rather than the company’s bottom-line earnings. The stock price multiples of the metric result in lower multiples.
How to calculate EBITDA?
A company’s EBITDA can be calculated from the information gathered from its cash flow statement, income statement, and balance sheet. The calculation formula is –
Earnings Before Interest, Taxes, Depreciation, and Amortization = Interest + Company Taxes + Depreciation + Amortization + Net Income
Earnings Before Interest, Taxes, Depreciation, and Amortization = Depreciation + Amortization + Operating Profit of a company.
Components of EBITDA
Precise results can be produced when each component of the calculation formula is understood thoroughly.
Earnings are company turnovers over a specific period. Earnings can be calculated by subtracting the operating costs from the total company revenue.
The cost of servicing debt is a company’s interest expense. Apart from this, it is also the interest earned by the company. However, in most cases, interest points towards a company’s expense. In the calculation formula, interest-related costs are not subtracted from the company earnings.
The calculation metric measures company earnings before calculating its taxes. Operating profit, often referred to as EBIT, is a company’s earnings before interest, taxes calculation.
Depreciation and Amortization in EBITDA
The general meaning of the term ‘depreciation’ is the loss in value of tangible company assets, generally related to their usage over a while. Such depreciated assets include company machinery, vehicles, etc.
On the other hand, amortization in EBITDA deals with the expiration of intangible company assets, such as patents. In the calculation, depreciation and amortization are added to the operating profit or EBIT to get the final value.
Example of calculation of EBITDA for startup valuation
To understand its calculation better, Professor Ron Auerbach of the City University of Seattle came up with the following example:
Say Company X has the following financial credentials:
· Company net income = $1,800,000
· Interest paid = $ 260,000
· Depreciation amount = $ 180,300
· Amortization = 0
· Taxes = $ 132,500
So, according to the formula listed above, the EBITDA calculation of company X would be:
= Net income + Interest paid + Depreciation amount + Amortization + Taxes
= $ (1,800,000 + 260,000 + 180,300 + 0 + 132,500)
So, EBITDA = $ 2,372,800.
How does the EBITDA method help in startup valuation?
Evaluating the worth of a startup is not a simple process. Company figures are vital as it helps to get funds from investors. Also, a startup valuation is used to understand financial health with respect to industry standards. In such cases, a strong solution has to be used to find the most relevant results in startup valuation.
EBITDA is one such effective method to measure a company’s cash flow generated by its activities. It is one of the two reliable methods of measuring a company’s growth and performance, the other being Discounted Cash Flow (DCF). A positive value is an indicator of a company’s profitability.
In other words, a positive value means that the company sells its products or services for a price greater than the production cost. Conversely, a negative value implies that the company is procuring losses from its products or services.
Therefore, through the metric, companies can have a clear picture of their business situation. Since investors look for an accurate metric to measure the viability of an investment, EBITDA works to give the investors ample idea to understand the map of the particular company’s development.
EBITDA provides a fair analysis of a company’s finance. In order to provide ample proof of the company’s value, the metric has to be applied and calculated efficiently. However, relying too heavily on the startup valuation may not be favorable while selling off a company. The estimated value does not influence the selling price of a company alone. A company’s intangible assets, performance, consumer base, know-how, and growth potential are also crucial indicators for its saleability.
HOW DOES EBITDA AND REVENUE AFFECT YOUR STARTUP?
When a startup starts making revenue, it is unable to keep all its earnings. There are several expenses that a company has to pay to keep operating. When these costs are deducted from the revenue earned, the cash left is divided among the business shareholders.
The income statement is a testament to a company’s income and expenses spent in a specific period. The top of the financial statement states the revenue generated by the company, and the net earning is listed at the bottom. So, the income statement is crucial to understand the difference between EBITDA and the revenue of a firm. Each line of an income statement represents the money the startup has earned at two different stages.
EBITDA vs. Revenue
The difference between EBITDA and the revenue of a startup is essential for varying purposes. While the former is a metric of a company’s profitability that can be used to measure the efficiency of a firm, the latter is the sole representative of the company’s income in the first place.
While the general public pays a great deal of attention to a company’s income, the analysts, business owners, investors, managers, and moneylenders pay close attention to the metric EBITDA. The metric helps determine how cash flow is generated from the company operations, which, in turn, helps them understand the financial health and investment potential that the company has.
What is Revenue?
A startup’s revenue is the total money it generates from its business operations without deducting any expenses associated with those sales. It is the pure amount of money that the company generates.
As revenue is the primary income coming into a firm by selling its products and/or services, no expenses are deducted from it. Hence, it can be seen sitting at the very top of every income statement of a firm.
There are different sources from which a company can earn its income:
- Products sale
- Charge of services
- Commissions, etc.
Other sources include dividends on company-owned securities and interest earned on the money the company has loaned. Thus, any money earned by a company qualifies as its interest, usually reported 1 or 3 times a year.
To sum it up, revenue is the business generated by the company (accrued income and cash) before expenses are brought into the picture within a specific accounting period. The other terms used to denote revenue are income and gross sales.
Who uses revenue calculation?
Revenue calculation is mainly used by personnel like Chief Financial Officer, Sales Manager, and Chief Revenue Manager. Besides, the general public finds it easier to measure a company’s revenue as a scale than the EBITDA metric.
Formula and example of revenue calculation
The income of a company can be calculated with the help of the following formulae:
Income = Total no. of consumers * Average price of company services or products
Income = Total no. of units sold * Average price of company services or products.
For example, if a customer signs a one-time annual deal with a company for $24,000, then the monthly income will be $2,000, and the yearly income for that year will be $24,000.
What is EBITDA?
It may seem like a technical or unfamiliar term, but like income, it is a metric to measure a company’s earning power, i.e., its profitability. It stands for ‘Earnings Before Interest, Taxes, Depreciation, and Amortization.’
It is a tool more nuanced than revenue to understand a firm’s ability to generate cash flow from its operations by adding back the expenses indirectly tied to the company operations to its net income.
Company costs like depreciation and amortization are added back to the revenue as they are non-cash expenses. They are recognized as expenses on an income statement of a company, but they do not need to be laid down as actual money.
On the other hand, taxes and interests require cash payments but come under non-operating expenses that remain unaffected by the company’s primary activities. These, too, are added back to the metric.
Who uses EBITDA?
This metric is commonly used for analyzing a business’ performance. Hence, it is mainly used by experts like financial analysts, chief financial officers, accountants, business owners, and investors.
Why do companies use EBITDA?
Companies, as well as analysts, investors, and accountants, prefer the metric over other tools because it solely measures a firm’s operational profitability. The costs that are deducted from income to evaluate it are linked directly to the firm’s operations. These costs include rent, salaries, research, and marketing costs borne by the firm. Thus, EBITDA primarily indicates a firm’s operational efficiency and financial strength.
So, financial analysts and investors use the Earnings Before Interest, Taxes, Depreciation, and Amortization metric to compare the operational health of companies with varying capital structures.
Drawbacks of EBITDA
The metric does not qualify for the standard metric of financial performance called GAAP, an acronym for Generally Accepted Accounting Principles. Due to its non-GAAP measurability, the calculation can widely vary from one firm to another.
In the preference of EBITDA vs. revenue, it is often not uncommon to notice firms emphasize the former over the latter. The former is more flexible and has the ability to distract financial experts from crucial problematic areas in the account statements of companies.
Moreover, investors have to keep an eye on companies when they start reporting EBITDA more distinctively than they ever did. Such practices can essentially signal a red flag to investors as there can be instances of firms borrowing money heavily or undergoing rising development and capital costs. In such cases, Earnings Before Interest, Taxes, Depreciation, and Amortization can mislead investors in assessing a company’s actual financial performance.
- Ignores Costs of Assets
EBITDA is not the representation of cash earnings or the cost of assets. One primary limitation is the assumption that a company’s profitability directly affects sales and operations. It does not acknowledge the contribution and the importance of assets and financing in the upkeep of a company.
- Ignores Working Capital
The metric also does not include the cash required to maintain company inventory and to replenish working capital. For instance, in the case of a tech company, the EBITDA calculation does not take into account the expenses related to current software development or the development of the upcoming products.
- Varying Starting Points
While the metric calculation might appear simple enough, various companies use different earnings amounts at the start of the metric analysis. It is prone to produce changing values on the financial statements. Even if we consider the anomalies in the calculation that result from taxation, interest, amortization, and depreciation, the earnings figures are still not reliable.
- Obscures Company Valuation
The worst of all its drawbacks is there’s a possibility of distorting the company image. Through EBITDA, companies may appear less expensive than they are. If stock price multiples of the metric are taken into account, rather than bottom-line earnings, they result in lower multiples.
Formula and example of EBITDA
EBITDA is a valued tool that determines the capability of a business to generate cash flow from its operations. Thus through the metric, the company’s performance can be measured.
EBITDA = (Revenue — Expenses) + Amortization + Depreciation
It measures the actual business earnings before operating expense deductions and accounting.
More than one working formula can be used to deduce a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization. Another famous formula that is used starts with the net income at the bottom of the income statement. The metric then adds back to its figures the tax, interest, amortization, and depreciation entries. So, the formula stands to be:
EBITDA = Income + Interest + Taxes + Amortization + Depreciation
For instance, if the net income of a firm X is $200,00 and owed $30,000 for taxes, $10,000 for interest, $5,000 for amortization, and $7500 for depreciation, then the figures would be:
EBITDA = $200,000 + $10,000 + $30,000 + $5000 + $7500
The EBITDA value of company X for a specified time would be $250,000.
Difference between Revenue and EBITDA in startup valuation
Even though cash is the lifeline of any business, revenue is more significant as it generates cash flow in businesses. But revenue and cash are not the same. One major distinction is that a firm’s revenue is the amount accrued, whereas the reported cash is that the amount received.
So, when a company makes a sale, it gets added to revenue, even without the customer paying. As revenue is at the top of an income statement, its fluctuation might influence a company’s net income.
Business owners and accountants use EBITDA values to compare their business standings to that of similar firms. Besides performance assessment, it is beneficial for analyzing capital-intensive companies as they can take large debts to sustain themselves.
Furthermore, moneylenders and business investors prefer EBITDA over revenue for startup valuation. The former can be less manipulated with financial and accounting methods. Besides, it helps reveal the financial status and cuts away the factors business managers and owners exercise discretion on.
So, to answer the vital question of why companies use EBITDA instead of revenue, the former is more successful in producing cash flow figures. It is calculated by investors and lenders to foretell how well a business will operate by paying its expenses and maintaining or boosting its net income. Through the metric, a company can be evaluated before it makes a sale.
EBITDA and Revenue
In the discussion of EBITDA vs. revenue, financial analysts put significance over both parameters. Revenue is the net money a company generates, whereas EBITDA is the figure at the bottom of a company’s financial statement. More specifically, the metric shows the total figure with income and expenses — subject to the owner’s discretion — depicting a company’s ability to generate cash.
As EBITDA does not qualify under GAAP, it might not be available in most finance statements of a company. But if it’s included in an income statement, it would appear way below the revenue item line.
Simply put, the primary difference between EBITDA and revenue of a company will be that the former figure will always appear lower than the latter in an income statement as operating costs like Cost of Goods Sold (COGS), General and Administrative Expense (G&A), etc. are deducted from revenue.
WHAT DOES COMPANY VALUATION MEAN?
This guide provides the concept of company valuation, the methods of valuation, and also the benefits of company valuation.
Whenever there is a discussion about funding a company or an entrepreneur and company financing, it always turns into a topic of company valuation. Figuring out the worth of your company is almost like determining the value of a child. Though it is not exactly the same, a company can be seen as a child in the eyes of an entrepreneur, something that needs constant nurturing and care to grow.
In case you haven’t had your company’s valuation assessed over the last 12 months, it is vital that you have it done. A company’s valuation offers the owner with the actual facts and figures that show the value of a business in terms of its income, assets, and market competition.
This is the information that every company should have with them, and they should check it annually to see the growth of the company from year to year.
Not sure why this is something important? Well, that is what this article is all about, letting you know the ins and outs of the company valuation process.
WHAT IS A COMPANY VALUATION & WHY IS IT IMPORTANT?
Company valuation is a process where the economic value of a company is determined. With the help of the valuation, you would be able to determine the fair value of a company. These include determining the sales value, establishing partner ownership and also closing deals. The owner of a company usually visits professional business valuators for getting an objective estimate of the business’ value.
There are numerous reasons as to why a company valuation is needed, but one of the leading reasons is when a business wants to sell a portion or all of its operations. Another reason is when a company wants to acquire a company or merge with another company. The process of finding the value of a business involves evaluating all aspects of the business and using objective measures.
The methods of valuation can vary among industries, businesses, and valuators. But some of the most common methods of valuation include similar company comparisons, discounting cash flow models and the review of financial statements.
To understand briefly about the various methods of valuation, the following terms should be kept in mind:
This is the overall money that the business gets if the assets of the business were liquidated and the debts were paid off. This is also a method for the company valuation that is considered by some companies.
As shown on the balance sheet, the book value of the company is the value of the shareholders’ equity in the business. This value is calculated by subtracting the cumulative liabilities of the business from the total assets that it has.
DISCOUNTED CASH FLOW (DCF) METHOD
This method of valuation is based on the predictions of future cash flows of the company. These are then adjusted in a way that helps to determine the current market value of the company. The main focus of this method is that it also takes inflation into consideration when calculating the present value of the company.
The earnings multiplier is a method of valuation that can be utilized to obtain an accurate image of the value of a business. This is because the profits of a company are a much more reliable indicator of its financial success as compared to the sales revenue of the company. This method of valuation adjusts the future profits against the cash flow that has the potential to be invested at the prevailing interest rate over time. In short, the current P/E ratio is adjusted for accounting the current interest rates.
TIMES REVENUE METHOD
This is one of the methods of valuation where the stream of revenues produced by the business over a specified period is applied to a multiplier. This multiplier is based on the economic and industry environment. For example, a tech company may have a value of three times the total revenue. On the other hand, a service firm might only be valued at 0.5 times the total revenue.
Out of all the methods of valuation, this is the simplest method for company valuation. The process is simple, by multiplying the share price of the company by the total number of outstanding shares. Let us say for instance that Microsoft Inc. traded at $86.35 on January 3, 2018. And with a total of outstanding shares of 7.715 billion, the company’s value would be $ 86.35 x 7.715 billion = $ 666.19 billion. Even though these are some of the common methods of valuation, the list of the valuation methods used today is endless. Some other methods include the asset-based valuation, breakeven value, replacement value, and many more.
Moving ahead, company valuation is also essential for tax reporting. As per the IRS (Internal Revenue Service), the company has to be valued based on its actual and fair market value.
REASONS FOR COMPANY VALUATION
Are you aware of how much your business is worth at any given moment? This is a valid question for your company and one that shouldn’t be answered with a “ballpark” guess. Obtaining an accurate company valuation is a very crucial aspect of an ongoing business strategy, and should be kept up to date with monthly accounting and annual valuations.
Below shared are some of the main reasons why there is a need for company valuation.
COMPANY VALUATION TO SEEK INVESTORS OR ADDITIONAL CAPITAL
For different stages of a business, there is always a different type of investor for it. For instance, if you are at the startup stage, you may need a startup angel investor. In the initial stages, you cannot show patented equipment or technology that has a quantifiable or logical value, nor can you show a historical P&L. So, the company valuation here is based entirely on the founder’s vision for the company, along with the value of that market category or segment of the offering, the assessment of the market need, etc.
These kinds of angels who lead in the earlier stages usually demand a percentage of the company that they want in exchange for the funding they are offering. They would create a terms sheet that would permit you to earn or purchase all the equity back based on their terms.
In case you are a mature business and you are entering the next stage of the funding cycle, the tangible parts of the business like the profitability trending, sales reports, market sizings, audits, financial instruments, and more will likely be used for the company valuation. At this point, the investor is more interested in making sure that the business, its value or the cash flow would be the best collateral against their investment (mostly when the owner is not going to change any time soon.)
Many of the investors, like the banks, have a list of items that you would need you and your CPA to review that would show the financial health of the company and its estimated company valuation. Ensure that you know all about these documents, and remove any abnormalities in your financials before investors ask to see these documents. A CPA can normally help you with this process.
COMPANY VALUATION TO BRING IN PARTNERS OR TO SHARE EQUITY
Doing deals is another place where the shareholders of a company have a subjective and emotional view of value. And the very first step is to determine the company value through the right methods of valuation. After that, it is essential to decide on how the shares would change the game – earning shares instead of salary, additional investment, and others is an entirely different venture.
This logic becomes complicated in a service business since there are less fixed assets and the value of the enterprise is subjective. Hence, for the valuation, you would need experienced consultants in the specific business type or sector and who have relatable business examples to help them figure out the company’s value. Moreover, if you want to hire a CPA, it is better to hire the larger CPA firms that have a separate department just for this work.
Mostly, shareholders tend to have agreements done to avoid the discussions that are uncomfortable. But after the value has been reached, it is the right time to have more heated discussions about negotiations before the deal is made with independent people representing the shareholders.
With this, everyone would be able to start the new partnership without anything left out, and with the appropriate considerations. This would also help them to grow the value of the company collectively, rather than to just argue about the details of the equity exchange.
COMPANY VALUATION FOR A SALE
At the moment a company is about to be sold, there is a different group of experts who are needed for the company valuation. And of course, you would need all the financial documents, ideally those have been audited by the experts for your company. Moreover, the advisors for small companies could be consultants or brokers that are proficient in your sector. But if you have a big company, you would need investment bankers to help you in your deal.
These investment bankers usually have their own methods of valuation, protocols, formulas and would pitch you regarding their plan to assist you with a sale. This plan would also include their rough estimate to determine the valuation. As a matter of fact, it is crucial to have advisors who can assist you with both the investment value and the fair market value of your company.
The Fair Market Value sale would have the ‘multiples’ on your profit and revenue or comparables of other similar companies sold. Moreover, your cash, assets and other objective figures would be calculated as well. In the area of investment, the value of the business is observed in association with the considered value or gain of the buyer from the acquisition.
Let us understand this better with an example. A company has the fair market value of $50 million. This company got a strategic buyer who benefited by removing several deals and a key competitor that stood between them, adding key accounts the business had, and assisted them in adding geographic coverage where they had no footprint. After all this, the company had an investment value of about $80 million. With this example, hopefully, you might have understood the difference in investment value and fair market value.
BENEFITS OF HAVING A COMPANY VALUATION
Other than the reasons why you need a company valuation, there are many benefits that come with it. Here are the five main benefits of company valuation:
ACCESS TO MORE INVESTORS
When your company has been in the market for at least a year and you still need investment for it, the investors you reach out to would ask for a complete company valuation report. It does not matter if you need the investment for the growth of the company or if you want it for overcoming a financial disaster, you need the company valuation for the investments you are looking for.
The investors would want to understand why you need the amount and how exactly they would gain it back. Their return would be figured out only when they know the actual value of the company. In short, the investors focus more on how they would get a return from the investment they are offering as well as where their investment is going.
So, if you have the company valuation ready and it has reached the ears of an investor, it would help you get a lot of attention and open deals by a potential investor who feels that the funds would help increase the value of the company more than it is. In short, it is a benefit to always have an updated company value under your sleeve.
BETTER DURING MERGERS/ACQUISITIONS
In case a corporation asks that they want to buy your company, and you agree to sell it, you would need to show the person the company valuation that you had conducted recently for knowing the actual worth of the business.
Other than this, it is also important to show them how much the company has grown since it began, how many assets withholdings there are, and how the company would continue to grow along with the actual market value of the company from the starting years till now.
The reason it is essential for you to get the actual value is that many large corporations usually try to get other businesses or merge with other companies with as little money as possible. When you know what the company valuation is, you would be able to negotiate your way to get the actual worth in any selling or merging agreement.
After you learn about the value of the company, and if you are offered with a value that is less than what your company’s worth is, reject the deal or you can volunteer to enter a negotiation agreement. This would eventually assist both the sides to come towards a comfortable arrangement.
GET A TRUE COMPANY VALUE
You might already have a slight idea of what the worth of your business is from the financial figures like the company bank account balances, total asset value, and even the stock market value. But this is not all that is used for the calculation of the company valuation. There is a lot more to it. Hence, it is important to have a professional valuator for getting the company valuation done.
To have your company’s actual value is genuinely one of the benefits of company valuation since it would help you decide if you should sell your business or how much you should sell your business for. It would also help you see the company income and the valuation growth over the course of the previous years. Potential investors, as well as buyers, usually look for these things in a company before a deal is stricken.
BETTER KNOWLEDGE OF COMPANY ASSETS
It is important to get the actual value of the business since estimates are not only considered. There are a lot of benefits of company valuation, some of which include that the owner can easily get proper business insurance coverage, how much to sell the company for, and how long it might take to grow to an estimated value.
In the end, the company valuation would help the company produce profits and easily make the successful and right deals in the market.
WHY SHOULD EVERY COMPANY HAVE A VALUATION?
Still now convinced that you need a company valuation done with any of the methods of valuation?
Well, here is a checklist of reasons why it is better to know the value of your business.
IF YOU DON’T GET THE COMPANY VALUATION DONE, SOMEONE ELSE WOULD.
Yes, that is right! And even though it seems like a relief that you would not have to waste your time on it, it may be a bad thing in the end. If you are looking for a loan from the bank or any investor, they have their own methods of valuation that they work on. They may conduct a valuation process and get the value of your business, but if you indulge to cross-check with it, you would not have any valuation done to check their numbers. And that is why it is important that you have it done yourself.
In the same way, if you want to leave or sell your business, the IRS would end up getting the company valuation done. And since the IRS takes taxes from a company’s revenue, their valuation would be higher than what you might get or otherwise.
YOU CAN QUESTION A POTENTIAL BUYER’S VALUATION.
Again, the company valuation that you have done would have a different value as compared to an investor that is joining the company. Even though we expect the investor to come in with a lower value, it is not that simple. The reason why buyers or investors come with a lower value is since they believe that it would attract the seller to them during the due diligence period.
Or, it might also be provided in an expectation that a little of the company valuation would be recovered via the earn-out provisions in the agreement. All this might seem to be a bit cheap, but the best way of having a grip on the investors or buyer is by knowing the actual value of your company.
YOUR RETIREMENT DEPENDS ON IT.
If you haven’t come across this point till now, it is important to know as well. Every business owner should have a retirement plan since you aren’t going to work forever. And if your business is your retirement plan and you have not done the company valuation, it is difficult to figure out the true value left over for your retirement.
Let us take for instance that you would hand over your company to someone else, and expect a return every month. Or you want to sell off your company at retirement. And in this case, your final value of the company is $3 million, but you only get it at $2 million. You may end up sacrificing your happiness and financial health due to poor negligence.
IT’S USEFUL IN KEY PERSON PLANNING.
Let us say that you have an important person who you want to share your success with. But this person is not a successor owner, and you still want to share some financial incentives with this person. With the help of the sales, profits and other annual measures of the business, you would get the actual growth of the company, and this would help you have the right idea about the future.
In case you get a company valuation done, you would have a baseline value to utilize in prolonged compensation arrangements, like stock appreciation rights (SAR) and phantom stock plans. In short, there is no possible way to measure the growth of your business if you do not know where you are starting.
YOU MAY GET CHALLENGED IN COURT.
Sadly, a lot of businesses have been caught off guard when a company valuation issue reaches the court. There was a case where the family business went all the way to the supreme court since the family objected over the correct valuation to buy out a sibling.
On the other hand, there was a case where a business owner had used a book value to buy out the other family members. The IRS ignored each of the valuations and utilized an earnings-based, higher company valuation. Like these, there are many cases in the court where the IRS end up securing a multi-million dollar penalty from many of them. Hence, you lose everything you worked so hard for.
As soon as your company valuation is completed, it would be easier for you to set new goals to increase your company’s value in the coming years. Until now you might have understood that it is important to set some time aside to compare the previous year’s company valuation to this years’ to see where you have improved and how you can do this more in the future.
There are many methods of valuation, but the three main types of valuations used would be discussed in the next article. It would be good if you took the advantage of getting the company valuation done on time so that you do not have to suffer what you worked for due to negligence. In short, knowing what every element of your company is worth is priceless information for every business owner to have.
INTRODUCTION TO COMPANY FUNDING
Getting a small business loan or pitching to an investor to fund your new business may seem like a remarkable feat for new entrepreneurs.
Getting a small business loan or pitching to an investor to fund your new business may seem like a remarkable feat for new entrepreneurs. While they are often essential to get your startup off the ground, it can become overwhelming with the number of options, minute details, terms, interests payments, bills, and the possible rejection due to a bad presentation of your business plan.
Nonetheless, financing does not always have to be that complex. Before you begin to move down the road, it is crucial to know where you are going and what you are getting into. And this guide helps you with just that!
Every startup company often spends a lot of cash on purchasing equipment, hiring staff and even renting an office before they can work smoothly in their business. Other than this, startup companies need to adapt and grow to beat the competition in the market. And in most cases, these companies would require company funding for it.
For every entrepreneur who has just started their journey and is trying to understand the world of startup financing, they should be aware of the roles of the different types of investors and how they see new startup companies. At first, these new entrepreneurs may not see the full picture of a company’s life cycle and when investors enter to provide company funding.
And it is termed as “seed” since it is the initial company funding for the business, until the company has the ability to get cash on its own, or until the company is ready to obtain more investments.
Seed capital comes in various forms like family and friend funding, crowdfunding, and angel investor funding. This brief guide is a summary for what any startup founders need to know about seed funding and seeing their company grow.
WHAT IS COMPANY FUNDING?
Company funding is the money that investors offer to a company. In general, there are two types of financing that a company obtains; equity (stock) and debt (bonds/loans). And when a company receives it, they then use this cash for the operating capital. With this funding, shareholders and bondholders expect to earn returns from what they invested in the company in the form of stock appreciation, dividends, and interest. The growth and amount of revenue the company can gain will determine which type of company funding will be the best in the end.
Confused? Let us get a bit more into the details.
COMPANY FUNDING EXPLAINED IN DETAIL
Obtaining fixed assets or capital like the machinery, building, and land requires a large amount of capital upfront, so most companies usually raise funding for purchasing these assets. In short, the two primary routes to receive this company funding are:
- Raising capital through debt; or/and
- Raising capital through stock issuance.
To explain the idea better, normally a company is able to issue common stock by issuing extra shares to additional investors or via an initial public offering (IPO), in the case of bigger firms. In both cases, the cash obtained from investors is utilized to fund capital initiatives. So for offering company funding, investors usually expect a return on what they invested (ROI). This is called the cost of equity for the business.
The ROI can be offered to investors by expertly handling the resources of the company to increase the worth of the shares or by just paying dividends. However there is a drawback to this source to raise funding, as issuing these extra shares reduces the holdings of the current shareholders as well. In short, these shareholders would have less voting rights and ownership of the company.
The other way to raise funding is by issuing corporate bonds to investors. As soon as the bond is issued, they get in effect the amount that is borrowed from the investors as semi-annual coupon payments until the bond is completely paid off.
The coupon rate that is applied to the bond outlines the cost of the debt for the issuing business. Along with this, bond investors have the chance to buy a bond at a discount, while the actual value of the bond would be compensated when it matures. For instance, an investor who buys a bond for $1,500 would get a payment of $2,000 when the bond matures. This difference in amount is how debt investors earn money on their investment, which will be paid off by the company once it starts to grow
OTHER OPTIONS FOR COMPANY FUNDING
The methods mentioned are not the only method available. You can also raise funding via debt by taking loans from commercial lending institutions or banks. These types of loan are considered as long-term liabilities on the balance sheet of the company and this debt decreases as the loan is paid off over time.
You would also need to pay the interest on the loan as the cost of taking the loan from the bank. However, as the interest the company needs to pay to the lender is deemed as an expense for the company, the tax on the company profits would be reduced as well.
Even though a company is not required to give any payment to the shareholders, it has to pay all the coupon and interest payment to its lenders and bondholders. And this is one reason why raising funding via debt is much more expensive when compared to obtaining company funding via equity. Nonetheless, if the company goes bankrupt and the assets are liquidated, the creditors would be given the payment first before the shareholders are paid.
There are many companies that offer company funding to businesses, such as venture capitalists. However, these companies usually focus on a specific industry like the healthcare industry or tech companies, and also focus on funding a particular stage of the business, like the startup stage of a company.
WHY IS THIS IMPORTANT FOR YOUR COMPANY?
Most startups that come into the market need funding, and if there weren’t any method to raise funding for these companies, they would fail soon after starting. The amount of money needed for a company to be successful is more than what the founders, their family, and their friends usually can finance.
It is common for high growth companies to burn capital to sustain their growth before they get to a profitable level. And yes, there are some companies that fortunately self-fund (bootstrap) themselves, but these companies are exceptional ones.
Due to this, most startups make every effort to raise funding. The good news is that many investors are sitting out there hoping to invest in the right startup.
But there is huge competition to raise funding where the process is usually highly deflating, complex, arduous, and long. Nonetheless, this is a path that each company has to follow at least once. But when is the right time to raise funding for your business?
WHEN TO RAISE FUNDING FOR YOUR COMPANY?
Investors usually write checks when they believe in your company’s idea and find it compelling. They are persuaded that the founders and the team can realize their vision and if they feel that the probability of the plan has high potential, they will put their money in the idea. So, when you are ready to tell this story, you can raise funding at exactly the right time.
Though it is easy for almost every founder to have a reputation and a story, they would also need to have the product, idea and a little amount of customer traction. Fortunately, technology has enhanced considerably, where a mobile app or a sophisticated web product can be developed in a short amount of time and at a low cost.
That is not all. Everything has become easier due to technology and investors providing the company funding need to be persuaded. Normally they are not only looking for a simple product that can be seen, used or touched. You would also have to let them know what makes the product great for the market and what is the actual growth of the product for the future.
In short, it is better for the founders to raise funding when a product matches the market’s needs and has the potential for wide use due to the high market opportunity. Along with this, they would also have to determine who the customers are. So, to obtain the company funding, the founders have to have a project that impresses investors.
HOW MUCH FUNDS TO RAISE?
Preferably, it is better for you to raise the money for covering all the startup costs, match your breakeven level and reach the profitability, so that there wouldn’t be any need to raise funding until the company is running and making a profit. In case you succeed in this, you would find it easy to raise company funding in the future as you have proven you have a good idea and a company to support it.
With all this said, some startup companies would need a follow-up seed funding. Their main objective needs to be to raise funding that is needed until their next “fundable” milestone. This milestone comes typically after 12 to 18 months.
Also, you need to know that the amount of funding that you choose to raise would also determine what variables you are trading off, like the progress that the amount of money would bring, dilution, and credibility with investors. In case you succeed to give up just 10% of your company during the initial round (seed round), it would be great. But most of the rounds frequently require a 20% dilution, and it is advised to avoid a dilution of more than 25%.
It is recommended to create several plans with different amounts of company funding raised. This is so that if you raise a lesser or higher amount, you would have everything necessary to run the company. The only difference would be the time that the company takes to grow with the company funding obtained.
BETTER EXPLAINED WITH AN EXAMPLE
One of the best ways to get the optimal amount in your seed round is to decide how many months of the company’s operation you would want to fund. Let’s say that you are opening a software development company, and an engineer charges $4k per month as salary. If you want 5 engineers to work with you and you want to fund them for 18 months, you would need to have at least 4k x 5 x 18 = $360K. You just need to see what you want for the company and for how long would you be funding the company in this case.
Now getting back to the actual question: How much are you raising? The answer is simple where you are raising company funding for N months (where N can be between 12 months to 18 months) and would need $X (where funds can be between $500k and $1.5 million). In short, you can have multiple ranges of X and versions of N, giving you the possibility for different growth situations.
Every company needs a different amount raised, and the variation in the amount raised for every company can be enormous. However, what you need to focus on is the funding which usually ranges from a few thousand to several million.
REAL WORLD EXAMPLE OF FUNDING
Let us take an example of the famous Amazon that was founded by Jeffrey P. Bezos and generates about $61 Billion as revenue in a year today. Amazon started in Bezos’ garage and holds the title of the world’s largest online retailer now.
- Industry: Online Retailing
- Annual Revenue: $61 Billion
- Number of Employees: 97,000
How Amazon Got Started
It was in 1994 when Bezos came up with the idea to quit his job and start an internet company, due to the sudden popularity of the internet amongst people around the globe. But things didn’t work out for him immediately. He prepared a list of 20 top products that he could sell online and decided that books were the best choice. And that is when things took a good turn, where this was just the beginning for Amazon at that time.
The seed funding was from his parent’s personal savings, where they didn’t even know what the internet was at that time. They had basically put a bet on their son. Moreover, Bezos had told them that there was a 70% chance that he might lose the complete investment, but they still invested a few hundred to thousand dollars in his idea.
After that, Bezos needed more funding in the second year, and Amazon had raised a series A from the Kleiner Perkins Caufield & Byers of about $8 million. As you may know, that was not the end of it. Amazon went public in 1997 to raise more funding and by 1999, the investment that Kleiner Perkins Caufield & Byers made had a return of over 55,000%.
When Bezos had to raise funding for the company, Amazon had sales that were up to $20,000/week. And since then, the company has become one of the biggest corporations in the world, and is now focusing on long-term growth and global dominance. As you can see, Amazon is a perfect example of how a small one man startup, through the years, can become a big corporation which can change the market completely.
The important thing to keep in mind about company funding is that paying back lenders and dealing with them can become a nightmare if everything is done carelessly. If you are doing it right, you will see your business grow. The pros and cons to search for the external capital comes back to the ROI (return on investment).
Hence, it is crucial to evaluate the ROI. You would need to use the investment to grow the company and generate revenue. The same rule is applied to raising debt or equity. You need to know how to grow your business with it.
So, if you have decided that you need outside company funding, the next thing is to determine what type of financing you need. Do you need debt financing (various forms of small business loans) or equity financing (money from investors)?
11 years ago
These ’90s fashion trends are making a comeback in 2017
Reposition Yourself6 months ago
Build for Expansion
Jewels8 years ago
19 Hard Things You Need To Do To Be Successful
Definite Chief Aim6 months ago
The Luthas Center for Excellence
11 years ago
‘Better Call Saul’ has been renewed for a fourth season
Jewels6 years ago
For What It’s Worth..
Books9 years ago
Best Business Books – Recommended Reading List
Help Through The Storm4 months ago
HOW TO ORGANIZE YOUR LIFE