Two different startup owners recently called me with this same question. “Do I need a valuation to set the sale price for my company?” Good question. Valuations can be expensive—not something you want to mess around with if you don’t need to. And it makes sense to assume that having a reported business value would help you set a price.
But what you need to know is that a valuation is not the right thing to use to establish a sale price. Here, briefly, is what a valuation IS for, and what you really do need to do to set a good sale price for your business.
A Valuation Is for Governance or Dispute
A valuation is typically done for the purpose of governance. A common example is when you need to set a value in order to grant equity to employees or other stakeholders. The IRS needs to understand exactly the valuation of equity grants to determine the tax obligations of either the grantor or the grantee. As an owner, you want to be able to defend your valuation, not pull numbers from the air. So you need a robust, official valuation.
Another situation that calls for valuation is a dispute. For instance when you want to calculate the buyout value in a business partner divorce. We have a client right now that was a two-partner partnership when one of them suddenly passed away. Now the estate of the deceased owner is the second owner. The trustee of the estate is a voting shareholder of the business, and the remaining executive needs to buy out the estate. The two parties must determine the appropriate value of the firm, and the trustee has the responsibility to ensure the estate is properly compensated. That requires a valuation.
But the calls I got were asking about the potential M&A of the business—setting a value on a company’s capital based on market forces. That’s a different animal. Asking, “How do I get a valuation done to tell me how much I should sell it for?” is the wrong question.
Larger Startups: CFOs or Investment Bankers Can Find Your Unique Market Value
It’s important to understand that the purpose of a valuation is to determine something much different than the value you want to capture in a sale. A business valuation may not fully appreciate what the market is willing to pay. It may overlook the strategic value of the relationships or intangibles you have, or the value of the intellectual property (IP) you’ve developed.
Your company likely has a unique value to a specific buyer. A strategic buyer may say, “Hey, I have operations in Texas, Oklahoma, South Dakota and Wyoming, but none in Colorado. It would be substantially to my benefit beyond the value of the revenue or the cashflow alone to have operations in Colorado. That would give me a complete overlay of the entire region where right now I have a large gap.”
A valuation is not going to point out these types of opportunities for the buyer or the seller. For a sale, especially when you have a fairly robust operation, it becomes valuable for a CFO and an investment banker to come in to help find a price. They will say, “Here’s what the market is really trading at for companies your size, at your level of profitability, based on your management team, based on your customers, based on your tenure, and considering many other non-financial and non-hard assets.”
This type of CFO/investment banker analysis is more robust than an appraisal. A strong banker will look at potential buyers and consider what they’re thinking in terms of what value you offer them. It’s like in poker, where you’re saying, “I know what I have in my hand. I’m trying figure out what they have in their hand and what they’re going to bet, so I know how I should react/bet.”
It helps to begin the negotiation early. You may see that that company really benefits from your Colorado operations. Or you may see they’ve got all these expensive products and you have this inexpensive product that complements theirs. You want to find where one plus one equals three, from a go-to-market strategy.
It’s important to bring in a sophisticated resource who has done this many times. They can establish a target sales price based on everything they know about your company. A good investment banker will say, “We think we can get $10 million. But we want you to be comfortable with 9, because 9 is what we would expect the market to pay. Meanwhile, we’re gonna to try to create a competitive situation that gets you 10.”
There may be a lot of other work with tax and estate planning. The owner has to decide, “Is $9 million worth it to me right now to sell this business?”
By the way, an investment banker usually works on a fee, which can be structured in many different ways. Sometimes there is equity or upsides. Sometimes there is a retainer that, as long as the deal is open, charges a monthly fee. And there’s a percentage of the price option. Generally, bankers are incented to sell at a higher price.
Smaller Businesses: Negotiate Market Value
Smaller businesses may not always have the economics to hire an investment banker. One of the companies that called me had about half a million in revenue. It had a great idea, a great product, and significant intellectual property and patents. But their product was still relatively new.
Their interested acquirer was a company that did have the distribution, with products selling in 10,000+ stores. They said, “Hey, if we make your product, we’re willing to pay a fair premium on your IP and product even though you have minimal cash flow. It makes a lot of sense for us.” The owner running this company had to make a similar market-value analysis without the help of a banker. It was a small company and a modest purchase price.
Don’t get me wrong—the price was meaningful for this individual. It just wasn’t going to be a full investment banking process. That owner needed to find out: “What value does this product and this IP have for this buyer? What is it worth for them? What is it worth for me?” The founder engaged a CFO to help him figure out exactly what the buying company was modeling as to the value of this product under their umbrella. That helped the CEO determine his strategy for negotiating the deal to a successful sale.
Trying to get to a price that both sides are comfortable with becomes a negotiation. And that back-and-forth, not a valuation, leads to the best outcome to get the deal done.
If you’ve got more questions about valuation and setting a price to sell your startup, shoot me your questions in the comments.