What Are the Top 3 Methods Venture Capitalists Use to Value Businesses for Acquisition?

"Business Valuation" is the general term for determining the current "worth" of a business, by using quantitative and qualitative measures, and evaluating all the elements of the business. A business valuation would probably cover the management of the company, the current and future revenue, and the value of the tangible and intangible assets.

Why would a business owner want to do a valuation of their business? Businesses are valued for a number of reasons: you may have a potential buyer, or you want to get ready to start having acquisition conversations, or because you're making some big moves and want to have everything in order.

Assuming you're talking to a firm that wants to acquire your business, it would be helpful to know what you can expect. When it comes to valuing businesses for acquisition, venture capitalists (VCs) use a variety of methods to determine the value of a business. While there is no one-size-fits-all approach to valuing a business, the most common methods VCs use are:

• Multiple of Earnings
• Market Comparables
• Discounted Cash Flow

We'll take a look at these, and some steps that businesses can take to improve their valuation.

1. Multiple of Earnings:

This is one of the most common methods VCs use to value businesses for acquisition. The Multiple of Earnings method of business valuation is a way to estimate a company's value based on its past financial performance. The earnings (income or profit) of a business are used to value a business in this multiple method. By the way, the terms “Earnings”, “Income”, and “Profit” have essentially the same meaning.

Depending on what is included, earnings can be calculated in different ways. At which point do you deduct taxes? Does the calculation include non-sales income like interest? In most cases, EBIT (earnings before interest and taxes) is the measure used in this measurement, and other times EBITDA (Earnings before interest, taxes, depreciation, and amortisation) is used.

This method relies on the premise that the value of a business is equal to a multiple of its past earnings. The multiple is determined by comparing the company's financial metrics to other similar companies. For example, a business with a current earning of £1 million and projected earnings of £1.5 million could be valued at four times its current earnings, or £4 million.

To maximise valuation:

To maximise the valuation under the MoE method, a business should strive to increase its profitability, and reduce its operating costs. Additionally, focus on increasing cash flow, reducing debt, and diversifying revenue streams. All of these will boost the earnings in the financial reports, and help the company valuations look strong.

2. Market Comparables:

VCs will often look at the market comparables of a business to determine its value. The Market Comparables method of business valuation is a valuation technique that uses the values of similar businesses in the same industry to determine the value of a target company. This method compares the financial and operational metrics of similar companies to arrive at a reasonable value for the target company.

To maximise valuation:

Businesses being valued through this method can maximise their valuation by refining their financials and operational metrics to align with those of the companies being used in the comparison. Companies should also focus on demonstrating the ways in which they are different from other companies, in order to set them apart and add to their value. Additionally, businesses should focus on increasing market share to increase the value of their company.

3. Discounted Cash Flow (DCF):

The DCF method is a more complex way of valuing a business. The Discounted Cash Flow (DCF) method of business valuation is a method of valuing a business by analysing its projected cash flows, discounted to their present value. It is used to estimate the value of a business today, based on the expected future cash flows it will generate. In simple terms, a discounted cash flow valuation is used to determine if an investment is worthwhile in the long run. The fundamental thinking of DCF is that £10 today is worth more than £10 a year from now. While this approach feels more complex, there are a number of free resources and calculators available to help you get a better understanding of how this works.

To maximise valuation:

To maximise your valuation if the investor is using this model, focus on increasing its future cash flows and reducing risk. This can be done by steadily and consistently increasing revenue, focusing on reducing costs, and increasing the efficiency of operations.

Additionally, the business can seek to strengthen relationships with existing customers, expand into new markets, and develop new products or services.

When it comes to valuing businesses for acquisition, these are the top three methods VCs use. Regardless of which method is being used, to improve your valuation, focus on improving profitability, increasing competitive advantage and market share, and reducing costs.