The first and most important thing to understand about business valuation is that valuations are estimates; specifically, an estimate presuming a willing buyer and seller engaging in an informed, voluntary, arm’s-length transaction. In the absence of an actual deal, valuations are an imperfect mix of art and science. Valuations are not defined by how much equity a greedy founder wants to keep, or how badly an aggressive investor wants to screw somebody. Instead, valuations are defined by the figure rational parties can actually agree upon.
In short, valuations are opinions; transactions are facts.
Valuation opinions are derived using three basic methodologies that consider intrinsic value, marketability, and income potential:
- Cost (or Asset) Approaches (e.g., adjusted book value) assess some form of intrinsic value and/or replacement cost.
- Market Approaches (e.g., market comps and multiples) compare the subject company to other marketable assets, using available metrics.
- Income Approaches (e.g., DCF, capitalization of income) reflect the anticipated earnings potential of the subject company.
Usually, it makes sense to use some combination of methodologies to derive a reasonable range of prospective valuations. Technically, calculations are subject to a number of further adjustments for applicable marketability/liquidity discounts, control premiums, and the time value of money.
Note that pre-money valuations are figured prior to new investment. The pre-money valuation plus the financing amount equals the post-money valuation.
In any case, a valuation opinion can only be “proven right” when somebody writes a corresponding check per mutually agreed terms.