260 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
three general approaches under which each of the methods fall. Table13.2
summarizes the three accepted methods.
We will discuss each of these approaches in the subsequent paragraphs.
13.5.1 Income Approach
This determines the value based on how much the business is forecasted
to earn in the future. This approach is based on the theory that fair mar-
ket value is the present value of all future benets. Fair market value is the
amount at which the property would change hands between a willing buyer
and a willing seller, when the buyer is not under compulsion to buy and the
seller is not under compulsion to sell, and both parties have a reasonable
knowledge of relevant facts.
4
Figure13.4 illustrates the pros and cons of the
income approach.
Capitalized Returns Method
is method determines value by dividing a single return (income) amount by
a capitalization rate in the following formula:
Return (income) = Investment Value
Capitalization rate
Example: Calculate investment value of $150,000 at a capitalization rate
(discount rate; hurdle rate) of 15%
$ 150,000 = $1,000,000
15%
Note: this method tends to be appropriate when the estimated future return
is expected to be consistent with a normal, predictable growth rate.
Figure 13.4 Capitalized returns method—Value determined by dividing economic
benets by a capitalization rate.
Table13.2 Valuation Methods for Companies with Revenues
Approach Based On
Income Present and future earnings capacity
Market Comparable companies valuations
Asset based or cost Current market value
Valuation Techniques ◾ 261
Mathematically, the income approach involves computing future benets
and discounting them to their present value at a rate that reects the inher-
ent risks associated with the operations. The primary three include:
1. Discounted future returns method
2. Capitalized return method
3. Excess earnings method
13.5.2 Discounted Future Returns Method
Proper use of this method assumes the appraiser can estimate future returns
with a reasonable degree of accuracy, and there is a reasonable probability
that those returns will continue. The value determined under an income
approach is based on discount or capitalization rates using public market
data or internally generated hurdle rate. Hurdle rate is the minimum ROR
(interest rate) on a project or investment required by an investor in order to
compensate for risk. Thus, from an investment standpoint, the riskier the
project, the higher the hurdle rate should be.
5
Figure13.5 shows Present Value (PV) multiple cash ows in multiple time
periods are discounted, and it is necessary to sum them as in the gure.
13.5.3 Capitalized Returns Method
The capitalization of earnings valuation method is a method within the
income approach to value whereby economic benets for a representative
single year are converted to value through division by a capitalization rate.
How Do Entrepreneurs Raise
Money over time?
Sweat Equity (Bootlegging)
Savings, 2nd
Mortgage, etc.
SBIR (government grants)
Friends, Family, Fools (3 Fs)
Banks (debt)
Angel groups
Venture capitalist investments
IPO (initial public offering)
Figure 13.5 How do entrepreneurs raise money—The possible sources of capital
available to entrepreneurs.
262 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
The valuation concept is a company’s value as established primarily by the
income it can be expected to earn on an ongoing annual basis, in relation-
ship to a capitalization rate measuring ROR, investment risk, and potential
earnings growth (Figure13.6).
6
13.5.3.1 Assumptions
Fair Value Standard of Value. “Standard of value,” as it is generally dened
for business valuation purposes, is the fundamental way in which the
value of a business or ownership holding will be established, based on the
purpose of the valuation. For the subject valuation, the standard of value
being employed is “fair value,” which is an opinion as to what is fair from a
nancial point of view as dened by law and precedent.
Net Income. “Earnings” for the method have been dened as “Net Income.”
The value used in the method is the one-year extension of a straight-line
trend based on ve historical years rounded to the nearest $1,000.
Net Income Capitalization Rate. A capitalization rate is a rate of return
divisor used for converting an earnings value into an investment value. The
25.0% capitalization rate used here is a 28.0% ROR reduced by 3.0% for
expected future earnings growth. Reducing the capitalization rate for the
expected future earnings growth is mathematically equivalent to adjusting
the earnings value for growth in perpetuity.
Discount for Lack of Marketability of 25.0%. A discount for lack of mar-
ketability is a recognized business valuation concept and, as dened in
the International Glossary of Business Valuation Terms, is “an amount or
• Magnitude of investment; market potential
• Staging of investment (early; first; mezzanine)
• Years to break even
• Syndication possibilities
• Target IRR
• Investment time horizon
• Terminal value of firm at exit
• % ownership required by VC partners
• Deal structure (board seat; management)
VC investment criteria at-a-glance
Figure 13.6 VC investment criteria—How do venture capitalists think?
Valuation Techniques ◾ 263
percentage deducted from the value of an ownership interest to reect the
relative absence of marketability.” The discount applied here is such a reduc-
tion in value applicable to the subject valuation.
Discount for Lack of Control of 15.0%. A discount for lack of control is a
recognized business valuation concept and, as dened in the International
Glossary of Business Valuation Terms, is “an amount or percentage deducted
from the pro rata share of value of 100% of an equity interest in a business
to reect the absence of some or all of the powers of control.” The discount
applied here is such a reduction in value applicable to the subject holding.
13.6 Market Approach
The market approach determines the proposed value based on the price for
which similar businesses are being sold. The foundation of this approach
is the principle of substitution, which states, “a prudent buyer will pay no
more for a property than it would cost to acquire a substitute property with
the same utility.” The three primary methods are:
1. Comparable sales method—actual transactions
2. Guidelines companies method—public company data
3. Industry or broker rules of thumb
13.7 Asset-Based or Cost Approach
This determines the proposed value based on what the assets in that busi-
ness are worth. This approach separately values each asset and liability in
the business. It does not value the unidentiable, intangible attributes of the
enterprise. The two primary methods are:
1. Adjusted book value method
2. Liquidation value method (assumes that operations will be
discontinued)
13.8 Venture Capital Valuation
“Life is a dogsled team. If you ain’t the lead dog, the scenery never
changes.” —Lewis Grizzard
If you are seeking venture capital (VC) nancing, it is because you “have
arrived.” VC nancing is the last step in the private equity market. After VC,
264 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
many companies opt to go public. The entire process can be summarized as
shown in Figure13.7.
A VC fund is a nancial intermediary, collecting money from inves-
tors and investing the money in certain companies on behalf of the inves-
tors. The VCs invest only in private companies that meet stringent nancial
requirements. After the initial investment, the VC actively monitors and helps
the management of the portfolio rms. The VC mainly focuses on maximiz-
ing nancial return by exiting through a sale or an initial public offering
(IPO). Last, the VC invests to fund internal growth of companies (organic
growth), rather than helping rms grow through acquisitions.
7
VC is a subset of the larger private equity eld, and refers to institu-
tional investments in early-stage, high-potential, privately held growth
companies. Institutional refers to investors that are not investing their
own capital (like the 3Fs or Angels), but instead invest moneys obtained
from pension funds, endowments, corporations, institutions, and very
wealthy individuals.
VC clients only are paid when there is a liquidity event, such as a com-
pany sale or an IPO. Liquidity events are popularly known as “exits.”
Liquidity events are infrequent; thus, VC investments are very risky. VC is
very risky because the equity investment is made in an immature company,
V.C. Financing rounds
Time
1st
2nd
3rd
Mezzanine
Later Stage
Early Stage
Seed Capital
Angels, FFF
IPO
Public
Marke
t
Bootlegging
Venture capital investments
Venture capital investments
Modified after Cumming, Johan “Venture Capital
and Private Equity Contracting”
Bank borrowings
2
nd
mortgages
Savings
Break
Even
Valley of
Death
Profits
Figure 13.7 Venture capital investments—VC nancial rounds start at the early stage
of development.
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