Top 3 Valuation Drivers that Help Land Early Stage Investors
When Anthony decided to start his own software company, he knew he’d need an investor to bring his idea to life. So early on, he dedicated time and effort to position his company for equity financing. In doing so, he had to learn how investors would value his business that had yet to demonstrate meaningful revenue or profitability. At first, the path was unclear. But eventually, he realized three important business valuation drivers that all early stage companies should know. By being able to clearly communicate the value of his company around these value drivers, he was able to secure financing from an angel investor.
So, how exactly did Anthony create value within his business before the ask?
He crafted a value story that was realistic, coherent, and compelling. While Anthony spoke the “language of an entrepreneur” (one around opportunity, optimism, and vision), he knew he had to also speak the “language of an investor” (one around reducing risk and improving returns).
Here’s the secret sauce:
1. Assemble a Strong Management Team
The management team is one of the most important value drivers that a business can have. The key word here being “team.” Commonly, entrepreneurs tie their company’s value directly to their involvement in all operational aspects. Contrarily, investors want to see a group of people who possess complementary skillsets. Specifically, they want to view the team’s ability to work together in setting objectives, monitoring activities, and motivating employees. All of which are qualities that help funders determine the likelihood of future growth and success. Thus, strong teams can drive higher prices.
2. Develop an In-Demand Product or Service
Increased demand and opportunities for growth are the first two things investors look for in business. They want to see specific cash flow strategies and a diverse customer base. Companies with a single client accounting for more than 10 percent of overall sales is a red flag. Those who have plans for new products and product lines get viewed more favorably. Investors also like a marketing plan that tells a good story. They should be able to see upfront the problem solved and the unique business solution. Essentially, investors want assurance that the business has momentum. The best way to assure them is a written plan documenting a clear strategy for growth.
3. Define and Document a Clear Growth Strategy
A well-written business plan and brand strategy can increase the value of a company because it helps investors see the risks and rewards. Good plans document all systems including automated and manual procedures that generate revenue and control expenses. They also list the methods used to identify and track customers, as well as, deliver products and services. Standard business procedures and systems that are well-documented add value to the final asking price.
In conclusion, it’s the business owners job to tell the company’s story. Craft a tale that shows value using the three strategies listed above. A company that demonstrates limited risk and real returns can attract investors at a premium price even in the earliest stage of business.
To learn more about early stage valuation drivers, join Quist at Colorado’s Longmont Startup Week, July 24 through 28. Entrepreneurs, wanna-preneurs, intrapreneurs, creatives, techies, inventors, business owners, and investors are all invited to attend as our guests. Register for our presentation “The Art and Science of Valuing Your Startup” on July 25 at 9 AM here.
As of Tuesday, California, Massachusetts, and Nevada joined Alaska, Colorado, Oregon and Washington, along with Washington DC to legalize marijuana, pushing the percentage of Americans living in states where marijuana use is legal for adults to above 20 percent.
As voters in more states embrace legalized marijuana, the burgeoning cannabis industry has gone from a curiosity to a bona fide booming market. Legal marijuana sales in the US are expected to increase from $5.4 billion in 2015 to $6.7 billion in 2016 and reach a whopping $21.8 billion by 2020, according to ArcView Market Research. When we consider what other industries are poised to experience this level of growth, there are very few to consider. As such, we attended the Cannabis Capital Summit hosted by Rockies Venture Club to gain greater insight into how the industry has performed, where it is heading and who participates in it.
Ever since recreational marijuana was legalized in Colorado in 2014, the industry has matured and grown. The cannabis industry made gains on the state’s largest industries, including oil-and-gas sector, and contributed an economic impact of $2.39 billion in 2015, according to research. Although last year saw a huge bump in financing to US-based cannabis startups, regulatory issues remain in flux and there is uncertainty how a new administration will handle varying state laws. Dollars invested have fluctuated significantly over the past seven quarters, according to CB Insights. After a steady rise in funding from 2013 through Q1 2015, dollars invested have been erratic on a quarterly basis. The most recent quarter saw the lowest total disclosed funding since Q3 2015. And if trends continue at their current pace, the total deal count for the year will come in at just fewer than 80 deals, 25% lower than the 2015’s total. Despite the noted trends, the hype around the cannabis industry continues to be high and a diverse group of quality companies are innovating within the space.
Canopy Boulder, the leading cannabis accelerator, where the Cannabis Capital Summit was hosted, attracted a group of business owners, investors and service providers who were interested to learn how the cannabis industry has changed and how to be successful in this fast growing sector. The four companies that pitched at the summit represented ancillary cannabis businesses that included biosciences, e-commerce and analytics expertise and offered various solutions for market participants. The solutions that were presented ranged from tissue culture clones for cannabis and hemp cultivation facilities, improved delivery of cannabinoids, a platform for responsible consumption practices to the ability to analyze millions of transactions from dispensary point-of-sale systems and turn it into actionable insights.
The summit also hosted an investing panel that included experts from private equity, marketing, legal and angel investor community, who discussed financing options in the cannabis industry and shared their knowledge about current and future trends. Despite securing sizable amounts of funding for their companies, much of the financing available still stems from the participation of high net worth individuals due to the challenges that investors and companies face participating in an industry that remains illegal on the federal level; institutional rounds of financing are difficult at best.
Furthermore, it was pointed out by panelists that the trends have also shifted around product variety, consumption and demographics. More women are consuming cannabis products compared to only 3 years ago, and the average age of a person using a cannabis product has shifted to an older age group. One of the panelists described the future of the cannabis industry in four words: commoditization, consolidation, demystification and mainstream.
Despite growing public support, the federally illegality of marijuana hangs over everything in the industry. However, the longer it takes to develop a nationwide solution, the better it might be for those who aim to make money in cannabis; piecemeal legalization with each state developing its own cannabis regulations, could be favorable to a bourgeoning industry than a heavy handed, top down approach from government. Meanwhile, we will have to wait and see what the future holds for the cannabis industry, but for now it remains the fastest growing industry in Colorado.
Did you ever wonder why one business has buyers lined up willing to pay top dollar while another sits on the market for months, or even years? What do buyers look for in a prospective business acquisition?
There are many opinions about what attributes or characteristics buyers seek, but here’s what we know: the characteristics buyers seek must exist before the sale process even begins and it is your job as the owner to create value within your business prior to the sale. We call characteristics that impact value “Value Drivers.”
Walk a Mile in a Buyer’s Shoes
To get an idea of the importance of Value Drivers when preparing to sell your business, it is important to put on the buyer’s shoes for a minute. Let’s look at a hypothetical case study that illustrates how a buyer might compare two similar companies with a different emphasis on Value Drivers.
The A Factor Company has EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of $2 million, an owner who runs the business and the systems and processes that create growth. The A Factor Company doesn’t have a real management team in place and the owner generates a majority of its sales. The owner is the center point of the company, holding both the CEO and CFO positions. With this level of responsibility, the owner is burning out quickly.
In comparison, The B Factor Company also has EBITDA of $2 million and a solid management team that runs the business, systems and processes. The management team creates efficiencies within the business and the owner vacations for six weeks a year.
If you were a buyer comparing these two companies, which would provide a more attractive business opportunity? How much more would you pay for a business with a strong management team (one of the most important Value Drivers)? Would you even be interested in buying a business whose management team (the owner) walks out when you walk in?
Investment bankers understand that companies that lack strong Value Drivers also lack a bevy of buyers. Those buyers that do come to the table do not arrive with pockets full of cash.
Let’s look at several of the more important Value Drivers common to all industries:
- A stable and motivated management team. If you can wait a year to sell your business, we suggest that you consider an incentive compensation system, cash or stock-based, that rewards key employees as the company performs (usually measured by increases in pre-tax income). Sophisticated buyers know that with a solid management team in place, prospects are good for continued business success. Without a strong management team, it may be very difficult to sell your business to a third party or transfer it to an insider.
- Operating systems that improve sustainability of cash flows. Operating systems include the computerized and manual procedures used in the business to generate its revenue and control expenses, (i.e. create cash flow), as well as the methods used to track how customers are identified and how products or services are delivered. The establishment and documentation of standard business procedures and systems demonstrate to a buyer that the business can be maintained profitably after the sale.
- A solid, diversified customer base. Buyers typically look for a customer base in which no single client accounts for more than 10 percent of total sales. A diversified customer base helps insulate a company from the loss of any single customer. If the majority of your customer base is made up of only one or two good customers, consider reinvesting your profits into additional capacity that will make developing a broader customer base possible.
- A realistic growth strategy. Buyers tend to pay premium prices for companies with realistic strategies for growth. Even if you expect to retire tomorrow, it makes sense to have a written plan describing future growth and how that growth will be achieved based on industry dynamics, increased demand for the company’s products, new product lines, market plans, growth through acquisition, and expansion through augmenting territory, product lines, manufacturing capacity, etc. It is this detailed growth plan, properly communicated, that helps to attract buyers.
- Effective financial controls. Financial controls are not only a critical element of business management, but they also safeguard a company’s assets. Effective financial controls support the claim that a company is consistently profitable. The best way to document that your company has effective financial controls and that its historical financial statements are correct is through a certified audit or perhaps a verified financial statement by an established CPA firm.
- Stable and improving cash flow. Ultimately, all Value Drivers contribute to stable and predictable cash flow. It is important, especially in the year or so preceding the sale of the business, that cash flow be substantial and on an upswing. You can begin increasing cash flow today by simply focusing on ways to operate your business more efficiently by increasing productivity and decreasing costs.
If you have any questions about increasing the value of your business prior to your exit, please contact us to discuss your particular situation. We can help you identify and strengthen the current Value Drivers in your business, install additional Value Drivers, and create a road map to meet your overall exit objectives. We also have additional resources that explain Value Drivers in more detail.
If you’d like more education on our entire range of business valuation topics or wish to discuss transfer planning in general, please Contact Quist.
Copyright BEI Inc.
Full disclosure: Wealth preservation planning can’t help any of us cheat death, but it can help business owners to avoid taxes and achieve financial security. Read on.
The ideal Exit Plan (one that provides the business exit you desire) includes a strategy to help you preserve your hard-earned wealth from unnecessary taxation when it is transferred to your family. But to preserve wealth, business owners must take steps before they actually have it. In other words, to realize all of the potential benefits of various wealth preservation techniques, owners must make plans before they convert the value of their businesses to cash.
The foundation for wealth preservation planning is found in the answers to two of the questions you answered in Step One of this Exit Planning process:
- How much wealth do you want when you exit your company? And, for parents, the follow-up question: How much wealth do you want your children to have?
- How long before you leave your company?
Using your answers as guideposts, you (and your advisors) can then choose the planning technique that will best preserve your wealth, provide for your family and minimize your tax bill. Let’s look at how one fictional owner used wealth preservation techniques to do exactly that.
George recognized that he’d waited too long to begin gifting part of his company to his kids. A week before, George’s CPA had told him that, based on the company’s pre-tax cash flow of $2 million per year, his company could be worth as much as $12 million to a third party.
After recovering from that shock, George realized first that he didn’t need nearly that much cash to retire in style and second, that if he didn’t transfer at least half the value of his business before a sale, his family could be looking at millions in gift or estate taxes!
To remedy this situation George and his Exit Planning advisors:
- Hired a Certified Business Appraiser to assign a conservative, but supportable value to the company.
Result: Based on current tax case law and valuation principles, the appraiser valued the transfer of a 49% minority (less than controlling) interest at $4 million. In her opinion, the appropriate minority discount was 35 percent of the full fair market value (assumed to be $12 million) of the stock.
Result: Using the 35 percent discount, George could give away half of the company to his children (a gift valued at approximately $4 million) and would pay no gift tax based on 2011 law which provides for a $5 million lifetime gift tax exemption.
While George was happy with the idea of not paying tax, he didn’t relish using most of his lifetime gift and estate tax exemption, and wanted a better answer. So he took another step to avoid needlessly wasting this most valuable exemption.
- Created a GRAT—a Grantor Retained Annuity Trust. (See “GRAT Note” at the end of this article for more detailed information.)
Result: Using a GRAT—perhaps the biggest lever in the Wealth Preservation Game—George would avoid using a significant part of his $5 million lifetime gift tax exclusion, and would still give almost 50 percent of the company to his children.
Through wealth preservation planning performed well in advance of George’s exit George was able to:
- Transfer one-half of a business with a fair market value of $9-$12 million to his children in four years (a timeframe George chose) using little or none of his lifetime exemption.
- Receive all of the cash flow from the company during that four-year period, because the annuity payment to George was designed to equal the amount of cash flow expected from the stock transferred into the GRAT. And George needed this income to achieve his financial security exit objective.
- Transfer (after four years, or at the termination of the trust) the trust asset (one-half of the company) to trusts for his children, completely free of any gift tax.
George had established these trusts when he created the GRAT to carry out his wishes regarding when, and if, his children would receive money from those trusts.
Techniques such as GRATs and the careful use of minority discounts (as well as many other estate tax avoidance techniques), only work as intended if they are put in place well before you exit your business. These techniques also work well when two objectives, in this case George’s financial security and his desire to provide for his family, must be achieved in tandem.
If you wish, we can provide you with additional information about transferring wealth to children and/or protecting as much wealth as legally permissible from unnecessary taxation.
We provide here additional details about how and why a GRAT can help to achieve an owner’s twin objectives: the need for financial security and to provide for one’s family.
A GRAT is an irrevocable trust into which the business owner (and the Trustee of the GRAT) transfers some of his stock. The GRAT must make a fixed payment (annuity) to the owner each year for a pre-determined number of years. At the end of that period, any stock remaining is transferred to the owner’s children.
Stock transferred into a GRAT is treated as a gift. The amount of that gift is the value of the asset transferred minus the present value of the annuity that the owner will continue to receive. (George’s advisors made sure that the present value of the annuity paid out over four years almost equaled the value of the stock transferred into the GRAT. In doing so, George made only a nominal and non-taxable gift.)
The key to a GRAT’s success is to transfer to it an asset that appreciates in value and/or produces income in excess of 120 percent of the federal mid-term interest rate. This rate fluctuates monthly; for example, the rate varied from 7.5% to 2% in the period 2003-2011.
Copyright BEI Inc.
Top 3 Valuation Drivers that Help Land Early Stage Investors
When Anthony decided to start his own software company, he knew he’d need an investor to bring his idea to life. So early on, he dedicated time and effort to position his company for equity financing. In doing so, he […]
Continue reading →
The Green Tsunami
November 10, 2016 Strategic Valuations 0 Comment(s)
As of Tuesday, California, Massachusetts, and Nevada joined Alaska, Colorado, Oregon and Washington, along with Washington DC to legalize marijuana, pushing the percentage of Americans living in states where marijuana use is legal for adults to above 20 percent. As […]
Continue reading →
Creating Value in Your Business to Get Top Dollar When You Leave It
Did you ever wonder why one business has buyers lined up willing to pay top dollar while another sits on the market for months, or even years? What do buyers look for in a prospective business acquisition? There are many […]
Continue reading →
Death and Taxes vs. Preserving Wealth – The Final Exit Planning Contest
April 14, 2016 Strategic Valuations 0 Comment(s)
Full disclosure: Wealth preservation planning can’t help any of us cheat death, but it can help business owners to avoid taxes and achieve financial security. Read on. The ideal Exit Plan (one that provides the business exit you desire) includes […]
Continue reading →