Valuing a Small Business in its Startup Phase

Business Valuation

Repost from BizBySell

Many of the analyses and valuation techniques most business appraisers rely on to value small businesses use an analysis of historical financial statements to:

  • Identify potential trends
  • Compare the subject to the industry average
  • Find any required normalization adjustments

The question then becomes, how does one appraise or value a business that has no historical record? Sometimes the business that needs to be appraised has been in operation for less than a year.

 

As a real world example, a restaurant that had been open for seven months can be used. The business was started by two partners, each owning 50% of the business. After they had been in business together for a few months, these partners realized they could not work together. They both wanted the restaurant, so one of the partners had to buy out the other. What was the value of a 50% ownership interest in this startup restaurant?

Usually, an appraiser or business broker would be able to analyze the last several years’ financial records to see what kind of growth the restaurant would have seen, and then compare those results to industry average data, in order to determine if the business was more or less risky than the industry average. However, in a startup business like this, there was not sufficient data to run this historical analysis.

The value of a going concern business is based on what its expected future earnings will be. These results can be projected. However, with limited historical data, any single projection built can’t necessarily be relied upon because there is nothing available to base it on. The definition of the fair market value includes the words, “…both parties having reasonable knowledge of relevant facts…”, meaning potential buyers and sellers can consider all the possibilities inherent in the operation of such a small startup business.

To solve for this, one option is to build three projections; an expected case, a best case, and a worst case scenario. Each case is weighted based on its expected likelihood of achievability. This method allows the most likely possibilities to be considered in a situation when the future is very uncertain.The weightings below are what were used for the specific case in question, and are not appropriate for use in all cases.

 

Expected case – Weight: 65%

The expected case projection was based on reasonable growth assumptions that would take the startup business from its current status to stable growth as a going concern similar to its industry average.

 

Best case – Weight: 10%

The best case projection was based on the slightly accelerated growth assumptions that would take the business from its current status to stable growth as a pretty successful going concern.

 

Worst case – Weight: 25%

The worst case scenario was based on the assumption that the business failed at the end of its first year and went bankrupt.

A startup business is full of potential! No one really knows what is going to happen, and the uncertainty can be exciting, but it also increases the risk of achieving an income stream. No matter how the valuation of a business such as this is conducted, make sure the risk is incorporated appropriately.

by: Shawn M. Hyde, CBA, CMEA, BCA is the Executive Director of the International Society of Business Appraisers. He has 20 years of valuation and appraisal experience in numerous industries. He is a Certified Business Appraiser, a Certified Machinery & Equipment Appraiser, and a Business Certified Appraiser. He has written and taught courses for the Institute of Business Appraisers (IBA), for the National Association of Certified Valuators and Analysts, and for the International Society of Business Appraisers. He has served on the IBA’s Education Board, and the IBA’s Board of Governors, and is a past Editor in Chief of the IBA’s professional journal, “Business Appraisal Practice”.