By Michael S. Melfi JD, MBA
They often say how much something is worth is based on what someone is willing to pay for it - the ol’ supply and demand rules. However when dealing with inventions and emerging brands, it is important to develop a valuation that is based on industry standards, investor criteria and reliable financial data. A valuation is a financial number generated to various accounting and financial models to create a representative financial value of the idea, invention or business. The reason why this is so important is that any type of funding for lending will typically take into account this financial number. Plus, it is necessary that any inventor or business owner at least understand the value of their business. The tricky part is that many people often overvalue what they have worked on or the amount of sweat equity they have put into a business.
Before we discuss what a valuation does include, let's review what it is not. Most of the time evaluation does not consider sweat equity by a founder or owner. It also gives little weight to business ideas with little execution or no traction around them. Lastly, anything surrounding the idea or business that cannot be accounted for through some type of accounting, may have perceived value, however will have little to no actual value for the purposes of valuation.
The key to understanding valuation is to understand how value is created in an invention or business. There are three key areas where value can be created in a business. The first is value with the customer base; the ability to create actual or perceived value to customers who are willing to spend money demonstrates something that can be financially measured. Additionally having demand from a consumer base, even if they are not paying to use the product or service, also can be financially measured.
The next area of value is created with the team that is involved in the business. The ability to identify and recruit key employees and management, which make the operations possible, creates value from a valuation standpoint. Being able to identify people who can grow the company directly correlates to the value of the team.
The last area is directly related to any funding sources. An invention or business’ ability to create financial value for a funding source is a very important aspect of the valuation process. At the end of the day, the funding source is going to inject capital as debt or equity and be looking for some form of return based on the funding sources underwriting or due diligence on the idea or business.
Depending on the size of the company and the stage of the invention, there are many options for how to obtain an evaluation from professional service providers to online portals. Ultimately, all the models will have various areas of a business they will use to assess the business in comparison to a financial model, or other comparable assets. Sum of the typical areas looked at for emerging companies, especially when pre-revenue, include:
- Industry & Market Size
- Product Maturity
- Competitive Position
- Sales/ Revenue
- Management/ Leadership
- Future Funding Needs
- Investor Exit
- Risk Factors
- Capitalization Table
There is a great tool to use when creating an evaluation model for a business called Worthworm. It can be found at www.worthworm.com. This tool allows the inventor or entrepreneur to answer a series of questions in key business areas and express confidence levels around the data to ultimately create evaluation for their business. The great feature about this program is that once completed, it can be shared with an investor and allows for an opportunity to collaborate around the data points, financial analysis and ultimately the ability to determine an agreeable valuation.
So, while an entrepreneur may not currently feel they need a valuation or what they have may not be worth very much, it is important to start early on to understand how valuation works. This will not only give an idea of where the company stands, it will become important with any ownership discussions between founders, investment conversations with funding sources and necessary during any long term growth conversations.
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