“Weighing in” on Business Valuations
In our high technology valuation practice in Silicon Valley, typically we develop estimates of the client’s value using two or more valuation methods. For instance, we might use a discounted cash flow method, and another method that uses valuation multiples derived from publicly traded companies; there are other methods as well.
We will sometimes select one method’s result for our final conclusion of value, sometimes we will use an average of results, and sometimes we will weigh the results and use a weighted average.
In a perfect world, each method should be expected to come up with a result that is very close to the others. And for companies with established business models, this is frequently the case.
Valuations of early stage companies can vary dramatically
However, for early stage technology companies, this is not always the case. These companies are often characterized by a distinct absence of revenue or other metrics of customer validation. They are often not profitable, and if showing accounting profits, they may still be significantly cash flow negative. Financial projections (if available) may be purely speculative, reflecting management’s hopes rather than expectations. The public companies in their industries are typically much more mature. New entrants are often trying to disrupt and change their industries with new business models.
The selection of a particular set of weightings for any particular valuation depends on an assessment of the quality of the data (the evidence) upon which each analytical method relies, and the degree of similarity of the subject company to the other companies used as a basis of comparison. If there are recent transactions in the company’s common or preferred stock, these transactions can be used to help reach a conclusion of value. Other factors may also be considered.
Using weighted averages is an acceptable valuation practice
The simple averaging of results can be reasonable and acceptable. For instance, Rosetta Stone, Inc. disclosed in its SEC filings that its valuation firm used the simple averaging of the results from different valuation methodologies in the valuations it performed in the three years prior to IPO:
“We considered numerous objective and subjective factors in valuing our common stock at each valuation date in accordance with the guidance in the AICPA Practice Aid Valuation of Privately Held Company Equity Securities Issued as Compensation. For each common stock valuation that we performed, we determined the fair value of our common stock by taking the average value calculated under the discounted cash flow method, the guideline method, and the comparative transaction method. We weighted each method equally.” (page 51, SEC submission filed pursuant to Rule 424(b)(4), dated April 15, 2009).
However, each company’s circumstances are unique. The weighting of results will need to be considered in each valuation performed.
Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.
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