The Venture Capital Dream

You may have considered raising money for your startup from a venture capitalist (VC).  Not only it’s a great achievement to get your products or services validated but it’s also financially rewarding. A suitable venture capitalist can drastically shorten your market development time and speed up productions, not to mention a successful exit.  After all, who doesn’t like another story about a visionary entrepreneur carrying a start-up company from his or her own garage to the New York Stock Exchange? Before you get too excited, let’s take a look and see how much your company is worth to a VC.

How Venture Capitalists Value Your Company

If your start-up is not generating revenue, it is considered a pre-money startup. VC generally uses a scorecard approach to value your company. As the name suggested, the scorecard approach is about the score of your company. And the score is generated by comparing your company with other funded start-up companies.  In another words, it’s a market approach.

VC firms pull comparable companies at a similar development stage. If your company is funded by seed capital or angel investing, your company would stand side by side with other companies in the same seed group. The mean value of all comparable companies will be used as a benchmark for your VC capital. Each VC has its scorecard system to generate a weighted-average multiplier for your company. For example, if the VC cares about management and assigns a 50% weight on the experience of the management team and your startup gets a score of 80%. The assigned score for management would be 40% for your startup. The sum of all weighted scores will then be multiply by the benchmark valuation.

Nonetheless, the VC approach is appropriate if your company is generating income or has a solid chance of doing so. The VC approach is a form of income approach and venture capitalists typically value start-up companies based on their required rates of return on the investment and required exit values.

Partnerships and trusts are attractive because of their flow-through system. However, there are some distinctive differences between the two.

Partnership & Trust?

Like a corporation, a trust is a legal separate  entity. However it’s use is different from a corporation due to its flow-through function as a business structure. For family offices and investment management businesses, a trust might be an ideal structure because income to beneficiaries can be deducted from the trust’s income. The paid income will then be taxed in the beneficiary’s hands, effectively working as a flow-through system. As a result, a trust investor will only pay one tax.

Partnership Differences

Unlike a trust, a partnership is not a separate legal entity. For partnerships, taxable income needs to be calculated and allocated to each partner. As a result, a partnership is also a flow-through system where the partner will only pay one tax, if the partner is an individual. The sale of of partnership usually results in the disposition of of capital property and therefore a capital gain or loss. The gain or loss will then be allocated the partners according to their proportions of the partnership. While an interest in a cooperation represents a share, an interest in the partnership is more like a right. Each partner does not own anything but the right to use the capital properties.

 

Although there are no standard requirements for a business valuation report or who can legally provide a valuation report, company owners should ensure the professional they hire has one of the following professional designation – CPA, CBV, ABV, or CFA.

For U.S., ABV or Accredited Business Valuator are awarded to CPAs or valuation professionals whom have passed a list of courses and an exam and fulfilled a number of valuation hours. For Canada, CBV designation is the most recognized credential for professional business valuators in the Country. CFA is the gold standard for the financial industry and CFA charterholders might or might not be specialized in private company valuation but the designation warrants a high level of expertise and professionalism in the industry.

For Canada, the history of professional valuation goes back to 40 years ago since the 1971 tax reform, where Canada Revenue Agency (CRA) required valuation for income tax purposes for gift and estate tax, capital gains tax purposes. CICBV were designed to fulfill these formal valuation needs. Ontario Securities Commission (OSC) later issued valuation-related policy and the standard for business valuation reports. As a result, CBV by CICBV was introduced.

For businesses with over 500k revenues, owners should seriously consider having a valuator report done by a professional with one or more of the above designations. Business buyers and investors typically have sufficient resources and knowledge about the valuation metrics and will investigate the facts, reasonableness, legitimacy of the business valuation. A poorly prepared valuation report will not only have bad representation of your business reputation and lower the true value of the exit value but also invite future expensive law suits.

Business Valuation Report