By Adam Hoeksema
For many entrepreneurs there is a desire to know the true value of their business. Unfortunately, business valuation for early stage companies is both art and science. A great example is the recent $1 billion acquisition of Instagram. This valuation makes any business valuation expert scratch their head. I think there are essentially 3 techniques that can be used to value a business.
1. Textbook Business Valuation – If you are an MBA student you will learn a couple different formulas and techniques for valuing a business. These textbook equations will put a fair value on your business in many cases. Rather than explain the details of each equation in this blog post I am simply going to point out two valuation options:
These are two of the most common valuation techniques you might learn in business school.
2. Comparables Valuation – If you ever watch those TV shows where homeowners are trying to place a value on their house in order to sell it, you might hear the realtor talking about the price of comparable homes in the neighborhood. Similarly you can value your business based on the sales price of a comparable business in your industry. For example, if you own a McDonalds franchise that generates $2.5 million in annual sales, and a Burger King Franchise store with $2.5 million in sales that is located next door just sold for $6 million, then you should be able to make a strong case that your McDonalds store is worth at least $6 million.
3. Defensive Valuation – I believe that Instagram was valued defensively. What do I mean by this? Some analysts suggest that 1/3 of Facebook page views and potentially 1/3 of Facebook revenues come from photos. If you haven’t noticed, there are advertisements in the bottom right corner of the picture viewer on Facebook.
So here is my hunch.
Facebook realized that a rapidly increasing number of pictures viewed on Facebook came from Instagram. If Facebook generated $1 Billion per year from advertisements in the picture viewer, and by the end of 2012 one third of those pictures viewed would come from Instagram, then Instagram would hold immense power. What if Instagram decided to close off the ability to post photos to Facebook? Instantly, Facebook would lose over 330 million in annual revenue due to lost ad clicks. That is a HUGE risk that shareholders would not be willing to live with. Facebook had to buy Instagram to stay in a position of control. Even though Instagram had not earned a dime in revenue, it was a threat to Facebook. They had to pay a premium because Instagram was a threat, and they were growing incredibly fast!
At Instagram’s current growth rate they might be worth $330 million in annual revenue in 2012, but they might double to $660 million in 2013. Now the acquisition price starts to make sense. The purchase of Instagram at $1 Billion will essentially breakeven in 2 years if those prior assumptions are correct. That is the power of a defensive valuation.
Unfortunately, the value of your business is ultimately whatever a buyer is willing to pay. Good luck as you work to determine the true value of your business!
About the Author: Adam Hoeksema is the Co-Founder of ProjectionHub. ProjectionHub helps entrepreneurs create financial projections without the need to have a PhD in spreadsheet modeling.