In our Business Law practice, we routinely deal with entrepreneurs and investors who are trying to structure an investment opportunity on the basis of the company’s value before the outside investment is closed. This challenge exists whether the investment will be with debt or equity. The backdrop in many of the discussions relates to how to value the start-up from a risk-reward standpoint.
Since funding a new business or idea is generally a high-risk endeavor, the valuation process is a combination of art and science to arrive at what is called a pre-money valuation, which is the value projected prior to taking into account the investment.
What the investor is seeking to accomplish during this process is weighing the company’s potential success against the risk being taken. The spectrum of what is determined to be success would range from never reaching its potential to being highly successful. In moving through this process, the investor may use one or more methods to value the company and corresponding financial investment.
One method used by investors and entrepreneur to value a company is called the discounted cash flow model, which means they would be estimating the present value of future cash flows from the company. Essentially, the investor is determining what the time value of money is for an investment in this particular company. The corollary is the value of equity is equal to the present value of future cash flows. What this means to the investor is that the company’s future cash flows should not only be equal to the present value of the equity investment, rather, it should exceed it; otherwise, the investor would likely conclude that investing in the prospective company is not worth the risk.
Predicting a company’s future cash flow and applying a discount rate that would reflect the risk is also a combination of art and science. If present value is projected to be higher than the cost of the investment, the investor may decide to proceed. And if it is equal to or lower, the investor would more likely withdraw from the discussion and seek other opportunities. When they use a discount rate in projecting future cash flows, the investor is seeking to find the difference between the present value of the investment compared to future cash flows. If projected future cash flow is high, the discount rate to be applied would be lower, and if the risk is determined to be high, the discount rate would be lower in attempting to predict the return on the investment.
A second method of determining a company’s value is by using what is called a multiple valuation, which compares the company’s earnings rate or projected cash flows to the current price of the equity, which calculates a price to earnings ratio. Using the enterprise value, which is the value of equity plus outstanding debt in comparison to what was determined to be value of future cash flows arriving at what is called EBITDA or earnings before interest, taxes, depreciation and amortization.
The challenge in using any valuation methodology is arriving at a multiple that is reflective of the type of company and industry. Once the multiple is determined, the investor has the tools to project a value by multiplying the multiple by the figure arrived at after determining its EBITDA. Our role as lawyers begins after the investor and entrepreneur have concluded their discussion relating to valuation of the shares or membership interest, which would be critical to determining the most appropriate structure to close the transaction. If you would like more information on valuation methods and related issues or other business matters, please contact PLDO Managing Principal Gary R. Pannone at 401-824-5100 or email gpannone@pldolaw.com.
Disclaimer: This blog post is for informational purposes only. This blog is not legal advice and you should not use or rely on it as such. By reading this blog or our website, no attorney-client relationship is created. We do not provide legal advice to anyone except clients of the firm who have formally engaged us in writing to do so. This blog post may be considered attorney advertising in certain jurisdictions. The jurisdictions in which we practice license lawyers in the general practice of law, but do not license or certify any lawyer as an expert or specialist in any field of practice.
Gary R. Pannone is the Managing Principal of Pannone Lopes Devereaux & O'Gara LLC and has been representing closely held business owners for over thirty years. He is an experienced business lawyer specializing in the areas of business formations, corporate restructuring, mergers, acquisitions and corporate compliance. His practice includes the representation of nonprofit organizations with respect to consolidations, mergers and acquisitions. In addition to his role as Managing Principal of the firm, Attorney Pannone serves as the team leader for the Health Care Law, Corporate & Business Law and Nonprofit Organizations teams.
Attorney Pannone serves on several boards and governance committees of nonprofit organizations. He is a former Town Solicitor and has served as special counsel to several municipalities. He is also a frequent lecturer and author in the areas of health care law, corporate compliance, board governance and best practices.
Prior to the founding of Pannone Lopes Devereaux & O’Gara LLC, Attorney Pannone served as the managing partner of the Providence office of Holland & Knight LLP. He is a prominent member of the legal community and was honored by his peers and judges with the AV Preeminent rating from Martindale Hubbell, which is the highest rating based on both legal ability and ethics. In addition, he has been recognized by his peers as a leading lawyer in the areas of business law and corporate compliance by Best Lawyers® in America, Chambers USA, Super Lawyers and Corporate Counsel. For the past four years, Attorney Pannone was named Rhode Island’s “Lawyer of the Year” by Best Lawyers in his practice areas and he was selected as a 2020 Excellence in the Law Hall of Fame honoree by Rhode Island Lawyers Weekly. He is also a Fellow of the American Bar Foundation, the nation’s leading research institute for the study of law.
Attorney Pannone received his J.D. from Suffolk Law School after earning his undergraduate degree in Finance and Accounting from the University Of Notre Dame. He is admitted to practice law in Rhode Island and the U.S. District Court for the District of Rhode Island.
To contact Attorney Pannone, call 401-824-5100 or email gpannone@pldolaw.com.