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When starting your business, you will need to consider what type of business structure is right for you. This article will talk about some important considerations when deciding which business model is best for you.
The most common types of businesses are Sole Proprietorships, LLCs, Partnerships, and Non-Sole Ownership (also referred to as “General Partner” or “GP”) in an LLP (Limited Liability Partnership). Each of these structures has their benefits and drawbacks, so it is very important to understand them before choosing one!
This article will focus mostly on the differences between investing in a General Partner vs. owning shares in a limited liability company (LLC), but we will also briefly discuss the pros and cons of each with examples.
Just like buying a car, knowing the difference between individual ownership and partnership/llc ownership is key to understanding if this is the right financial solution for you. Both can be cost effective at the same time making them good choices depending on your needs.
There are several different types of business valuations, but one of the most important is the value model that determines the present value of future income. This type of calculation looks at how much an investor would have to invest now in order to earn the same amount of money later on.
A common example of this type of calculation is investing in a house. You could spend less than $100,000 today, and still eventually receive a return on your investment when you sell it. Because you’ll be earning more from the property down the road, this approach calculates the price as an inflation rate.
With respect to businesses, this kind of analysis assumes that the company will continue to generate revenues in the coming years. Therefore, the cost of buying out or shutting down the operation is removed because there is no longer a need to do so.
Instead, these calculations focus on what the business is worth right now with no assumption about its long-term viability. The average person doesn’t usually have a lot of experience calculating real estate values, but they can calculate their own personal savings effectively.
By using his or her savings as a comparison, then applying an appropriate inflation rate, people can get a good idea of the market value of a home.
The most common way to calculate recurring revenue is to multiply the product of the time horizon, the average monthly revenues, and the difference between those two numbers times the appropriate discount rate (the interest that you would have to pay to get back your investment) to arrive at the NPV or net present value of the business.
When calculating the value of a business, there is an important step that many business owners skip or mis-calculate. This is how to discount future revenues!
A common way to do this is by applying what’s called a growth rate in your equation. The growth rate is typically calculated using either average annual growth or compound yearly growth.
When using average annual growth as a discount, you divide the company’s earnings per year by the same period last years and then multiply it by one minus the ratio of today’s price to yesterday’s price.
Using compound yearly growth works like above except instead of dividing by one month, you use twelve. So if we rewrote the formula just mentioned, our discounted cash flow (DCF) valuation would look like this:
Value = current market capitalization x (growth rate used to calculate DCF) x (present value factor - for example, 2 means two times the original investment)/growth rate
Present value factors are simply ways to adjust for differences in time when investing money. For example, a 1% present value adjustment makes your invested dollars worth 0.99% more than they were before. A 2% PV adjustment makes your investments 2% better!
We usually use a percentage referred to as the “discounted” or “net present value” (NPV) factor.
A key part of determining if a business has enough revenue to keep operating efficiently is knowing when it costs more to operate than it makes back in revenues. This is called breaking even, or the point at which the business earns as much as it spends.
At this stage, the business can stop investing in new equipment or expanding production facilities because it is already paying for itself. It may also start thinking about how to lower its expenses or find ways to produce less expensively to stay within that margin.
By calculating the break-even point, you can determine whether a business with no profits exists before it happens.
The growth rate of a business is an important factor when determining its valuation. This is because market value is determined by how much money you would be willing to pay for a company, not what they are currently worth!
Business owners often underestimate the true value of their companies due to two reasons. First, they may overestimate the effect that current performance has in influencing the price they are asked for their company. Second, they fail to consider the potential future success of the firm.
The first reason was discussed in our article “Valuing Your Startup By Creating A Discounted Cash Flow Model” where we explained why it is important to understand the underlying economics of your business before setting a sale price.
In this article, we will discuss the second reason why the growth rate of a company should influence the price you set – the anticipated continued growth of the company. When assessing the expected growth of a company, there are several factors that can play a significant role.
We will now look at three of these key variables — industry, competition, and net profit margins. By understanding the significance of each of these, you will have more insight into the likely future growth of the company.
The next step in calculating your starting valuation is to calculate your initial investment. This includes cost of goods sold, working capital needed for start-up costs, and invested capital which we will discuss further down.
It’s very important to understand that this number should be lower than the business exit value because you are investing into the company before it exits. Therefore, your calculated investment must be less than the market exit price!
Business owners often get rid of their businesses due to financial reasons beyond their control (like death or retirement). When this happens, there are no longer revenue streams coming in and operating expenses being paid out, resulting in an unrealized profit.
This is why it is crucial to account for these potential losses when determining your startup price. You can deduct these loss amounts from your calculations if and when they occur, but not before!
By accounting for these possible setbacks, you ensure that your business is still fairly priced.
In the recurring revenue business model, you start with the assumption that there is already an audience for your product or service. You then create additional products or services to be attached to this existing audience.
These attachments are called “products” or “services” because they feel like standalone items (think of how most businesses have access to their own books and accounting software).
With these additions, your company starts to make money continuously instead of having a big launch event that requires lots of investment and then some more maintenance fees after that initial break-even period.
Because there is no one moment when the company makes its first dollars, only it can determine when it reaches profitability. This is known as the average revenue per user (or ARPU) metric. It typically refers to the monthly cost of using the app plus what users pay for additional features.
The math behind calculating ARPUs varies slightly from business to business, but many use either EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) or net income (profit before expenses) as a basis.
When calculating the expected duration of business, you will need to know how many months or years sales are projected for. You can calculate this by figuring out what percentage of time the company has been in existence and then multiplying that times the number of months or years they have been operating.
This calculation is slightly complicated because it includes both past and future projections. Past projection accounts for how much revenue the company made before while they were offering their service, whereas future projections account for how much revenue the company expects to make during the rest of its life (which may be longer than just the remaining term of the contract).
By adding these two numbers together, you get an estimated amount of money the company could earn over its lifetime. This total is then divided into the present value of the firm to determine how much profit the company would bring in per month or year if it was bought now.
