Reverse Mergers – Determining the Valuation of the Operating Business

Posted by on November 08, 2016

Reverse Mergers – Determining the Valuation of the Operating Business- Determining the valuation of the operating business is necessary where negotiating an equity deal or concurrent financing transaction as part of a reverse merger.

For business entities with operating history, revenue, and profit margins, valuation is determined by mathematical calculations and established matrixes (usually 1x to 8x EBITDA). For a development stage or start-up venture, the necessary elements to complete a mathematical analysis simply do not exist. In that case, valuation is based on negotiation, future potential and a best guess.

Establishing valuation for a development stage or start-up entity ultimately comes down to an investor’s perception of risk versus reward. Risk is easy to determine: If I could get $300,000 cash for the public vehicle today, I may lose that $300,000 by accepting equity instead. Reward, on the other hand, is an elusive prospect based on the potential success of a business.

In determining value thorough due diligence should be completed and consideration given to numerous factors including for example:

1. Investment comps: Have investors, either private or public, recently funded similar companies, and if so, on what terms and conditions and at what valuation;
2. Market Data: What is the product market; what is the size of the market; how many new players enter the market on a yearly basis and what is their success rate;
3. Competition: Who are the major competitors; what is their valuation; how does this company differ from these competitors;
4. Uniqueness of product or technology: How is the product or technology unique; can it easily be duplicated; patent, trademark and other intellectual property protections;
5. Pricing and Distribution Strategies: What are the major impediments to successful entry into the marketplace and the plan to overcome those impediments;
6. Capital investments to date and details about that capital such as outstanding preferred stock, warrants and convertibles:
7. Assets and liabilities:
8. Technology Risks including what technologies are being relied upon;
9. Product Development Plans: Are there a model and samples; have they been tested; have manufacturing channels been established; and what is the overall plan to bring the product to market and subsequently become a competitor in the industry;
10 Legal documentation: Not only whether corporate records are in order, but are all contracts and arrangements properly documented;
12. Future financing needs:
13. Exit strategies: How will the current shareholder be able to sell; will the shares have piggyback or demand registration rights; reliance on Rule 144?; lockup or other additional holding periods?;
14. Management: This is perhaps the most important consideration – Does the management team have a proven history of success; prior business experience in this and other industries; work ethic; general management skills; organization skills; presentation skills; research skills; coachability; ability to attract others with strong credentials who believe in the business and are willing to work to make the business a success; does management present well in meetings and face-to-face discussions;
15. Developmental milestones: Has the company achieved its developmental milestones to date?