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How Investors Place a Value on Your Cannabis Business

To try to ensure that they're not going to lose money if they invest in your business, investors will determine a value for it. Find out how they do it.

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The following excerpt is from Ross O’Brien’s book Cannabis Capital. Buy it now from Amazon | Barnes & Noble | iTunes

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When a cannabis investor feels certain they have a good understanding of an investment’s risk profile, they assign a valuation to the investment. This valuation that the investor and current owners agree to will have long-term implications and impact the type and magnitude of any return the investment will provide back to the shareholders — it will map directly to the risk-return profile for the investor and the long-term ability for the entrepreneur to create personal wealth.

Cannabis investors will employ a variety of valuation methodologies and tools at their disposal, which provide data points the investor will ultimately rely upon for their judgment. In the absence of an explicit market where investors buy and sell equity in companies with a stated valuation, the CVC investor will triangulate the value of the investment by using a combination of several methods for valuing a company. There are five main analytical approaches that are relevant for valuing a private company.

Let’s take a look at each of these.

Related: How Risky Is Your Cannabis Business?

Asset/Equity valuation methodology

This is a review of the net asset or equity value of a business, otherwise known as “book value” or “liquidation value” and is most relevant for companies that own explicit assets that can be assigned a value if disposed of and converted into cash.

When taking the value of the tangible assets into consideration, the investor can calculate the book value of the company. Book value is a common calculation that is also known as net book value (NBV). Book value refers to what’s carried on the balance sheet of the company stating the cost of the assets minus the accumulated depreciation, which is theoretically what the equity owners would receive if the company were liquidated. Net asset value is then the value of the total assets (not including intangible assets such as trade secrets, patents, or goodwill) minus liabilities.

With a stated net asset value, the CVC investor can perform a comparison to the company’s valuation. Simply stated, if the value of the company is greater than the ability to dispose of the assets, the valuation would imply that there’s greater value in the intangible assets of the company and would need to be justified through alternate valuation approaches.

Income methodology

This involves a review of a company’s historical performance com­bined with its projections with a discount rate applied to future cash flow used to indicate a present value on an income basis. Using a company’s income in order to value the business is most relevant when the business or asset has a steady history of revenues and earnings together with a level of certainty that the revenues will continue. The more certain the future revenues are, the more relevant an income analysis will be. One common analysis investors use is to articulate the present value of future cash flows in a discounted cash flow (DCF) model. The model assists with identifying the intrinsic value of a company by placing a value today on the future cash flows of the company.

What the DCF model aims to quantify for investors is the trade-off for what their investment could earn in an alternate investment vehicle vs. what the potential cash produced by the proposed investment would be discounted to a value today. Due to the volatility and uncertainty of future events, however, a DCF model is rarely the sole method for formulating a valuation for a private company in cannabis investing, especially for early-stage private companies.

Market comparable analysis

This is the most common method used to develop a valuation for a private company and involves studying the market of what other buyers or investors have paid for other private companies that are similar to the intended target. As with all the valuation analysis techniques, there are several issues to consider. The primary issue is that the type of information the investor is looking for is difficult to access. Unlike the public markets, there isn’t one source of consolidated publicly available information. In most cases, investors will look to evaluate a business in terms of a multiple of EBITDA and use the market mean to start a sensitivity analysis of the company’s value.

Related: Insider Tips for Crafting a Cannabis Business Plan That Attracts Investors

Sensitivity analysis

Using appropriate discount rates, investors conduct a review of what impact underachieving or overachiev­ing revenue, EBITDA or transaction multiple projections has on valuation. It’s with near certainty that CVC investors can expect that a company’s projected revenues and EBITDA won’t turn out to be exactly as expected. Therefore, many cannabis investors account for the volatility in outcomes by performing a sensitivity analysis of the future value of the target company. They specifically want to know what reasonable expectations are for a company’s future value should one of two things happen:

  1. The company misses their projected revenues or EBITDA, or —
  2. The multiples that a buyer’s willing to pay either increases or decreases due to market changes or other events.

Companies that are valued on a multiple of revenue are typically valued as such because the buyer is most interested in the value of the top-line revenue profile of the company. Companies that are bought and sold on the basis of an EBITDA multiple are an expression of either the buyer or investor’s desire to acquire an interest of the profitability of the business.

Replacement value

Another way to come up with a projection of a company’s value is to estimate what it would cost to build the business again from the ground up. Investors will sometimes perform a build-vs.-buy analysis. This means they’ll assess what it would cost to start at zero, hire the management team, and replicate the business. This is more difficult for a company that has significant intellectual property that may take years and millions of dollars to replicate. But in the case of a business that’s operating a physical production facility that doesn’t have anything proprietary to speak of, tasks like real state, business licenses, hiring staff and purchasing inventory can be done relatively quickly.