How can I calculate the value of a business?

Oh, that's a big, big question. There are some standard approaches to calculating the value of a business, but they're rarely useful in this sort of situation (things like 24x monthly revenue, for example). Instead, I would suggest that you have a pessimistic analysis of future business growth, calculate per-customer revenue possibilities, and project that out 18-24 months.

For example, let's say you want to purchase an Internet business that has a gross income stream of $7.50/customer/month against marketing and server hosting costs, etc., of $5.00/customer. However, it turns out that the ongoing costs are fixed, so if you can attract more customers, you'll be more profitable exponentially (that is, 1000 new customers isn't worth $2.50/customer in monthly profit, but closer to $5 or even more). Make sense?

Now we have a baseline. For 100 customers you have a gross income of $750 against operating costs of $500, a miniscule profit of $250/month. If you can double that customer base, however, your gross income of $1500 goes against that same fixed $500, so you'd be in pretty good shape at that point with $1000 profit per month (see how we doubled the customers but quadrupled profit?)

The next question to address is how quickly can you realistically grow the customer or membership base. It's nice to project 2x on a monthly basis but imagining that you're going to compete with MySpace in 18 months is perhaps a wee bit optimistic. :-) Instead, you can project a steady 20% combined growth month to month, and if we start at that core base of 100 customers, that means that month #2 has 120 customers, month #3 has 144, and so on, to where month #12 has 743 customers and month #24 has 6,625 customers. If your fixed costs were constant, you'd be doing great by then, pulling in a cool $49,185/month in profit!

If your costs didn't increase as your customer base did, and if you really could get a predictable 20% growth every single month, then I'd say this business would be pretty darn valuable. If you just summed up the projected profit for those first two years, it'd be $282,363, so you'd be looking at a company ostensibly worth a quarter-million, even though it's currently only generating $250/month in profit.

The problem here? There's no way in the world that you can grow so smoothly and keep your costs fixed. That's where just about all startups fail with their financial projections: we aren't looking at churn (the percentage of customers that quit on any given month) or any other variable cost. If you assume that you're going to lose 10% of your customers each month, for example, then we can, for purposes of calculation, say that's the same as cutting our 20% growth rate to 10%, which dramatically changes things: in month 24 you have 895 customers now and the sum profit for the two years is only $54,373.

Here's a simple Excel spreadsheet that lets you play with the numbers and see how even small changes in your assumptions can dramatically change the end valuation figures using this admitedly simplistic model:

Click to download the XLS file

Finally, I'm not privvy to any of the specific numbers for this opportunity you're considering, but I am sincerely hoping that you find what I've written here to be useful and helpful in your calculations. Be pessimistic, but positive, and good luck to you!

This article was written by Eric Savage, who has been involved with business and management for long enough to figure this all out.