Microsoft’s $8.5bn (£5bn) deal for the internet phone service Skype has once again thrown up discussion around the topic of valuation.
Valuation is not a precise science. The founders or existing share holders want to maximise the value. An investor is typically much less optimistic about the companies prospects and more acutely aware of the risks, and therefore wants to minimise the value. This is a minefield that can damage a company and moral of the team even after it is successfully completed. Years later founders can be resentful of deals that they thought underestimated the value and therefore robbed them of value.
So what is value? How can a loss making company with revenues of $9 million sell for $210 million; an idea on paper raise $10 million on a $20 million pre money valuation; whereas another company with revenues of £3 million making £0.5million profit sells for £3million ? Value depends upon an assessment of the future risks and potential and, in the case of a trade buyer, the strategic value and synergies that an acquisition can deliver.
Valuation Techniques
So how do these wildly different valuations come about? The answer depends upon why you are valuing a company and the techniques used. There are broadly speaking two types of approaches that are useful for valuing intellectual property based businesses: Discounted cash flow and market based approaches.
Discounted Cash Flow Approach: Conceptually all income/revenue based valuation techniques use discounting of the future as an underlying basis for coming to an assessment of the current value. The techniques vary but the assumption is that the business is worth some discounted sum of the future revenues or profit. The key assumptions are what stream is being discounted and at what rate. In practice DCF approaches are very hard to use for early stage technology companies as the projected financials are often extremely speculative and the variables determining outcomes many and various. DCF works best when applied to companies with a proven business model and a reasonable history of performance.
Market Based Approaches: How can a loss making company be worth millions? The answer lies in market value. Which is not so much a technique and more a hunch. The buyers feel that it would give them a compelling edge in the market that would transform their strategy and/or there is a compelling proposition with an excellent team who have proved they could build a successful company.
A highly experienced American venture capital investor explained this approach as follows:
“we believe that we can exit for over $200 million in five years time, we think that it will cost $15 million investment to get to exit, our target rate of return is 10 times over the investment period, we think that to incentivise management requires them to have 25% therefore resolve that equation and you get a pre – investment valuation and that’s as scientific as it gets.”
Just in case you are wrestling with the answer it is $5 million.
For many early stage investors investment valuation is even less scientific. Many funds in the UK have a view that all technology businesses that they are willing to invest in are worth £1 million irrespective of the technology or the market. This is not based on any assessment of exit value it is just a policy. If pushed they will offer the management team a ratchet or options package determined by achieved exit valuations that effectively give the business a higher initial valuation. In effect the approach is to say if you think its worth so much well lets see what’s achieved at exit and if it is much greater than our 10 times target you can get a bigger share of the upside.
Factors affecting Value
The biggest factor that affects valuation of technology companies is risk: market risk; technology risk; and management risk. An investor is looking at how to minimise these risks: does the technology meet a genuine unmet need or solve a real problem or is it a technology looking for a problem to solve; is the technology protectable and does it confer defensible competitive advantage or can it be easily re-engineered; is the management up to the challenge, can they work with investors, can they grow with the business.
As well as execution risk there is commercial risk – will anyone want to buy the business when an investor wants to exit.
Maximising Value
Technology businesses seeking to maximise value need to focus as much on managing the downside as emphasising the upside. This requires building the right management team; understanding the market and the value proposition in detail; getting the pricing right; creating partnerships with other businesses which can help take the product to market and create synergies.
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