Though it’s often said that business valuation is more of an art than a science, we’d go one step further when valuing technology companies and call it 100 per cent art.
This is partly due to the disruptive, unpredictable and nascent aspects of the industry, partly due to the high growth levels often achieved – not necessarily in earnings, and partly due to the super-bright minds often behind the scene.
One therefore has to be wary when either acquiring or selling an IT company not to fall into the trap of relying on a formal valuation with its couple dozen or so pages of formula-driven analysis and excel spreadsheets. Leave these valuations to those people needing a figure for IPOs, divorces or tax reasons. The range of values will be extraordinarily wide and will not take into account many of the value drivers of today’s marketplace.
The wider marketplace of buying and selling businesses is very inefficient. It’s illiquid, there are not big numbers of buyers and sellers out there, and information is not easy to obtain. It’s at the other end of the scale to buying or selling a house, where there is no shortage of prospective buyers and nearly all the information is readily available.
This inefficient market can either work for you or against you. What is for certain is that a huge amount of work needs to be done to achieve a high price for a company. A well-executed exit can easily lift the transaction price by 50 per cent or more. Simply finding a shortlist of prospective purchasers that are actively looking for a specific type of business to buy is a substantial amount of work. The ultimate purchaser may not have even known they wanted to buy a particular business until it has been brought to their attention and its potential as an acquisition made clear.
So broadly speaking is this a good time to be selling up? Are we in a tech bubble? Notwithstanding the sky-high valuations being paid by Facebook and other industry behemoths for companies like WhatsApp (£16bn), technology industry valuations are not in a bubble like 2001.
Buyers are aware that many areas of technology are relatively new and once exploited, have the power to disrupt traditional models with the reward of large potential profits. The value to them therefore is the extra profits the technology will bring, compared to those profits the company would make without the technology.
How to get to a starting-point valuation of a technology company
Broadly speaking, there are two major valuation approaches being used to get to a rough guide of what the company should be worth. These are the Income Approach and the Market Approach.
This calculates the value of the company today as being worth the sum of its future earnings, in today’s terms (discounted to reflect the risk of that income eventuating).
Most technology valuation theories are based on this approach. The problem is obtaining decent forecasts in a volatile and new technology area, where disruptive competitors can spring up overnight. Notwithstanding, this is how many of today’s technology companies are valued and is the favoured approach when historic earnings figures are just not available i.e. when the companies are yet to record profits.
When looking at public internet companies or other high-growth tech companies, two common income approach ratios in use are enterprise value/next-year revenue and price/earnings-to-growth ratio (PEG), which uses next-year earnings. Both are ‘rules of thumb’ tools that focus on tomorrow’s likely performance in relation to today’s valuation.
This means that the valuation takes into account the immediate growth prospects rather than historical earnings or sales figures. Buyers are prepared to pay higher amounts for companies with higher growth prospects. A PEG ratio of less than one will suggest that the company may be undervalued, although it is worth remembering that this ignores economic conditions.
This is sometimes referred to as the ‘comparables’ approach. The company or its technology is compared to other similar companies or technologies recently bought or sold and a valuation estimate is interpolated. The problem with this approach is that innovative technology is often unique and therefore there isn't always something to compare it to.
The market approach will sometimes base a valuation on the price/earnings (P/E) multiple or a sales/earnings multiple. There are ‘rules of thumb’ applied in many tech sub-sectors. We have already noted that larger Software-as-a-Service (SaaS) companies often sell for around three to four times their annual sales. But at the lower end, ‘body shops’ like web design firms and IT consultancy firms can have a PSR (price/sales ratio) of around 0.5. Unique visitor numbers or Alexa rank offer other rules of thumb upon which valuation models for websites can be based. Theoretically any factor can be used to build a valuation model.
The Income Approach and the Market Approach undoubtedly have their uses. But neither take into account strategic behaviour, which is at the heart of many of the technology deals we read about in the press, and in smaller deals taking place below the surface.
What is the real value of the target company or its technology to the competition? This is where the traditional valuation methods can come unstuck. For different companies, the acquisition could have entirely different values. The sheer number of potential strategic reasons a company may want to acquire another often makes a valuation figure very difficult to assess.
If the company would otherwise fall into the hands of a competitor who are likely to leverage the acquisition to control a market, the value to some buyers will be huge if it means that by buying the business they can protect the market. A company may want to purchase a competitor to remove a brake to setting higher prices. Or, a company may want to acquire a competitor that buys the same resources, and the amalgamation reduces the ability of suppliers to set higher prices.
Other aspects affecting the strategic value of a company include the stage of development of the technology. How will the acquisition of the company affect the development timeline? Over and above the possible income the target technology company might deliver in the short and medium term, does the technology represent a distinct competitive advantage to the acquirer in respect of their current business initiatives?
Are you ready to discover the two biggest drivers of enterprise value in the global tech sector?
Talent and Intellectual Property
What staff are being brought across? This is one of the most important questions surrounding the decision to acquire. The search for talented, key tech people is currently driving the majority of deals at the innovative end of the tech sector. Whether in mobile or artificial intelligence, the highest prices are being paid not on the basis of multiples, distribution channels or cash flow. These are talent acquisitions.
In as many cases as not, a buyer is just as likely to be hungry for the developers, possibly with some core development process underway, as they are with the company's services and products.
If you have assembled a team of top minds in a tech sub-sector, you are sitting on a gold mine. Sure they will have to be seen putting together something useful, even if that is an assumption based on noise, to get under the radar of buyers. You don't need to look hard for examples. The £400m purchase of artificial intelligence company DeepMinds by Google. Few even know what it is they do! Or the £300m+ acquisition of games developer NaturalMotion by Zynga.
The Business Sale Report is based in London where some of Europe's most talented mobile app developers are beavering away on products that may or may not take off. What is certain is that companies like Facebook with an £11bn armoury are snooping around ready to pick off teams by simply offering to buy the company at a price they could only have ever dreamt about.
What is often overlooked is that Intellectual Property (IP) has become the biggest overall driver of enterprise value in the 21st century. Exit values of IT companies are particularly influenced by IP, which often represents the greatest asset on the balance sheets: something that prospective vendors ought to be very aware of. Poor IP planning can often result in a lower deal price, not to mention unnecessary due diligence.
Experienced tech company buyers are often skilled at recognising under-utilised IP and working diligently to increase its value over the long term. All companies should conduct an IP audit, but those intending to sell would be foolish not to ensure that all IP is documented, following an independent assessment, to maximise the deal value.
Whilst income and market approach valuations are useful in estimating a very basic valuation of a technology company, the art to obtaining a true valuation lies in understanding the market, bringing the company under the noses of hand-picked potential buyers and pointing out the strategic advantages of the deal.
Just Eat's recent acquisition of start-up online ordering firm Meal2Go is a perfect example of the difficulty inherent in valuing a technology business. Meal2Go provides innovative EPOS (electronic point of sale) technology, designed to work specifically with take-out restaurants. It has a strong position in the UK market, but its services remain relatively niche.
Niche they may be, but for Just Eat, buying up the business represents a valuable opportunity thanks in large to the firm's extensive take-out network.
JE's MD, Graham Corfield, noted that it will enable the business to meet the “huge demand”from takeaways for high quality EPOS technology, adding that the deal is part of a wider strategy to innovate and drive growth through bolt-on acquisitions and partnership deals.
The acquisition has a clear unique value to the online takeaway group, saving JE from investing in the slow process of developing its own system and instantly offering a tangible return in improving its customer service.
The Income and Market Approaches will not have been a huge amount of use in evaluating the company in this case, but Meal2Go's IP, staff and systems make it of great value to the perfect buyer, which in this case happens to be Just Eat.
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