Issues arising in the valuation ofhigh-tech companies

Tzur Fenigstein
PricewaterhouseCoopers, Tel Aviv


High-tech companies are characterised by high losses or small profits in the first few years of operation. Some high-tech businesses do not make a profit in the first 10 years of operation. However, high-tech companies on average enjoy high growth rates. A high-tech business in its early stages can expect that it will grow on average much more rapidly than a traditional business or the economy as a whole. The problem is, of course, that there is extreme uncertainty regarding its future. It may enjoy very high growth rates and reach high profitability in the future, but the probability of the business failing is also high compared to more traditional businesses.

A further characteristic of high-tech companies compared to traditional businesses is that they have only minimal tangible assets but a number of intangible assets. In a traditional business, say a food factory, the business' assets are primarily production-lines, machines and other tangible assets along with some intangibles such as the know-how for manufacturing the food. However, a high-tech company such as a software company has little property, plant and equipment and the majority of its assets are not in the company's balance sheet. The assets are the knowledge and experience in the minds of the people that comprise the software company.

What other considerations are there when evaluating high-tech companies?
Firstly we should remember that cash is still king. The value of any business, whether it is traditional or high-tech, stems from its ability to generate cash. Before the Internet bubble popped people forgot this rule and started to believe that other metrics such as how many people come into a certain website were more important.

The second consideration is that the basic fundamental principles of investment remain the same. It doesn't matter if we are investing in a food company or a software company. This means that in both cases we should try to analyse the basic or the critical success factors based on which a business can survive and succeed. Due to the difficulty in analysing and making forecasts for high-tech businesses we should try to use more than one valuation approach. We should use cross checks where possible to strengthen our confidence in the value or the range of values that we receive.

But what are the key success factors or value drivers that influence a high-tech company's value? What are the value drivers with most influence? The first is the business opportunity. This value driver is not only relevant to the high-tech industry but, in this industry, the intensity of opportunities is stronger as is the pace at which each opportunity appears.

The next value driver is the unique value proposition that the business offers in the market and whether there is a sustainable competitive advantage.

Another value driver is the customer base of the company. In Internet companies, especially Internet service companies, the customer base is counted as the most important value driver in determining the business value. The bigger the customer base the bigger the success prospects of the business.

Then there is whether forecast growth can be substantiated. The value of the business is derived from its cash generating capability.

Next comes competition. The evaluated business offers a solution with certain competitive advantages to cater for a need in the market, but is not alone in catering for this need. There are other businesses that compete with it and one of the key success factors is the capability of the business to cope with competition.

Some venture capitalists perceive the management team to be the most important value driver. They are less interested in the unique technology or unique value proposition of the business but are mostly interested in how much management can deal with foreseen and unforeseen market opportunities and risks. As one venture capitalist said, they like to see "the spark in the eye of the entrepreneur".

But management capabilities are not enough. When we are dealing with high-tech start-ups we should be asking ourselves whether or not they can penetrate the market and succeed without any strategic alliance with strong market players. In most cases we find out that they cannot, no matter how unique and promising its value proposition may be.

Another key success factor is funding. In finance theory, funding is not a question. Whenever a business has an expected positive net present value then the question of funding is not a problem, the business is assumed to have enough. Finance theory and valuation practice mostly ignore the problem of funding and assume that if a business has good prospects then it will always be able to raise the required capital to realise its prospects. However, in practice we know that there are times when even good businesses with good prospects find it hard to raise money as potential investors, including venture capitalists, prefer not to invest as they fear that general market conditions will not allow a particular business to develop and pursue its strategic objectives.

Finally, we should remember that there are always things that can go wrong. A business could have an excellent business opportunity with a unique solution, developed with great competitive advantage against competition and with a growing customer base, excellent management team, strategic alliances and enough funding. But things still go wrong. Thousands of high-tech start-ups have not survived despite everyone being sure that they had the right service or product to offer at the right time and in the right place. Sometimes no-one can predict exactly what will catch on in the market.

The validity of different valuation approaches
There are three principal valuation approaches accepted by valuation practitioners. These are: the cost approach, the market approach and the income approach. Each is briefly discussed below.

The cost approach
The cost approach establishes value based on the cost of producing or replacing an asset. The principle behind the cost approach is that the fair value of an asset should not exceed the cost of obtaining a substitute asset of comparable features and functionality. In other words, replacement cost is the greatest amount that a buyer would pay for a specific asset. This approach is usually appropriate when we are evaluating tangible assets, for example real estate. When we are dealing with high-tech companies where one of the characteristics is that they do not have large tangible assets we may find the cost approach mostly inappropriate. The balance sheet of a typical high-tech company, especially in its early stages of life, does not reflect the real economic value of the assets that these companies own because the majority of them are intangibles such as knowledge, patents, brand names etc. These are not usually recorded in the company's financial records unless they have been purchased from another company.

The market approach
The market approach is used to estimate value through the analysis of recent sales of comparable companies or assets. Market derived multiples based on such measures as earnings, book value, cash flows and revenues and also other operational non-financial measures such as number of subscribers in cable companies or number of hits in cases of Internet companies are typically applied to the appropriate financial indicators or operating indicators of the subject entity to determine a range of values. However there are some major disadvantages in applying the market approach. Firstly there is always a difficulty in identifying comparable companies or comparable transactions and when we are trying to evaluate specific assets it is almost impossible to identify active markets or relevant prices for comparable assets.

The income approach
The income approach utilises the procedure generally known as the discounted cash flow method (DCF) of valuation. The DCF method measures value by reference to the enterprise's expected future debt free cashflows from business operations. This typically involves a projection of income and expense and other sources and uses of cash, the assignment of a terminal or residual value at the end of the projection period that is reasonably consistent with the key assumptions and long term growth of the business and the determination of an appropriate discount rate that reflects the risk of achieving the projections. Factors that form the basis for expected future financial performance include historical and projected growth rates, business plans or operating budgets for the enterprise in question, prevailing relevant business conditions and industry trends including growth expectations in light of general market growth, competitive market environment and market position. Typically a five to 10 year projection period of annual free cash flows is needed, plus an estimated terminal value, which represents the value of the business enterprise beyond the projected period. This is discounted to present value through the application of a discount rate that reflects the weighted average cost of capital for the subject enterprise. The present value of aggregate annual free cashflows plus the terminal value represents the combined debt and equity capital or enterprise value of the company. The income approach is the most acceptable method among practitioners and is also the most theoretically sound.

The income approach is also the most suitable for evaluating individual intangible assets. It may be misleading to evaluate intangible assets such as knowledge or other intellectual property using the cost approach as real economic benefits and value of such intangibles are different and often far above the cost invested. Equally, applying the market approach to intangible assets is also very limited as usually there is no truly comparable business.

The income approach however deals directly with cashflow. Also, as opposed to the market approach, the income approach tries to reflect all the unique characteristics of the subject business. In addition, when we apply the income approach we try to look, analyse and decide on the business's long-term direction and ignore occasional downturns or upturns which are influenced by general market conditions. This means we suspend the assumption of the efficiency of the market - judgementally we know that general market conditions and trends are not always reflective of the subject business conditions or a reflection of long term general trends of the market.

The income approach does however have certain disadvantages. It is the hardest approach to apply, as it requires a full financial model that forecasts future cashflows of the subject business. This is not an easy task, as it requires analysis of the business, the economic and regulatory environment, the competitive landscape of the business and so on. The second disadvantage of the income approach is that at times of turbulence such as the current market, it is harder than ever to estimate the future cash flows. In this context we should recall that we should estimate and discount only expected future cash flows i.e. not the most likely but the expected future cashflows. This is harder to estimate in times of turbulence, especially for high-tech companies. However, using probability based option analysis to calculate the expected cash flows can refine this approach.

Case study 1: the E-opportunity
Company A was an off-line direct marketing company. The company was considering moving on-line based on its existing marketing experience and customer base. The company was questioning the economic viability of the on-line move.

What were the valuation issues? Although at the time of the valuation there were several on-line direct marketing companies operating in the US there wasn't any such operating business in the local market. Furthermore, the business model of on-line direct marketing as compared to those of the existing US companies was quite complicated and included affiliation agreements, database management issues, leveraging off line databases etc. In addition, there were no comparable listed companies with similar business combinations and market characteristics even in the US. The companies that did operate in the on-line direct marketing business were also engaged in other businesses, either on-line or marketing businesses. Since we could not directly use the comparable approach we applied only the income approach but in two complimentary ways to strengthen our results.

The first way was a bottom up valuation and the second was a top down approach. For the bottom up valuation, we built a full financial model that projected cashflows for the online direct marketing business in the local market. We based the model on research of the US and the local markets for the following value drivers. First the size of an average customer database as a percentage of total Internet population, second the CPM number and other relevant fees, then the number of direct e-marketing campaigns per month, the size of campaigns by segmented population, the average revenue sharing parameters and other value drivers. Based on the value drivers we built detailed pro-forma models for the on-line local direct marketing business for that company and the model resulted in projected free cashflows which we discounted to estimate the value of the project.

In parallel, we also applied the top down approach, which was also based on research of the US and local markets but that focused on total on-line marketing business as a whole. We first estimated on-line marketing budgets as a percentage of total marketing budgets both in the US and local market. Doing that we differentiated between what is called in the advertisement and marketing world the "above and below the line". Then we estimated direct e-marketing budgets as a percentage of total on-line advertising budgets. We then applied these estimations to the company's projected market share of the estimated direct e-marketing budgets. Discounting the results we received estimates of value ranges for the project. Combining the results of the two approaches to valuation gave a reasonable range of values for the project of on-line direct e-marketing and also a forecast for the project's free cashflows based on which the company could estimate its financial requirements and how much capital it was going to require.

Case study 2: the innovative
Company B is a high-tech software company listed on a European stock exchange and engaged in the virtual studio market. The company develops and markets to media companies, TV stations, its virtual studio software and other services. The company established a spin-off start-up that has developed an Internet product that enables three dimensional interactive customer graphics based on video streams for the web. The spin-off was about to negotiate the licensing of its product to a large entertainment sport portal in exchange for some share in the portal. The objective of the valuation exercise was to estimate the value of the spin-off company as a percentage of the value of the entertainment sports portal in order to start negotiations on the ownership.

What were the valuation issues? Firstly a complicated revenue structure for the entertainment portal raised difficulties in calculating the product contribution to the portal's revenue. Secondly, there were no comparable transactions due to the unique characteristics of the product. Finally, there was much uncertainty regarding the portal's revenue volume.

Fortunately, on the positive side, the owners of the portal had prepared a comprehensive valuation of the portal so we based our valuation of the spin-off company on the portal's valuations. In order to prepare the relative valuation we applied the following steps. Firstly, we did market research of web usage patterns for the following value drivers: surfing habit parameters, among them surfing sessions per month; stickiness; pages viewed per surfing session; and unique users volume. We then estimated revenue-driving parameters including sponsorship fees, CPM, customer profile fees, e-shop transaction commission and subscribers' fees. Then we moved to the valuation model itself. We firstly analysed thoroughly the valuation model of the entertainment sports portal. The valuation model assumed four different revenue sources: selling of customer profiles data; selling of subscription fees to sports fans; advertising revenues; and e-shop commission. The valuation model of the portal was based on the net present value of these four streams of revenue less expected costs. To derive the relative valuation of our spin-off company we tried to conclude what influences the product of this company would have on users' surfing habits and other revenue drivers determining the level of expected revenues for the portal. First we built a three-dimensional contribution model to estimate the company's contribution to the portal over three dimensions. These were the volume of unique visitors in the portal, user stickiness and the revenues per page viewed. This three-dimension cube was built, analysed and estimated for each of the four-revenue sources. In each case analysis of the product's unique features of surfing patterns of users and of the characteristics of the portal itself helped us to conclude what will be the contribution of the product of the spin off company to the revenue increase in each of the four revenue sources. Then we aggregated all four types of contribution to receive total revenue uplift contributed by the spin off company and determine its relative value of the value of the portal and finally to develop a proposed revenue sharing model.

Conclusions
How should we approach the valuation of high-tech companies? We should always remember that apart from rare cases the income approach is almost always feasible although it can be very hard to apply in practice. If the cash flows are difficult to estimate, ignoring the income approach and applying the easy solution of using some kind of comparables just sweeps the problem of forecasting under the carpet. We should always ask ourselves whether this business is really capable of generating cashflows with reasonable probability. Finally, when applying the income approach for high-tech companies we should bear in mind that the major value drivers for these types of companies is the expected growth rate and expected profitability in the long run.

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