Valuing Technology Companies

Abstract

The Catalyst Briefing Papers series are intended to provide investors and management with general guidance on key issues facing growth companies. While all attempts are made to ensure accuracy, for the most up to date information please contact your authorised financial advisor, lawyer or local tax office. 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. The venture capital method uses the following steps:-Determ ine a rea list Proform a forecast.-Find Price to Earnings (P/E) rations for comparable businesses.-Determ ine a c om p a ny s future value by multiplying earnings by this comparable P/E.-Determine what % ownership is required to achieve the required ROI on the initial investment. For VCs this ROI is typically between 30% and 80% depending on risk.-This will determine the post-money valuation.