WHETHER A COMPANY IS GETTING READY FOR A MERGER OR ACQUISITION OR PREPARING TO ISSUE STOCK-BASED COMPENSATION TO THEIR EMPLOYEES, ONE OF THE ITEMS ON THE TO-DO LIST SHOULD BE GETTING A VALUATION.
The three approaches to estimating the value of a company and its securities are the market, income, and asset approaches. Though these methods are widely known, and their formulas are simple math, a valuation analyst is needed to tackle the challenge of determining which of the three methodologies is most appropriate for the company.
In determining the appropriate methodologies, some important factors to consider include the following:
– Stage of enterprise development
– Milestones achieved
– Industry and economic outlook
– Competitors and risk factors
– Relevant recent transaction
– Enterprise cost structure and financial condition
Stages of enterprise are characterized as follows[1]:
– Stage 1: No product revenue; low expense; minimal product development; first-round financing from friends, families, and angels; securities issued as preferred stock and occasionally common stock.
– Stage 2: No product revenue; substantial expense; ongoing product development; second or third round of financing from venture capital firms; securities issued as preferred stock.
– Stage 3: No product revenue, operating at a loss; significant progress in product development; later financing rounds with venture capital firms and strategic partners; securities issued as preferred stock.
– Stage 4: Some product revenue; operating at a loss; mezzanine financing rounds; discussion for liquidity event.
– Stage 5: Operating profitability; possible liquidity event; securities issued as common stock and preferred stock conversion.
– Stage 6: History of operating profitability; remain private or IPO.
MARKET APPROACH
“A valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business” (ASC glossary).
GUIDELINE PUBLIC COMPANY METHOD AND GUIDELINE COMPANY TRANSACTIONS METHOD
Comparable companies should have similar industries, revenue and business model, financial condition, etc. Depending on the industries and enterprise, valuation specialists may need to select different multiples. More than one multiple may be selected; valuation specialists will need to determine the weighting by observing the correlation between prices, values, and each metric.
This methodology is generally not suitable for Stage 1 and Stage 2 companies due to their niche nature. Oft-times, early-stage companies do not have revenues and their projections can be highly speculative. There are usually not a lot of comparable companies, if any at all. Transaction data for similar companies can also be difficult to obtain. Their comparable counterparts are usually public companies that have matured and have a steady stream of revenue and reasonable projections.
BACKSOLVE METHOD
This method implies that the most recent round of financing is most indicative of the value of the company. Under this method, the total equity value of the company is allocated to each security in the capital structure using the Option Pricing Model and the “solved for” equity value is the Backsolve value of the company. Only an arm’s length transaction should be considered. To consider a recent financing, the funding should be highly negotiated between the company and sophisticated investors, should generally be within one-year, and should also consider the rights and preferences of each class of securities.
This methodology is suitable for a company that has a recent arm’s length transaction or a transaction that is about to occur. If the transaction is not negotiated, this method should be used in accordance with another methodology in order to alleviate the impact of the assumptions.
INCOME APPROACH
“Valuation techniques that convert future amounts (for example, cash flows or income and expenses) to a single current (that is, discounted) amount” (ASC glossary).
DISCOUNTED CASH FLOW (DCF) METHOD
This method utilizes financial projections and discount them back to the present value. The value of the firm is the sum of the present value of the discounted cash flow over an explicit forecast period (begins at period 1) and the present value of the continuing value (begins at period t + 1) at the end of the forecasted period of the firm. The equational form of the firm’s present value of expected future cash flow is:
The value of the firm is calculated using both the explicit period and a continuing period. The cash flow used can be in the form of Free Cash Flow (FCF), Net Income (NI), Earnings before Interests and Taxes (EBIT), Net Operating Profit Less Adjusted Taxes (NOPLAT), or Economic Profit if it provides an incentive to shareholders. Shareholders look at expected future cash flow as a major driver of the firm’s production value. The discount rate should be higher if there is a high risk associated with the cash flow projections. Though cash flow projections are the responsibility of management, valuation analysts must review their assumptions for reasonableness. In this case, the market Weighted Average Cost of Capital (WACC) is used because it is the opportunity cost of equity and debt invested in the firm valued at the most recent market without considering future inflation and interest rates. Identifying the expected growth rate (g) is undoubtedly one of the most important and hardest assumptions made. Valuation analysts typically default to the economic outlook and GDP growth rate.
This methodology relies on many assumptions such as projected cash flows, the discount rate, and growth rate. As such, it is not suitable for early-stage companies that do not have revenue or operating profit history. Stage 5 and Stage 6 companies may use this method if their projections are reasonable compared to their historical margins. Stage 4 companies may use this method with discretion, while Stages 1 to 3 companies should avoid this method considering their projections will highly be hypothetical.
ASSET APPROACH
“A general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities” (ASC glossary). It is important to note that assets that are not recognized on the financial statements should also be considered. This method provides a default value and serves as a “reality check” for the company.
COST APPROACH – REPLACEMENT COST
This method assumes the value of the asset to be the cost of substitute assets today. Adjustments such as depreciation may be made.
COST APPROACH – REPRODUCTION COST
This method assumes the value of the asset to be equivalent to the cost required to replace the asset with identical asset. This method does not consider current technology advancement and is used less than the replacement cost method.
The asset approach is most suitable for early-stage companies that have yet to raise an arm’s length transaction, so Stage 1 companies may utilize this method. Early-stage companies are valuable due to their intangible assets, so valuation analysts need to make sure to include intangible assets in the valuation. When using the asset approach, valuation analysts need to consider the state of obsolescence or impairment of the asset, sunk costs, as well as the developer profit component.
KEY TAKEAWAY
As a rule of thumb, early-stage companies without an arm’s length transaction should stick to the asset approach, mid-stage companies and mature companies should use guideline public comparable companies method, guideline comparable transaction method, and discounted cash flow, and any company with an arm’s length recent round of financing should consider the backsolve method. However, valuation analysts need to be careful. Although there are set formulas and methods to use, the key to a good valuation is the art and assumptions that are put into play