Author Archives: DVP

Valuation 301: The DCF and Forecasting

In my last post, I reviewed the various discounts and premiums to be applied in the market comparable approach to valuing a company.  Other approaches that use company specific earnings and cashflow include the capitalized earnings and the Discounted Cashflow (DCF) method.

A DCF requires a forecast of the company’s revenues and earnings and then a terminal value is established (to represent the value beyond the forecast period), all of this is then discounted to arrive at present values to be added up.  The discount rate must reflect the inherent risk in generating the cashflows and the terminal value must reflect the growth rate beyond the forecast period.  The cashflow used is “free cashflow” which requires adjustments for capital expenditures and working capital requirements and is net of taxes. Technically, the DCF is the more sophisticated valuation methodology but practically speaking the determination of the discount rate and the terminal value are highly subjective and small changes in assumptions can result in large changes in value.

Irrespective of the discipline brought to the process, multi-year forecasting can be challenging for any company and is particularly hard for early stage, new product/service companies.  I want to note three things about emerging company forecasts: (i) they should be bottom-up, (ii) they should be integrated, and (iii) they should sync with valuation expectations.  Many investor presentations will say: “…look, I only need to capture 1% or 2% of the market and I will reach $100M in sales”.  There are two problems with this statement, one you end up being a small market participant when VCs are looking for the sector winner and, two, you don’t say how you will get the 1%.

Forecasts should be bottom-up, meaning, they should reflect specific actions such as: (a), we will hire Joe and he is going to call 100 prospects and he will close 5 deals and generate $1M in sales in the first year; then, (b) in six months we will hire Mary and she will…etc.  Forecasts should be integrated, meaning an income statement should feed a cashflow statement which should feed a balance sheet on a monthly basis for at least three years.  Based on this investors can clearly determine the use of funds and impact on the cash position.  Lastly forecasts should result in the expected valuation.  For example, if you are looking to raise $5M for geographic expansion and you are willing to sell 33% equity for this, your forecast better illustrate an aligned use of proceeds and justify a pre-money value of $15M.

Once a sound forecast is prepared and the valuation math is solid, the question for the investor becomes; do I believe this team can, and will do a, b and c.  If they are comfortable with this, then the due diligence moves on to other items such as management’s past accomplishments, credentials, relationships etc.  While the value proposition and competitive differentiators are the primary attractions in a business plan, a sound, logical forecast is a core component needed to close a successful transaction.

While there are complexities in all valuation methodologies, it is perhaps most important to remember that value is relative and of the moment.  Whether that is relative to recent market information or relative in the context of an appropriate discount rate and terminal value.  It is affected by macro-economic factors such as public sentiment and company specific factors such as patents.  A valuation, like a balance sheet, is a representation at a moment in time but value changes on a daily basis.  Value does not naturally accrete with time.  When profit growth is accelerating there may be hubris but when it decelerates it will go away just as quickly.  When the collective wisdom decided that Apple’s growth would slow, it lost over 30% of its value in just three months.

Revenue Quality: What Does it Really Mean?

High quality revenue companies are valued higher than low quality revenue companies.  But what does this really mean and why is this? It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues?  Primarily it is about revenue continuity but also diversity and profitability.

Revenue Continuity
Long term customer contracts provide future revenue predictability.  In many cases capital projects will not get financed without long term customer contracts.  But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have?  What percentage of revenues can be counted on to recur every year?  Is the product/solution mission critical?  Is it embedded in your customers’ businesses?  Are switching costs high?

As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis.  In some cases upfront customization is required and in all cases customers have to learn how to use the new software.  Once customers have adopted such a solution, they will not switch very quickly.  The solution becomes embedded in another business’ processes which results in high switching costs.  As a result, its recurring revenues are usually quite stable.

There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.

Revenue Diversity
The greater the customer concentration the greater the risk.  The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a small company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value, the associated risk of these revenues will reduce value.

Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base.   Ideally no customer generates more than 10% of revenues.

If you operate in a low barrier to entry, fragmented market then it will be hard to increase prices and produce sustainably strong margins.  Of course different business models generate different margins.  For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%.  Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.

Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what.  But stuff happens.  Maybe this belief is based on personal relationships which cannot be sold with the business.  There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin.  Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.

The Top Five Impediments to Securing Exceptional Value in the Mid-Market

Many owner-entrepreneurs develop expectations for their business’ value based on news items and industry chatter about M&A and financing activity.  However, the small percentage of transactions that make the headlines are not reflective of the average transaction.  The factors we see most often (not in order of frequency or importance) that prevent private mid-market companies from achieving a premium valuation include:

Small Size:  Most transactions in the news concern multi-billion companies.  While we have seen one in a million start-ups fetch billion dollar valuations, most small companies are discounted to larger companies because of their riskier operating profile and because there is less liquidity in the lower end of the M&A market.  Companies valued at less than $10M will not find as much interest as larger companies.

Customer Concentration:  The issue of customer concentration varies by industry and by business model.  In the automotive sector, if you are a supplier to Ford, GM, Chrysler, VW, Honda and Toyota; six clients, then you are in a good position.  Generally, for B2B companies one would like to see at least 20 clients and if your business is a cloud based consumer or SMB focused business than 100 or even a 1000 clients will be seen as small.  Ultimately, it is not the total number of customers that is the measure of risk but the exposure to any particular customer.  Ideally no customer generates more than 10% of revenues.

Modest Growth Rate: Growth needs to be measured over an appropriate period and in the context of the economy and peers.  While a single digit growth is respectable for a mature company, in many sectors it needs to be double digit to warrant a premium valuation.

Principal Goodwill: Principal goodwill is the value of the knowledge and relationships that the Principal holds.  Large companies have documented relationships, usually multiple points of contact and formal processes for dealing with change.  This reduces risk and improves value.

Lack of Business Model Focus: The challenge with a business pursuing various services and segments at the same time is that it reduces the buyer universe.  As an example, take a business that starts out as a IT services/consulting business and then develops a SaaS based service.  It gets some traction and now the revenue mix is 60% consulting and 40% recurring SaaS revenues.

We would market this business as having recurring revenues but to pure SaaS companies this would dilute them.  Certain consulting businesses won’t have the appetite or capital on hand to invest in the marketing that the SaaS business needs.  Lack of focus in the business model will reduce buyer interest and hence value.

So, what does produce a headline grabbing valuation?  Simply put, you have to be viewed as being on a path to achieve a leading position in a new segment that is expected to be enormous.  Rare, but we do have a number of Canadian technology sector examples including Hootsuite in social media monitoring, D2L in personalized learning solutions, Shopify in online stores and Wattpad, creating a brand new segment, in a community of readers and writers.

What Exactly Does an M&A Advisor Do?

In “How Does an M&A Advisor Add Value to the Divesture Process?”, I noted that M&A advisors typically charge between 3% and 7% as a success fee for managing the sale process for a company.  The question I addressed then was, will engaging an M&A advisor improve your expected sale value by at least 5%?

Here I would like to outline exactly what an advisor does in the process of a sale mandate.  At this point I am assuming that pre-mandate matters such as preparing a business for sale, value expectations and timing from a business and market perspective have been discussed and it is agreed that it makes sense to proceed.

The advisor side of the deal team typically includes a senior lead such as a Managing Director or Senior Vice President plus at least one Associate and/or Analyst as support.  In addition, there are usually international resources involved through foreign offices or foreign partnerships.  Depending on the language and culture of the region, these partners can do as little as buyer introductions to as much as negotiating and structuring deal terms.

An M&A advisor will: (i) position the selling company as a strategic fit for target buyers; (ii) present the opportunity to numerous logical and capable buyers; and (iii) manage the process along a defined and orderly timeline, in order to generate the highest premium possible.  We typically identify what we are responsible for in our engagement letters as follows:

– Conduct a review of the company in order to better understand the nature of its operations and value proposition to prospective partners including:

  • a review and analysis of the historical and prospective financial results of the company;
  • a review and analysis of operational, marketing, technical and other information regarding the factors that influence the cash flow prospects and risk dynamics of the company;
  • discussions with management regarding the operations of the company;
  • a review and analysis of public information and other available information pertaining to the company and the industry in which it competes, and
  • a review and analysis of transactions that have taken place in recent years among businesses whose operations are similar to those of the company.

– Prepare company overview materials in consultation with the company, which will provide prospective partners with an understanding of the nature of the company and allow them to assess value;

– Conduct a search to identify suitable potential partners, guided by any criteria provided by the company;

– Contact and screen potential partners;

– Assist the company in the preparation of due diligence documentation, a management presentation and related materials for review by possible partners;

– Negotiate with possible partners;

– Work with the company’s legal counsel, tax advisors and other advisors to assist the company in structuring the transaction so as to meet its financial objectives;

– Review the documentation in respect of the transaction; and

– Other functions as required in support of the transaction, and as agreed to from time to time.

The whole process may take six to eight months and the M&A team will spend somewhere between 400 and 700 hours on a file.  M&A advisors will have a lot of familiarity with legal documents and tax issues, but ultimately lawyers and accountants are required in the areas of due diligence, purchase and sale contracts, and tax planning.

M&A advisors often highlight how competitive bidding between several eager buyers resulted in an extraordinary price for their clients but, like the over-night success story ten years in the making, a completed divestiture relies on a foundation of thorough planning and process.

Managing Operating Risk To Drive Value

In my previous post I said that if revenues are diversified and sticky then they are characterized as high quality.  A business with high revenue quality is one that will likely be around for some time to come, and is therefore highly valued.  However no business is risk free.  If your revenues are project oriented with little opportunity for repeat business, or you operate in an industry with low barriers to entry, or a people dependent business such as consulting, advertising or staffing, then what can you do to realize as much value as possible?

Mitigate the risks inherent in the business model by focusing on the following:

Differentiate your Product or Service
While at first glance, it may seem hard to differentiate a business in a well established and competitive sector, keeping an eye on consumer trends combined with creative marketing can often carve out a new profitable niche and present a tremendous growth opportunity.  Lululemon Athletica in the apparel sector and Chipotle Mexican Grill in fast food are examples of effective differentiation strategies.

Grow and Strengthen Customer Relationships
Reduce the unpredictability of project revenues by nurturing customer relationships.  If you can show that the same customers use your services several years in a row then you have an argument for revenue predictability.  If that list of customers is more than twenty then you have an argument for revenue diversity. Length of customer relationships is also a good indicator of a high quality product/service.

Focus on Execution Excellence
In a service business, it comes down to attracting and keeping the best personnel in order to deliver service excellence.  Human resources is a complex, multi-dimensional field and should include processes for recruiting, role definition and responsibility, position incentives and benefits, periodic feedback, and documentation and procedures to fill gaps in the case of unexpected departures.

Add Products and Markets
A one product company is riskier than a product line company.  A local company is riskier than one with a multi-national presence.  While it is easy to over-extend yourself, consider managed product and geographical growth to mitigate risk.

Cultivate Multiple Supplier Relationships
Don’t let your business become “captive” to a sole supplier of component parts.  Cultivate multiple supplier relationships to reduce supplier power and dependence.

Improve Profitability
Analyze your profit margin to see where you want to drive your sales — to higher-margin areas.  A trend of improving margins as a result of operational efficiencies and returns to scale will result in a higher valuation.

Protect Intellectual Property
IP can be patented, copyrighted or treated as a trade secret.  Identify the IP in your business and make sure it is protected and properly owned.

Build Your Brand
Spend time on all of the above will build your reputation and your brand.

The following chart summarizes various characteristics that drive company value.

op risks

Operating risk should be addressed by implementing formal processes.  A business with formal processes, systems and documentation reduces the dependence on individual talent and can quickly respond to exogenous shocks.  Items such as Service Level Agreements (“SLAs”), marketing plans, job descriptions, employment contracts, confidentiality agreements, professional codes of conduct, organization charts, etc. institutionalize a business.  Documented processes are transferable value.  Capturing and transferring knowledge will make the business more sustainable and more valuable.

If potential buyers feel that a business has a high risk profile, they will either not buy it, reduce the price they are willing to pay, or make a portion of the price contingent upon the business’s future performance.