Are you a corporation considering an acquisition or investment in a technology company? Maybe it can help you capture additional value from your existing customers OR protect you from other online attackers. Or maybe it seems like an exciting opportunity to earn some financial returns? However, you are taken aback by the valuation proposed by the startup and can’t seem to make sense of it given the startup’s current economics. If the above describes your situation well then you may find the below thoughts helpful.
Tech startups often lose money in their early years and therefore have the need to constantly raise capital as they fine tune their product, business model and operations. At the same time, they need to drive growth across segments and geographies to achieve scale that allows them to generate profits worthy of all the investment – the promised land. Not all tech startups succeed in doing so, therefore, as an investor you have to be careful about assessing the investment opportunities offered by tech startups. However, it is worth noting that most successful startups burn a significant amount of cash before starting to generate any – Amazon is a world famous example of such a trajectory!
Corporations with no experience of evaluating online businesses typically get taken aback when they come across relevant online businesses carrying a huge price tag while the bottomline looks highly unattractive. This shock is even more pronounced in family owned corporations, often with a significant trading business backbone, where the owners are used to consistent profits year after year and the concept of losing money for several years before the potential of earning any profits seems alien and unrealistic.
Given the MENA region is dominated by family owned corporations without a consistent track record of acquiring tech startups and successfully integrating them with existing businesses , this topic is very relevant for the region. If you are an owner or management team member of such a corporation and are considering investing or acquiring an online business, here is a methodology to assess the value of the target business in a structured manner.
Firstly, identify the intrinsic value of the target. This is the stand-alone value that any investor would be comfortable paying to acquire an equity stake in the target company. It does not consider any benefits that the target may contribute to your existing business in terms of bringing additional customers or new revenue streams or creating any efficiencies. Typically, investors look at one of the following 2 approaches to identify the stand-alone intrinsic value of the company.
- DCF (Discounted Cash Flow) based valuation: This approach relies on a good estimation of the company’s business evolution whereby one looks at the value of the expected future cash flows in today’s value. This methodology is much more relevant for more mature companies with stable cash flows and some consistency in track record. Unfortunately, for startups especially in early stages (seed, Series A and B), there is hardly any consistent track record and estimating future cash flows with some accuracy is extremely challenging if not impossible. Hence this approach to valuation is hardly ever used or recommended to value tech startups that are in their early stages. More often than not, investors use a comparable multiples based valuation, more on this below.
- Comparable multiples based valuation: This approach looks at recent transactions (investments or sale) at similar businesses (type of businesses / industry / stage of business) across similar geographies or markets and identifies the relevant valuation multiples (GMV, Revenue or Number of subscribers etc.). These multiples are applied to the performance of the startup being valued to arrive at a valuation. Please note that this isn’t a scientific approach to valuation of a company, it’s much more of “others are paying this much for similar businesses and therefore we think you should value it this much” type of an argument to defend the company’s valuation. Also, please note that one often finds a range for the comparable multiple that’s being used to value companies and it can be quite wide. For example, early stage marketplaces in MENA (Series A) typically get valued anywhere between 5 to 15 times the revenue. This doesn’t mean that some aren’t valued higher or lower than this range but most transactions would fall within this range for early stage marketplace startups. Now as you can see, there is a huge negotiation range and ultimately it’s the demand i.e. the number of investors willing to invest in a particular startup that determines which end of the valuation multiple it will receive. This approach also doesn’t really work for pre-revenue (seed stage) companies. For later stage companies (Series C and above), there is a track record and, theoretically speaking, one should be able to estimate future financial performance (and thus cash flows) with improved accuracy, and hence a DCF valuation is often done to triangulate and sanity check the results of a comparable multiples based valuation.
Then identify any incremental value offered by the target to your company. Please keep in mind that the below adjustments are only relevant if you are planning to acquire a controlling stake in the target. If you are considering a passive minority investment with no clear path to controlling the company, then the below synergies are not relevant to you, at least not at this time.
- Calculate the upside potential: Here, a corporation typically asks itself about the additional revenue (and therefore cash flow generation) potential that is offered by the startup if it were to be integrated into the it’s existing business(es). This additional value typically comes from either cross-selling the startup’s products to the corporation’s existing customers OR vice-versa; often it is the former as early stage startups have a smaller base but with the new generation’s increasingly digital lifestyle, it is no longer uncommon for corporations to consider the evolution of the startup’s customer base and its ability to target them with its existing products. Also, one needs to factor the efficiencies created by moving the corporation’s sales online. The need for fewer retail establishments in expensive locations, fewer frontline staff and potentially reduced complexity in operations are all tangible benefits that need to be quantified and added to arrive at the true upside potential offered by the deal.
- Identify the value of inaction: Online businesses have already disrupted plenty of traditional businesses and this disruption will continue. Technology offers far superior options to target and acquire customers and drive transactions (online) vs.the traditional way of doing business. Also, the online businesses have fundamentally different cost structures that renders traditional businesses in several sectors non-competitive. If your existing business is going away or is expected to go away the digital route, then you don’t really have a choice but to build or buy into an online business that allows you to continue to remain competitive and relevant in the sector. Unfortunately, this is the toughest message to digest for most traditional business owners, which is understandable given the legacy. However, one needs to dispassionately assess the downside impact of revenue and cost (and therefore cash flows) to identify the cost of inaction. Also, to better arrive at the “value of inaction” you need to consider the impact on your business if one of your traditional competitors were to acquire the target online business.
Once you understand the intrinsic value and the incremental value offered by a startup, you can better arrive at the price you are willing to pay. Of course, every corporation would want to keep the synergies (incremental value) to itself and kudos to you if you are able to do so, however, realistically speaking, be prepared to pay a premium if the synergies are significant.