Valuation Basics

VALUATI ON BASICS and …. Practical Tips Contents Valuation Valuation approaches and models Arriving at valuation Valuation in special cases Negotiations and valuation In summary Anjana Vivek

VALUATION Valuation of an enterprise … the price of a share Let us look at an example now and consider the case of an offer by Hello Corporation for Buy Inc. Hello initially offered $18 per share to shareholders of Buy. This offer was first, increased to over $22 per share and then to $30 per share. All these offers were within the space of a few months. How does one look at this issue? Did the value of Buy, increase dramatically over the months in consideration? Do you really perceive that the fundamental value of Buy increased so rapidly - over 60% - from the first offer to the third? Or was it something else? On going into more detail, we find that there were some rival bidders in this case. So would you like to say that the 60% rise in offer price was because of the rival bidders? Can this likened to an auction, where each person bids for a prized item? We are talking about purchase of a business in this case; enterprises cannot be bought and sold as if they were items in an auction. Or can they? Let us now take a look at the valuation of a company in India, some years ago. If we look at the IPO, we find that the floor price was taken at a little over Rs.100 per share. Analyst reports observed that the floor price might appear high, if one looked at the existing earnings. However, they added that if one took a long term view, one might expect improvement in the earnings in the coming period. Subsequent to the listing of these shares, the share price saw a general upward trend, moving towards almost 5 times this floor price in about seven months. Does this mean that the IPO listing price undervalued the company? Or again is it something else? There is in fact one school of thought, which says that if the IPO price is marginally below the expected value, one can expect to see the price go up on listing. This would lead to increased interest in the company, which would in turn generate more trades, which would further increase the value of the company after the IPO. This marginal undervaluing is then a strategy route that some companies take, when they are deciding on the listing price. In the last few years we have seen stock market prices fluctuating widely. Often we talk of valuation and pricing of company stock in the same breath. This paper is an attempt to look at some of the popular methods of valuation and trigger thinking. Initial thoughts on valuation What we can see from these examples is that valuation of an enterprise involves many factors, including data collation and analysis. Other factors which impact valuation include elements of the strategy of the business, understanding the position of the company in the industry, understanding the impact of general economic trends on the ©av Valuation Basics: Class Notes 2

business and so on. In fact, most of the time, it is these latter points, such as strategy and economic environment, which impact the valuation more than anything else. Further, in the case of a transaction between two or more parties, it can also sometimes; boil down to what price the buyer is willing to pay for the stake in the company versus what price the seller is willing to sell the stake in the company for. We all can therefore see that valuation is not something that is fixed and constant. It varies, from time to time, depending on the transaction and the need of the buyer or seller. It depends on the negotiation skills of the buyer or seller. Valuation models use a substantial amount of data and quantitative information as inputs to arrive at the final valuation numbers. There is, however, also room for a lot of subjectivity in these numbers. For example, if we take a relative method of valuation, how do we select companies that are comparable? Do we select companies in the same industry or those which have the same size as the company we are trying to value? The selection of our sample and application of this method may lead us to different values in both these scenarios. Further, valuations are a function of time. A company, which has a very high value today, may have a different value tomorrow. Much of the valuation is because of assumptions about the future of the business, which itself is uncertain. Valuation of a company is undertaken with an eye on the future. We value a company because of its tomorrow, in most cases. This estimate of the future carries its own risk. The valuation models provide for the risk to be built into the numbers in different ways. Some of this is by taking a higher discount factor, by having an appropriate risk premium or by performing a sensitivity analysis by making slight variations in the key value drivers of the enterprise being valued. In brief, valuation is a perception of the value of a business at some point in time. It depends on the purpose of the valuation. It depends on whether one wants to buy or sell or is looking for equity investors. Bankers value a company differently for lending as compared to a venture capitalist (VC) who is willing to take a higher risk. Both the banker and the VC are interested in financing future operations of the investee company. Both the parties, want to get a financial return from such a transaction. However, both will approach the project with different views. So, is valuation a science or an art? This debate can go on. The question and answer are not as important as arriving at the fair value of a business. What are the elements to be considered, what data is important and how does one arrive at a final value of a business? VALUATION APPROACHES AND MODELS At the start of any business valuation exercise one has to look at the various methods of valuation which are possible and then try to select the method(/s) that could be appropriate. ©av Valuation Basics: Class Notes 3

The difficulty is that there are actually too many models to choose from. In addition, some methods can be modified and used with slight variations, depending on the situation and requirement of the valuation. As a result, valuation is sometimes a complex exercise. In this section, we try to look at some of the methods that are used and the special aspects of these methods. Environments Impacting Valuation The value of an enterprise depends on a variety of factors, key among them being the industry environment, both in the country or countries of operation, the socio-political environment and the company specific environment. Industry Global Value Company of Busines Figure: Factors impacting valuation It is not unusual to find two companies, in the same industry, operating in the same region, with approximately the same number of people, having different values. The difference in the value could be for a variety of reasons. In fact this is to be expected. No two businesses are alike, and this is captured in the difference in the valuation. The differences in the two businesses could be due to the experience of the key management team, it could be due to the customers that one company has as compared to the other, or could be due to certain patents or intangible assets held by one company and not held by the other. Sometimes, this advantage which one company has over the other, maybe be perceived, and may or may not exist in reality. This is because of the intangible "Brand-image," enjoyed by one company as compared to the other. A good valuation model should be able to capture this intangible. For example if a Discounted cash flow model is used, the "Brand-image" may be captured by increased future revenues of one company as compared to the other, which will in turn lead to increased cash flow. ©av Valuation Basics: Class Notes 4

To expand this further, let us take an example of two (hypothetical) IT companies in Bangalore, Gyan Technologies Private Limited (Gyan) and Wave (Wave) Technologies Private Limited. Assume that both are in the same segment of business, with almost identical current year revenues. Further, assume that the key management team of Gyan as compared to Wave, has more experience and domain knowledge. It is therefore, not surprising that, in the future, the performance of Gyan is expected to be superior to the performance of Wave. Of course, this is with the underlying assumption that the two companies are quite similar in all other parameters of measurement currently. These parameters include measurable assets and intangibles. In this case, it is expected that this superior performance of Gyan will lead to better appreciation from existing customers, and as the word spreads, will lead to increased assignments from existing as well as new customers. This will translate into higher future revenues for Gyan, as compared to Wave in the future, and will be reflected in the increased value given to Gyan as compared to Wave. To sum up, though currently, if measured on current performance, the two companies appear similar, in the future, it is expected that one company will outperform the other. As a result, there will be a difference in the enterprise value, which is based on future expectations, rather than current performance. Factors that Impact valuation Prior to an exercise in valuation, the enterprise being valued must be studied in depth. In an existing company, historical data and other information, would be reviewed. As mentioned earlier, this would include company specific information, industry related information in the context of the global environment for business. In a start-up, the future expectations from the company and industry would be used as reference points. When a start up is set up to take advantage of emerging opportunities in a new market, in the initial phase several assumptions and estimates are made regarding the future. The valuation model should be one, which attempts to capture these expectations in one form or other. Sometimes, in a nascent, yet to become stable industry, the initial phase is very volatile. Valuation can reach absurd heights and depths, in these situations. This is what happened in the case of the valuation of the first few so called 'Dotcom' companies. Valuations models were based on a variety of non-standard assumptions. Many companies were valued based on page hits. A multiple was applied for every page hit. Different new technology industries, have tried different valuation models. It has been said that some biotech companies have been valued based on the number of PhDs in the company. ITES companies are often valued at a multiple of revenue. This base revenue could be either the current year revenue, or future expected revenue. Further, the multiple ©av Valuation Basics: Class Notes 5

could be as little as 0.8 times the revenue or could go to many times the revenue. This multiple would depend on a variety of factors, including inter-alia, the specific company characteristics and other factors such as whether the previous year's revenue is considered or the future revenue. We can see from the above as to how variations of valuation models are used to arrive at the value of an enterprise. Let us now look at some basic valuation models. Valuation Models Valuation models are forward looking. A valuation exercises is an attempt to capture the expectation of the future of the business in a numerical form. Valuation models can be broadly classified into three types: Valuation Methods Cost Based Income Based Transaction Multiple Figure: Broad Classifications of Valuation Methods These methods do not get tied into watertight compartments. One does sometimes see the use of hybrid models that are a combination of more than one of these methods. Cost Based Methods In the cost based method for valuation, assets of a company form the basis for arriving at a final number. Broadly, we can classify this into the following methods: • Net asset value or Book value method • Replacement cost method • Liquidation method or Break up value method Net asset value or Book value method The book value method, takes the value of the assets as per the balance sheet of the company on the date of valuation. This method can also be used with some variations. The value of the business can calculated as a factor of the net assets, plus a mark up or reduced by a mark down factor. As an example of the mark down, consider an enterprise, ©av Valuation Basics: Class Notes 6

which has some possible concerns, and issues that are not reflected in current financials. This could be the possibility of technological obsolescence or expected changes in statutory regulations, which may affect future profitability etc. Replacement cost method In the replacement value method, assets in the financial statements are taken at current values to reflect their 'true" or 'fair' value. The prime consideration in this case is the cost of setting up an enterprise similar to the business being valued. Liquidation method or Break up value method In the liquidation value method, the value of a business is that amount which is realizable on sale of the enterprise, either as a whole or in parts. This model has to be applied with care. It is important to know whether there could be buyers who would come forward to purchase the assets of the company. If there are no expected buyers, assigning the assets a value would be a meaningless exercise. There could also be a situation where a company is split into parts and sold. Here the liquidation value will not be a simple summation of the different values of the individual parts. The other costs of liquidation would also have to be deducted from the value of the enterprise. Ultimately, the value should be a realistic, realizable value of the enterprise on liquidation. Income Based Methods Income based methods are the most widely used. These are further classified into the earnings capitalisation method and the discounted cash flow or Net Present Value Method. Earnings Capitalisation Method or the Profit Earnings Capacity Method (PECM) In this method, the earnings of the company being valued are capitalised at a rate which is considered suitable. This method is profit based and values the company in terms of the profit earning potential. For example assume that Company Profittee Limited is earning post tax profit of Rs. 5 crores and we would like to capitalize this at 10%. The value of the Profittee Limited under this method is equal to Rs. (5/10%) crores, ie Rs. 50 crores. This is a simple method of calculation of the corporate value. Discounted Cash Flow Method In the discounted cash flow method, the net present value (NPV) of discounted cash flow is calculated. It is typically assumed that the business being valued will have a growth ©av Valuation Basics: Class Notes 7

phase, followed by a steady phase. In the growth phase, the business will be expanding and may have high capital expenditure. Revenues may grow steeply or jump to higher levels, as capacities are built up in the company. In the steady phase, the business growth may be slower than and not as volatile as in the earlier growth phase. The DCF model is a summation of the value of the company in the growth phase and the steady phase. The value in the steady phase is usually captured in the form of terminal value of the company. In some cases, the growth phase in turn is further split into two or more phases, with differing growth rates. In such cases the NPV is calculated as a sum of the value in the different growth phases and the terminal value of the company. The figure below, illustrates this, where a company has two growth phases, followed by a steady phase. Discounted Value: Phase 1 Discounted NPV of Value: Phase 2 Enterprise Discounted Terminal Value Figure: Net present value The cash flow model assumes that the enterprise is a going concern and that the value drivers of the company are also the drivers of the cash flow of the company. Transaction Multiples Method or Relative Method In the transactions multiples method (TMM) or relative method of valuation, the value of a company is calculated based on the values of similar companies. The difficulty is in identifying similar companies. Some common ways of selecting comparable enterprises is by identifying companies by way of size, ie in terms of revenues, number of employees etc. The other way is by looking at companies in the same industry, irrespective of the size. To illustrate this, let us take a company, Pleasant Services Private Limited (PSPL) in the ITES (IT enabled services) industry, with a revenue of Rs. 35 crores in the current year. PSPL expects revenues of Rs. 50 crores in the coming year. Some investors are interested in valuing PSPL. To arrive at the value of PSPL, one first tries to identify comparable transactions that have taken place in the past few months in the ITES industry. Out of the transactions that ©av Valuation Basics: Class Notes 8

have taken place five are selected. It is observed that the average value of these companies, in the transactions, was between one to two times the forward revenue. This input is used to value PSPL. One can directly use a multiple of 1.5 on the expected revenue in the following year to value the company. This will give us a value of Rs. 75 crores for PSPL. One can also make an adjustment to this multiple. Assuming that PSPL is superior to the companies being valued, one can even try to justify a higher multiple, for example, 1.75. This will give us a value of Rs. 87.5 crores for PSPL. On the other hand, one may feels that it is preferable to discount the multiple to 1.25, because of the size or nature of business of PSPL as compared to the other five companies which were used as the base for comparison. This will lead to a value of Rs. 62.5 crores for the company. Thus, using the relative method leads us to a value of the company based on its position relative to the other comparable companies in the industry. ARRIVING AT VALUATION As seen above, there are different options available to someone who is undertaking a valuation exercise. Selection and application of a valuation method is an important part of the process of valuation. How does one try to select from the various options for valuation? The valuation process has different stages, shown below: Data Validation Selection Valuation Validation Collection of Data of of the of the Valuation Company Value Model Relook at Finalise the the value valuation No Does the Yes arrived at exercise value stand starting up to from data scrutiny? collection Figure: The Valuation Process ©av Valuation Basics: Class Notes 9

A typical valuation process can consist of the following stages: i) Gathering information and data about the enterprise and the global environment ii) Validation of information iii) Selection of valuation models based on the data collected and preliminary analysis iv) Arriving at the value range of the company, based on the numbers that are used as input in the valuation models selected v) Review of the calculated value of the enterprise in the overall context of the transaction proposed Collation of Data In this stage, one has to understand the business environment in which the company is operating. One should collect information about the industry trends, in India and in the global environment. This includes data on expected future growth in this line of business, expected market shares, margins in the business and analysis of the competitive environment. It is at this stage that one tries to understand the underlying expectations of the company, in terms of its strategy viz a viz that of its competitors. This is of course assuming that the company has some strategy or plan for the future. This analysis is to be used in developing a business forecast. While forecast prediction can never be wholly correct, such analysis helps one get a clearer picture of the company and its position in the business environment. This in turn helps in getting a good valuation model in place. Validation of Data In this stage, we look at the business forecast and try to understand whether it is reasonable or not. The numbers and data must stand up to scrutiny. To illustrate this, let us consider the case of Swifter Private Limited, which is expected to have a growth rate of 20% every year for the next 5 years. If the industry growth rate is expected to be 12% in the next five years, then this growth rate of Swifter Private Limited is to be questioned. Is the company really in a position to deliver such super growth as compared to other companies in the industry? If so, then what is the reason underlying the superior performance? Is it better quality of products or service or cost efficiency or some Intellectual Property that the company has? What will happen to the value of Swifter if we reduce the growth rate to that of the industry, ie 12%? What will happen, if we take a rate of 15%, which is better than the industry rate, but still far below the super-optimistic rate of 20%? In essence, such deviations from industry performance are to be validated; otherwise, the valuation exercise will not hold credibility. ©av Valuation Basics: Class Notes 10

Selection of Valuation Model The selection of an appropriate model of valuation is sometimes easy, at other times, complex. A structured approach will help at this stage. One should first list out the possible basic models of valuation that are available and eliminate models that will not be suitable in the case in question. For example, if the enterprise is a start up, with negative cash flows in the first few years of business, we will not use the DCF model. The methods we select must reflect the methods used in the industry. In the IT enabled services industry in India; companies have been valued at multiples of revenue. While valuing a company in this industry, one must therefore, necessarily, value the company at a suitable multiple of revenue. If possible, one should try to select more than one valuation model, to arrive at the value of the company. If the value of the company varies with different models used, this can be a cause of concern. Either our calculations are flawed or one of the models is not suitable for application in the case under consideration. We should then look at our data and assumptions closely and go a step further to understand how we could address such discrepancies. Once one has narrowed down the models that can be used, one may try to do a quick ballpark calculation of the value of the company under the different methods. This will give the valuer some understanding about the appropriateness or otherwise of the models in question. The example below has two companies that are to be valued. We try to use the relative method in both cases. In Case A, we find that we can use the relative method for calculating the value of the company, Meadows Private Limited. In Case B, however, we find that the relative method is not appropriate to value PencilPens Private Limited. Example Application of the relative method of valuation to an enterprise. Case A In this example we try to arrive at the value of Meadows Private Limited, based on the enterprise value of three listed companies, Garden Limited, Parkland Limited and Plantation Limited. Garden Parkland Plantatio Average Limited Limited n Limited Enterprise Value/Sales 1.5 1.2 1.2 1.3 Enterprise Value/EBIDTA 18.0 16.0 17.0 17.0 Enterprise Value / Book 3.4 2.8 3.1 3.1 Value ©av Valuation Basics: Class Notes 11

Solution: Application to Meadows Private Limited. Meadows P Ltd. Average Enterprise of three Value of relative Meadows Rs. crores companies Rs. crores Sales 180 1.3 234.0 EBIDTA 14 17.0 238.0 Book Value 74 3.1 229.4 The value of Meadows could be in the range of Rs. 229 crores to Rs. 238 crores, based on the above. Case B Let us now try to arrive at the value of PencilPens Private Limited, based on the enterprise value of three listed companies, Papers Limited, Documentation Limited and Printing Limited. Papers Documentation Printing Average Limited Limited Limited Enterprise Value/Sales 1.5 1.8 0.9 1.4 Enterprise Value/ EBIDTA 14.0 21.0 10.0 15.0 Enterprise Value/ Book 2.1 3.0 1.8 2.3 Value Solution: Application to PencilPens Private Limited. PencilPens P Ltd. Average of Enterprise three Value of relative PencilPens Rs. crores companies Rs. crores Sales 160 1.4 224.0 EBIDTA 10 15.0 150.0 Book Value 85 2.3 195.5 The value of PencilPens, using this method, ranges from a low of Rs. 150 crores to a high of Rs. 224 crores. Perhaps one may come to a conclusion that one cannot use the relative method for valuation in such a case and needs to look for an alternate method. Do you think that is the right conclusion? What is your view? Perhaps the ©av Valuation Basics: Class Notes 12

companies selected are not appropriate, the method may be fine. Thus in each specific case of valuation, one has to look beyond the obvious and come out with solutions, which are meaningful and practical to use. To trigger thinking • Where could the problems arise in this method of valuation? • If you were valuing the two companies in the above examples, how would you go about selecting the sample companies? • Faced with the problem in using this method in the Case B above, how would you proceed? Would you drop this method altogether? If not, how would you address this concern? These above examples illustrate broadly how one can select valuation models, to be applied in a given situation. The use of the method or methods of valuation also depends on the nature of the proposed transaction and requirement for this valuation exercise. For example, if an acquisition is proposed, the valuation should reflect the synergy expected from the proposed transaction. The future expected cash flows post the transaction will reflect this synergy of the combined new enterprise and will automatically therefore get reflected in this value of the combined business. However, if the two companies are valued separately, on a stand alone basis and their values summed up, this may be different as the synergy may not be reflected when they are treated as independent business units. The choice of valuation model and its application is critical to the valuation exercise and must be done with due care and thought. Valuation of the Company Once the valuation models have been identified, data is input to obtain the value of the company. We are all aware that there are many uncertainties in the business environment. While due care may have been taken while valuing the business, it is a fact that some assumptions have to be made. These get reflected in the data used in the valuation models and impact the valuation. To reduce the impact of subjectivity in the corporate valuation exercise, one can look at alternate scenarios. Assume that a company does not perform as well as projected in one case, the pessimistic case. In another case, the optimistic case, assume that the performance exceeds expectation. In the pessimistic scenario, revenues will be reduced and some costs may be cut as the company tries to work with reduced cash flow. In the optimistic scenario, both revenues and certain expenses may be on the higher side. One could perform a sensitivity analysis and calculate the change in corporate value due to an increase (or decrease) in sales of say 10% and some other elements of cost, such as salary costs or marketing expenses. ©av Valuation Basics: Class Notes 13

Such an analysis will highlight and help understand the possible impact of variations in the value drivers of the company. The value drivers would depend on the industry and nature of business. The sensitivity analysis would thus, provide a value range of the company for different levels of performance. In some cases, weightages are assigned to the different scenarios. These weightages are supposed to reflect the probability of each scenario occurring in the future. For example let us take three possible scenarios, optimistic, normal and pessimistic, where the value is expected to be Rs. 200 crores, Rs. 180 crores and Rs. 150 crores respectively. If the probability of each of these occurring is 50%, 20% and 30% respectively, the expected value of the company is calculated as: Value (expected) = (200*0.5) + (180*0.2) + (150*0.3) = 100 + 36 + 45 = Rs. 181 crores The valuation of the company, which is the key objective of this exercise, is to be done carefully. The final valuation of the company or the valuation range has to effectively capture the story behind the enterprise. Validation of Final Value Once we arrive at a value of the company, we need to again raise some questions such as: • Does the value reflect the expected future performance of the company, based on its strategy? • Does the value reflect the position of the company compared to others in the industry and other competing companies? • Does the value reflect the quality of the management? The answers to questions such as these will help us get a comfort level on the value arrived at. Let us take an example of the value of Seels Private Limited (Seels), which has been calculated to be in the range of Rs. 95 to 103 crores. If a similar company, PS Private Limited (PSPL), was acquired by another enterprise for Rs.85 crores three months prior to this valuation exercise, we would need to question our valuation of Seels. One could either question the valuation model, or the inputs to the model, or both. If however, we feel that the higher value in the region of Rs.100 crores, is justifiable, we need to explain why this is so. This may be because Seels is superior to PSPL, or perhaps because there is a buyer, Buuy Private Limited (Buuy), who is willing to pay this higher value. This in turn may be because of the strategic requirement of Seels, which could be anything from wanting to increase capacity within a short period to wanting to enter a new market. Thus, we would validate the increased value assigned to Seels as compared to PSPL, by looking into the reason for this. ©av Valuation Basics: Class Notes 14

If the value arrived at appears incorrect or inconsistent with other available information, one needs to take a relook at the enter valuation exercise. For e.g. if the value of a listed company is significantly below its market value, one would try to understand where the difference could lie. Is it that the • data is not correct, or that • data has not been correctly input in the valuation model, or is • the valuation model itself not suitable for this exercise? Another reason could be that the market is assigning a higher value to the company, not based on its intrinsic worth, but based on the general market perception of the industry. In this case, one would actually need to revisit all the five valuation stages, listed earlier. Additional information and data, which may be obtained at this point, would be fed into the valuation model. There are many factors that affect the value of a company and need to be kept in mind while reviewing the enterprise value arrived at using valuation models. Some of these are: • Strategic requirements - These can override other considerations. For example, an IT company in India may be willing to pay a premium to buy a small company in US, because it wants access to some new markets in this country and perceives such acquisition as a means to achieve this object. Can you think of such examples? • Many interested buyers - If there are many bidders for one enterprise, the value of this company will be higher than what it would have otherwise been sold for • Flavour of the season - Sometimes select industries are perceived to be on a growth path. Others who want to enter this industry may prefer to purchase an existing company, albeit at a higher value, as this may be easier than starting a new company. This will in turn lead to increased values for all companies in the industry in question • Control premium - Sometimes persons who are investing in a company may want a controlling stake in the company in order that they can influence the future directions of the company. In such a case, they would be willing to pay a premium on the value of the company, which is arrived at based on the valuation model. A value is not necessarily a fixed, well-defined number. The overall value of the company is dependent both on the intrinsic value of the enterprise and the reason behind the valuation exercise. VALUATION IN SPECIAL CASES Standard models of valuation cannot always be applied. There are some situations where the valuation models discussed in earlier chapters have to be modified to take into ©av Valuation Basics: Class Notes 15

consideration the special nature of the situation. We take a look at some of these situations in this section. Valuation for Mergers and Acquisitions The majority of the valuations for M&A activity is done keeping a possible deal in mind. In case of such valuations it becomes important to understand the strategic rationale behind such a deal. M&A transactions are proposed when synergy is perceived between the merging companies. This could be in terms of increased revenues, reduced costs or other intangibles. Prior to the valuation exercise, it is useful to raise some questions on the proposed transaction. For example if an acquisition is being made to enter into a new area of business, one would value the target company keeping the following factors in mind: • What are the advantages of entering this new business segment? • What are the costs of setting up a new unit from scratch? • How much time and effort is saved by buying this company as opposed to setting up a new business • What is the competition for the target company? • How is this company more suitable for acquisition as compared to others in the same area of business? Is it because of the management, the infrastructure or something else? • Is there any other alternate company one could acquire or purchase? • Is it necessary to acquire this company, or some other company in this industry, or can one just look at a controlling stake? • Will getting into this new area, provide the acquirer an edge over competition? Are any soft issues such as HR integration likely to be faced on acquisition? • Are there any possible acquisition issues such as IT policy integration of the two companies, integration of administrative processes etc. likely to negatively impact the deal? • Are there any legal issues that can impact this transaction? • What could be the tax related issues in this transaction? The above questions are illustrative and not exhaustive. Regulatory and tax issues are also key deal issues, particularly in the case of cross border deals where regulations of more than one country are involved. These must be factored into the valuation and deal structuring. Once we have some answers to questions raised and some understanding of the rationale of the proposed transaction, we can proceed to valuing the business. The example, below illustrates the impact of expected synergy on the valuation of a company which is a potential target for acquisition in three situations in Case A, Case B and Case C. ©av Valuation Basics: Class Notes 16

Case A Sw Technologies (Sw) proposes to acquire Hardwiring Company (Hw). The following are cash flow projections for the next 5 years of the two companies, on a stand alone basis. Sw Amt. in Rs. crores Year 1 2 3 4 5 CF 20.0 23.0 30.0 38.0 50.0 Hw Amt. in Rs. crores Year 1 2 3 4 5 CF 2.5 4.0 6.0 9.0 12.5 The following is the expected cash flow of the combined business, due to operational synergies envisaged: Sw and Hw together Amt. in Rs. crores Year 1 2 3 4 5 CF 23.0 28.0 38.0 50.0 67.5 Please note that in the above example, the value of the cash flow of the combined business is shown as being greater than the sum of the cash flow of each of the stand alone companies. Do you think this is correct? What is the value that Sw can pay for Hw, assuming a discount factor for the cash flow, provided below for convenience? The net present terminal value after the five years has been calculated as Rs. 132 crores for Sw and Rs. 32 crores for Hw. The net present terminal value of the combined business after 5 years is calculated to be Rs. 170 crores. Year 1 2 3 4 5 Discount 0.833 0.694 0.578 0.482 0.401 factor 3 4 7 2 9 @20% Solution In the first step, we calculate the synergy expected by subtracting the cash flow of Sw on a stand alone basis from the cashflow of Sw and Hw together. This works out to: (Sw and Hw together) - Sw Amt. in Rs. crores Year 1 2 3 4 5 CF 3.0 5.0 8.0 12.0 17.5 Next we calculate the Net Present Value of the synergy expected in the next five years with the 20% discount factor. This works out to Rs.23.42 crores. ©av Valuation Basics: Class Notes 17

Third, we add to this we the expected synergy on account of the terminal value which is Rs. 38 crores (170 - 132). This results in a value of Rs.61.42 crores, which is the total value of the synergy in the combined business. Therefore, the maximum amount that Sw can consider paying for acquiring Hw is Rs.61.42 crores. Case B In the example above, assume that the two companies had several rounds of negotiation. The final price offered by Sw was Rs. 55 crores . Do you think that the shareholders of Hw should accept this price? Solution The proposed deal is now viewed from the perspective of Hw. For this we need to calculate the stand alone value of Hw. The NPV of Hw for five years is Rs.17.70, based on the discount factor of 20%. To this we add the terminal value of Rs. 32 crores. Thus the NPV of Hw on a stand alone basis is Rs. 49.7 crores. Since the price of Rs. 55 crores, offered by Sw, is higher than this price, the shareholders of Hw can accept this offer. Example Continuing with the case of Hw and Sw, consider three scenarios where the deal price is Rs. 45 crores and R.s. 52 crores and Rs. 65 crores respectively. In each of these cases, who benefits from the deal Sw or Hw? Solution If the price is Rs. 45 crores, all the benefits are with the shareholders of Sw. If the price is Rs. 52 crores, both the companies get value out of the deal. If the price is Rs. 65 crores, the deal has been over priced and the shareholders of Sw will not realize any deal value. A point of caution is that, in reality, monetary concerns are not the sole drivers of M&A transactions. The case of Hw and Sw above illustrates only monetary benefits. If there are strategic reasons for the acquisition, the price while an important issue, may become a secondary factor. The deal maker or breaker issue, could be something else. Another factor that can also play a crucial value in determining the final price at which a deal is closed is the negotiation skills of the parties to the transaction. A skillful negotiator may be able to get more value out of a deal than someone else. Valuation is also impacted by whether transaction are all cash deals or cash cum stock transaction or stock swap transactions. The value arrived at will be impacted by the ©av Valuation Basics: Class Notes 18

nature of the consideration. In some deals, the payment is structured based on future performance. For example, some cash payout could be promised after a period of time, such as a 20% additional cash payout if performance targets are met. This breaks down the valuation into two components, a basic fixed price and a flexible payment, linked to future performance. Valuation for Multi-business Sometimes one has to value a company, which has diversified into several industry sectors. Each sector will have its own risks, rates of return and growth and other special factors. In such a case the company can be valued by the "Sum of Parts" method. Each business unit is independently valued, based on the industry in which it operates. For example a company may have one unit in IT services and one in textiles. The two are in totally different sectors of operation. Obviously we cannot have the same growth rate and discount rates for the two areas. The two units are valued separately as if they were two separate, independent, enterprises. To get the final value of the enterprise, we take the arithmetical sum of the independent business units and then, reduce from this, the unallocated enterprise costs. Examples of unallocated costs are corporate overheads, advertisement costs of the company which are not specifically related to a business unit, listing costs of a publicly listed company etc. The advantage in this method is that it helps understand which of the business segments drive the value of the corporate group, in other words, which units are more valuable to the company. One can actually get some understanding on whether the units are independently more valuable, or whether there is some synergy which makes the company as a whole more valuable than the individual parts. This can be particularly useful in restructuring exercises. Valuation in cross border transactions As we see many global companies coming up, cross border transactions are increasing. Handling such transactions can be complex due to many factors, including: • Foreign exchange fluctuations • Difference in statutory regulations • Tax related issues • Difficulties in ascertaining cost of capital • Country risk, including political risk • Multi country transactions • Differences in accounting standards and policies ©av Valuation Basics: Class Notes 19

Let us take an example of a US company, which has subsidiaries in UK, Italy and Japan. If the UK company does business with the companies in Italy and Japan, then the foreign currency transactions have to be translated more than once during the valuation exercise. As valuation is generally based on forecasts for some years in the future, this involves forecast of exchange rates in many countries, some years into the future. Statutory regulations and tax issues such as transfer pricing rules and regulations, impact of tax treaties and tax planning strategies can impact cash flows. Some countries also have restrictions on transfer of currency by way of a cap on the amount of funds that can be moved out of the country freely. Regulations can, therefore, significantly impact valuations. Accounting standards vary from country to country. Some areas where accounting standards differ are accounting for provisions such as pension, goodwill, revaluation of assets, deferred taxes, foreign exchange, non operating assets and taxes to name a few. When companies operate in different markets and regions, it becomes very difficult to estimate the cost of capital. Capital can be raised in one country and used in another. Other difficulties arise when trying to calculate risk premium in different countries and the impact of illiquid capital markets, inflation and political risk. In all these areas, suitable adjustments are to be made for valuations. Assume that one is trying to value a company in US that has a UK subsidiary, which has international transactions. One would first prepare the financial statements and business forecast for the UK company, making all the adjustments and forex translations that are required. Subsequently, this would be converted into US dollars for valuation purposes. Valuation for Venture Capital Investment Venture capital (VC) investment is typically in high risk companies with high growth potential. Investors in such companies are willing to take a substantial risk if they perceive that there is an opportunity to get extraordinarily high returns. Many risk investors use the market multiple method for valuation. A popular method is valuation based on a one year forward revenue multiple. This involves a) forecasting the revenue of the immediate year ahead and b) arriving at the value by multiplying this one year forward forecast with a suitable multiple. The multiple will be arrived at based on comparable deals that have taken place in the market in the immediate past. This is the base value for negotiations. The difficulty arises when the deal multiples are not easily available as these are closely held companies. The difficulty also arises when the investors and promoters disagree on the revenue forecasts. Another method that is used by VCs is using an Exit Table in which they start with a forecast terminal value. VC investment is for a short period in a company, typically ranging from three to seven years. The Exit table assumes the period after which the VC will exit from the company and a value at this point of exit. ©av Valuation Basics: Class Notes 20

In order to look at different possibilities, VCs can change the parameters in the Exit Table to arrive at different valuations. There could be changes in the Exit value, there could be changes in the exit period and there could be changes in the discount rate. The value of the company is calculated for different scenarios to give insights into the potential risk and returns from such investment. Let us illustrate this with an example. Arc Ventures (Arc) wants to invest in a company, Entrep Private Limited (Entrep). The following information is provided: Expected terminal value $ 50 million Investment amount $ 4 million Exit period 5 years Discount rate 50% The post money and pre money valuation of Entrep is to be calculated along with their shareholding in Entrep at these values. The post money valuation is the term used by VCs to denote the value of a company after their investment. The pre money is computed by deducting the investment amount from the post money valuation. Solution We first discount the expected terminal value after 5 years at 50%. The Net Present Value of $ 50 million after five years at 50% discount rate is $6,584,232. This is the post money valuation. The pre money valuation is $ 6,584,232 less $4 million, ie $ 2,584,232. The stake of Arc in Entrep is $ (4,000,000 / 6,584,232) , ie 60.75% There are generally two key factors that drive the valuation in a VC backed start up. The first is the amount of cash burn in the initial period and the next is the stake in the company that the entrepreneur is willing to give up for this investment. The cash burn is something which has to be provided for as the company will otherwise not be able to continue in business. The VCs fund a substantial part of this requirement. The promoters of the company, however, cannot give up their stake in the company to the VC, beyond a certain point. Such an action would reduce their incentive to work in the company. Hence these two constraints become, in some sense, the value drivers of the valuation exercise in an early stage venture. The factors impacting pricing and valuation in a VC investment is explained well in this note on investment in Wireless Software Inc. prepared by Abraham Mathews, FCA, for the Akshara Study Circle, Bangalore. An extract of this is given below: ©av Valuation Basics: Class Notes 21

Wireless Software Inc. Wireless Software, Inc. was started by a technologist in February 2000. The company received start up funds from a venture capitalist - VC1. The initial seed round funding of Preferred A by the founder and VC1 was $ 4 million. A few months later came the Preferred B round for $12 million that brought in VC2 and VC3. The valuation post- Preferred B was $32 million. • Over the course of the next 18 months, Wireless changed its business focus • The global fall in valuations in its area of business, made the company rethink its strategy. Wireless shifted its market focus from the US market to the Asian market. The Preferred B venture capitalists continued to support the company, and brought in an additional $2.6 million in the Preferred C round. The valuation post-Preferred C was $8.8 million. Financing Rounds Investment Stage Investment Series Share price Funds raised in round Seed Preferred A $0.05 $ 4.0 million Round 1 Preferred B $2.00 $12.0 million Round 2 Preferred C $0.25 $2.6 million Total funds raised $18.60 million Equity Ownership Share holders Percentage of ownership Value of holding Post Preferred C round Technologist 15% $1.32 million VC1 15% $1.32 million VC2 and VC3 55% $4.84 million ESOP 15% $1.32 million Total Company 100% $8.80 million Pricing and Valuation Theoretically, while doing valuations, the guidelines that venture capitalists use are ratio analysis, price earnings ratios, discounted cashflow models, comparisons with recent transactions, etc. The more mature the start-up, the more likely these tools are going to give results that are closer to reality. However, for the very early stage companies, since the probability of the numbers being close to reality is quite low, venture capitalists are guided more by qualitative factors, such as the quality of management, similar deals that have taken place, etc. A rule of thumb used by some VCs is to value private companies at 60% of the valuation of comparable publicly listed companies. ©av Valuation Basics: Class Notes 22

If there are multiple rounds, in the first round, the valuation is likely to be largely based on qualitative analysis as there may not be comparable companies. In the second round, the VCs would look at the previous round valuation, how the company and the market have changed between the two rounds. Between this round and other filler rounds leading up to the IPO, VCs would question unreasonable increases in valuations between rounds. Most VCs know one another, and they normally club deals, hence, ensuring that they pay the same valuation. Finally valuation is more of an art in the initial rounds and becomes more scientific towards later rounds. The guiding principle is that there should be enough of an incentive for all the stakeholders – the founders, the employees and the investors. One technique that the VCs used in this case, was an exit table to compute their likely cash inflow on their exiting their position in the company, at different exit valuations. There were several rounds of negotiations between the various stakeholders, to decide upon an acceptable valuation, which would have an impact on the issue price per share of Series C, and would also result in the triggering of anti-dilution provisions of Series A and Series B stock. The agreed upon valuation changed the percentage holdings of the various stake-holders in the company, hence, the negotiation also centered around the final shareholding pattern. As it was a down-round, the VCs wanted an enhanced liquidation preference, since this would provide them with a far greater return on the later investment, as compared to the earlier investors. Hence, this brought in a pay-to- play situation, where existing stakeholders had to make fresh investments if they wished to protect their earlier investments. The concepts in this case were: • The Preferred C round VC looked at maintaining a certain % shareholding in the company, in order to control future operations. • The Preferred C round VC was extremely particular about keeping a priority in liquidation preference. Otherwise, the amount brought in was predicated by the burn rate that the company was expected to achieve, till it broke even. This imposed fiscal discipline on the company to reduce the burn rate. Valuation was effectively, incidental to the achievement of these objectives. The company had no option other than to accept the valuation fixed, in order to stay afloat. NEGOTIATIONS AND VALUATIONS Negotiations also have a key impact on finalizing deal values. Below is a write up which was originally published in the blog “Entrepreneur’s Corner” at www.citizenmatters.in; available online at http://bangalore.citizenmatters.in/blogs/show_entry/1112-negotiating- insights . This is a post on a role play in negotiations for sale/purchase of a business. The participants took different sides, some were buyers; some were sellers. There is an interesting incident on the impact of this role play. A day after the session, one of the participants was involved in negotiating the sale a unit of a family venture. She said that this role play helped her think through and plan for the deal, as a result of which ©av Valuation Basics: Class Notes 23

the family was able to get a significantly higher price for the sale of the unit than initially estimated. Negotiating Insights: From IIMB’s MPWE Programme Background: Negotiations are a part of life, whether it is in business or in the political arena, whether it is in selling a company or buying a stake in a business or raising venture capital for your company. In the last week of sessions of the MPWE 2009 at IIMB (Management Programme for Women Entrepreneurs) there was a negotiations role play for purchase/sale of a business. The participants were divided into 8 teams, 4 representing the buy side and 4 the sell side. There were therefore 4 sets of negotiations. The insights on valuation and negotiation were of high order. Rules: The rules were simple; a one page sheet of the case was given to the participants with a background of the company being sold as well as a sample set of companies. This was to help them arrive at a valuation range, prior to the negotiations. The groups were also given initial preparation time to plan and decide on their negotiation strategy. The 8 teams were instructed that they had to close the deal within the given time. They were also told that they had to really feel the part of the buyer/seller side and had to get into the role. The idea was to simulate a real life situation in a limited time period. Analysis: It was interesting to see the different permutations and combinations that came up regarding the sale price and deal structuring and the post deal plan. Three deals were struck, and the fourth set could not agree to a deal price in the time available. There were variations in the negotiating strategies and the deal price, however, some points were common across the eight groups and below are the key takeaways: • The fact that different persons negotiated differently came across very clearly. Some teams were able to take leading positions early on in the game, because of the way they took control over the whole process. • Negotiations are the starting point, many times if the deal goes through; the two sides have to work together in the future. It is therefore important to avoid getting into personal traits and offensive or overly aggressive stances. If one party feels it has been cheated or perceives unfairness, this will impact the future working of the combined entity, if the deal does take place. Therefore, it is important that the two parties realize that they should not perceive this as a battle with two opposing sides, but rather as a joint work to come to some agreement which is seen as fair to both parties. • Ultimately, the teams are made up of individuals and people may be sensitive to different things. Negotiators need to be aware of the signals sent out by these ©av Valuation Basics: Class Notes 24

individuals. Negotiations is about understanding or attempting to understand the needs of different people, in your team as well as in the team on the other side. • If team members of one group disagree in the meeting or give conflicting views, this can lead the other party to suppose that there is some problem to be addressed and can directly impact valuation and deal structuring. Thus teams need to be careful about what messages they are giving out, in their words as well as in their actions. • Sometimes, giving the other party a few options helps. Some examples: taking a certain percentage upfront for a certain value, taking some money now and some later, an option of keeping a board position, or an option to change the management of the company such as the CEO and CFO. • Sometimes news flashes about the business and industry are received and can change the whole tone of the negotiations. In the role play, there were two interruptions which announced some changes in the business and environment. These influenced the negotiators and the deal structuring changed as a result. For example, at one point, the buyers were given a message about a rumour that there could be a disagreement in the key team of the sellers. As a result, in one deal, the buyers decided to bring in a change of management and a part of the deal money was brought in as a severance package to the CEO of the selling company. • The side that was more prepared came out of the deal stronger. They went prepared not just with a valuation range, but also with a list of questions and answers to questions that they could be asked. These related to the company, the business and industry environment and the future plans post the deal, if it did go through. • Despite this being a simulation, for a period of time, participants actually felt that they were buying or selling a business and they felt pleased when the deal was finalized. This is of course to the credit of all participants who went into this role play with all seriousness and the outcome showed this. Many times, human emotion influences us to work towards deal closure, even though the financial aspects may not be very favorable. We need to be conscious of our emotions in addition to the financial and business aspects. • One of the participants summed up this set of sessions very nicely. She said, prior to this excercise, I thought I could just value my company and go out and raise funding for this, by offering an equity stake at a certain price. I now realize it is not like say ...one trying to sell something at a certain price point. There are many dimensions to sale/purchase of a business and negotiations play a key role in the price we can get. Conclusion: At the close, the learnings in the 4 different sets of negotiations were summarised and contrasted. The participants opined that these learnings and negotiating insights could help them, not only in instances where they had to sell a stake ©av Valuation Basics: Class Notes 25

in their company or raise capital, but also in other negotiations such as transacting with a customer or a buyer. FINALISING VALUATION Valuation is dependent on the nature of transaction and the reasons driving the valuation exercise. Valuation is also driven by market conditions. A business worth a significant amount at a certain point in time may suddenly lose much of its value a very short while later. This is what happened in many companies commonly referred to as ‘dot-com companies,’ which were valued at amounts which may seem absurd now…. in hindsight. Many persons look on valuation as a mathematical exercise; one inputs some numbers into a spreadsheet and hey.. magically we see a value of the company as per the spreadsheet. Is it really that simple? Is it really complicated? You can decide. This paper is an attempt to touch on some of the factors that impact the numbers that go into the spreadsheet. This is a vast subject, and the more one investigates, the more complex it can look. At the end of the day, this is a key component in any deal as the initial ballpark valuation is the starting point for any discussion between two parties. The author hopes that you have some answers to these questions and more: To trigger thinking: • Why do values of companies change from time to time? • Does value depend on whether one wants to sell a company, to buy a minority stake or to buy the entire company? • Will a strategic investor (for M&A) value a company differently from a financial investor (such as a venture capitalist)? • How can a company which is losing money have any value? ©av Valuation Basics: Class Notes 26

Valuation Basics

by Anjana Vivek on Sep 04, 2009

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Valuation Basics — Document Transcript

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