- September 7, 2019
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Business valuation of an Internet startup
- In this blog, we will discuss on the business valuation of an internet startup. As the world is moving from offline to an online digital world, all commerce transactions are happening on the internet, which has resulted in more companies moving to an internet business model where majority of the transactions happen online.
- Valuing a website is different from valuing a conventional business as an internet business does not have any physical assets.
- In this blog, we will discuss on the relevant valuation drivers to value a website.On identifying the right data for these valuation drivers and applying it correctly, we shall arrive at a valuation which would make sense.
Business valuation main Challenges
- The website business to be valued can use different monetization strategies like SaaS, Adsense and Subscription, hence valuation needs to account for this.
- The main challenges to derive a fair business valuation would be:
- Incorrect valuation techniques used that are not relevant to the business model.
- Identifying and using wrong information in the financial model.
- Losing sight of the bigger picture, thereby losing clarity of the overall business model.
Selecting the right method for business valuation
Business valuation method 1 – Discounted Cash Flow Model
- DCF is one of the most common methods used to value a business.The model primarily forecasts the future free cash flow of the target business and discount it to the present value using the Weighted Average Cost of Capital – WACC.This model relies on the Time value of money and follows the principle – A dollar today is of higher value than the dollar tomorrow.
- DCF is most useful when valuing a mature business with predictable cashflows.Unfortunately, this situation is absent in most internet business which have irregular cashflows.
- In addition, the business model is immature with lack of availability of quality financial information which renders DCF a useful reference point to consider when valuing an internet business and not the one whose valuation can be relied upon.
Business valuation method 2 -Precedent Transactions
- Precedent Transactions primarily looks at historical acquisitions of companies that exhibit the same characteristics that of the target company. This valuation method is used as an additional point of reference to the DCF model to validate the price range of the target company.
- In addition to Precedent Transactions, Comparable companies analysis is used to compare the target company with similar businesses (Public and Private) to arrive at the price point.
- When looking at the Target valuation, it is important to identify the right valuation parameter. Most companies are valued at EBITDA and revenue multiples.By identifying the right valuation parameter, one can use the multiple to value the target company.
- Another important challenge in Precedent transactions is the lack of quality information available on the past transactions. When acquisitions happen between public listed companies, the deals are made public.As most of the internet companies are private, deal announcements are not shared on public domain.This increases the difficulty in finding the valuation multiples of relevant transactions.
Business valuation method 3 -Earnings Multiple
- The third major valuation method is the usage of earning multiples.In the case of public companies, P/E multiple is most commonly used together with EBITDA and revenue multiples.
- The usage of multiples is more common in Internet companies due to the lack of financial data available.
- A multiple led method would stipulate the buyer arrive at valuation by multiplying the Seller Discretionary Cashflow to a multiple which is deemed appropriate by all the parties.This multipe is dependent on the business drivers of the internet business and is critical to arrive at the valuation multiple of the target company.
A multiple based approach to business valuation
- Earnings multiple is a popular valuation approach used by the Internet companies.The two factors that the buyers need to focus on would be profitability and the factors that influence the multiple.
- The profit number that is important in a multiple based valuation approach is the SDE – Seller Discretionary Earnings.This is the cash left after accounting for the cost of the goods sold and the essential operating expenses that is needed to be incurred in the business operations. The owner compensation is not included in the SDE and if there are multiple operators in the business, then their compensation is linked to the market salaries in order to arrive at the free cash flow available.
- SDE is subjective in nature and an investor/buyer can interpret the discretionary expenses accordingly. In the case of internet business, the cost structures are simpler, hence there is less chance of deviations.While evaluating the financials of the internet business, the following items needs to be added back to arrive at SDE:
- Owner compensation
- Travel expenses that are not linked to business
Once the SDE is calculated, the next step would be to arrive at a suitable multiple.
Factors that influence the business valuation multiple
As an acquisition is a complex activity, there are multiple factors that can affect the multiple. The three main focus areas that can impact the multiple would be:
- Scalability of revenues
- Transferability of revenues
- Sustainability of revenues
Any factors that influence the above three core drivers would affect the multiple.
Some of the major factors are:
- How old is the business?
- Gross and net income trends in the past 3 years?
- Can the cost structure be replicated by the new owner?Are there additional opportunities for savings?
- Quality of earnings of the seller?
- Can the customer relationships and its associated revenues be transferred post acquisition?
- How much influence is an owner on the business?
- What percentage of traffic comes from search and what will be the impact when there is a change in search engine algorithm?
- How has the traffic been trending for the last few months?
- Where does the referral traffic come from and how sustainable it is?
- Involvement of the owner in the busines
- Can the buyer run the business without the owner?
- What is the owner contribution in building the technical IP of the business?
- Quality of the employees in the business and how are they managed?
- How competitive is the seller business?
- What are the barriers to entry?
- Is the overall market that seller business operates in is growing?
- How can the buyer expand the seller business in future?
- What is the quality of the customer base?
- What is the customer acquisition cost?
- If it is a SaaS business model, then what is the churn rate and Customer life time value?
- If it is one time, then how active is the customer base?Are they reordering?
- Licensing requirements to run the business
- Does the business infringe any IP?
- Any advantages on seller IP or trademark?
The above valuation drivers can be give a better clarity to the buyers on the quality of the seller business and help to decide the appropriate multiple.
The valuation multiples is dependent on the monetization model.In the current market, SaaS and Software products are priced at premium as these businesses have recurring revenues, followed by e-commerce business that addresses a broader audience particularly from the offline market.
Role of buyer in deciding the business valuation multiple
- In case of any acquisition, price for a business is dependent on the value that the buyer perceives. Hence the price of a business changes among strategic and financial buyers.
- Strategic buyers operating in the same or adjacent business will perceive the acquisition target complementary to its operation and hence consider this a bolt-on acquisitions or merger to realize cost/revenue synergies.
- In case of Financial buyers, more PE firms are floating buyout funds to acquire tech companies. The major consideration for them is the RoI or the internally governed IRR which would influence their final multiple.
- Leverage based buyers use debt to acquire a business and hence their valuation multiple would depend on the target IRR that covers the interest payments and principal on debt along with a return.
Due Diligence – An important step
- Due diligence is an important process to determine the right valuation of the business.Successful buyers who have realized value from their deals perform a robust due diligence.
- The valuation drivers give an idea to the buyer the areas to focus for evaluating a business where as due diligence is done to validate those value drivers to confirm the quality of the business.
- Successful acquirers never lose sight of the bigger picture when performing a business valuation.These buyers look within for value and look beyond for perspective.
- Buyers with a solid growth strategy have a bigger picture in mind and look beyond the financial numbers to value a business.Sometimes they pay a premium for their acquisition, but end up with a successful deal that offers much higher value.
[…] In valuation, the topics of risk and capital cost are crucial, integral, and laden with misunderstandings. These misunderstandings can lead to strategic blunders. For instance, when a firm borrows capital to fund an acquisition and employs only the cost of debt to the target’s cash flows, it might inevitably overvalue by two times the target’s value. Conversely, when a company attaches an arbitrary risk premium to a target’s cost of capital in an emerging market, it could undervalue the company by half. In this post, I provide insights on understanding the risks and cost of capital in business valuation […]