Company valuation is always a very important part in closing either a merger or an acquisition deal, especially when it comes to high-tech companies and in particular when a small or a medium size company is involved in the process. There are many type and techniques for companies valuation, we will try to summarize the most standard and well none valuation types.
Widely used technique is comparative ratio either price earning ration or enterprise-value-to-sales ratio. Price earning ration is simply apply a standard industry multiple for the earning of the target company, then company valuation will be equal its earning multiplied by a multiple. Looking at the Price/ Earnings for all the stocks within the same industry group will give the acquiring company good guidance for what the target’s P/E multiple should be. Enterprise-value-to-sales ration is very close to Price earnings ratio, valuation will be equal to a multiple to the revenue.
Discounted cash flow DCF; discounted cash flow analysis determines a company’s current value according to its estimated future cash flows. Forecast free cash flows (net income + depreciation/amortization – capital expenditures – change in working capital) are discounted to a present value using the company’s weighted average costs of capital.
Replacement Cost – in a few cases, acquisitions are based on the cost of replacing the target company. For simplicity’s sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost.
Comparable Transactions is another way of determining a company. Valuation is determined as a comparison of the amount paid in acquisitions for other companies in some industry. Purchase Price Denomination is another way, when a large company pays cash for smaller company, large company will express the purchase price in dollars.
In an acquisition where large company issues stock to pay for smaller company, large company may express its offered purchase price in any of the following ways: as a dollar value of its shares, fixed number of shares, or a percentage of combined entity.
Net Asset Test is a technique in which, if either large company or smaller company believes that the balance sheet is likely to become significantly weaker or stronger between the date the definitive agreement is signed and the closing date, it may suggest that the purchase price be adjusted to reflect a change in the net assets.
Earn outs is another technique. In an “earn out,” some portion of small company’s purchase price will be paid by large company only if small company achieves negotiated performance goals after the closing. Parties typically use an earn out when they agree that a higher valuation would be justified if acquired company were to meet forecast performance goals.
Valuation Techniques for Technology Based SMEs
Always there is a dilemma when it comes to merger or acquisition of a small or medium software company. One problem in selling a small technology company is that they do not have any of the brand names, distribution, or standards leverage that the big companies possess. Therefore, on their own, they cannot create this profitability leverage. The acquiring company, however, does not want to compensate the small seller for the post acquisition results that are directly attributable to the buyer’s market presence. This is what we refer to as the valuation gap. To solve such valuation gap there are some techniques and methods but practically some of them are very hard to apply on the practical ground and other needs specialized professionals to apply. Those techniques includes:
Cost for the buyer to write the code internally, this technique could be applied through developing a constructive cost model for projecting the programming costs for writing computer code, COCOMO model.
Also first mover advantage from a competitor or, worse, customer defections, there is a real cost of not having your product today, this could be by justifying the entire purchase price based on the number of client defections the acquisition would prevent.
Another technique is restating historical financials using the pricing power of the brand name acquirer. The end-user customer’s perception of risk is usually greater with the small company. We can literally double the financial performance of small company on paper and present a compelling argument to the large company buyer that those economics would be immediately available to him post acquisition. It certainly not GAP Accounting, but it is as effective as a tool to drive transaction value.
Another component is for any contracts that extend beyond one year. We take an estimate of the gross margin produced in the firm contract years beyond year one and assign a five X multiple to that and discount it to present value.
In addition, another method is trying to assign a value for miscellaneous assets that the seller is providing to the buyer. Do not overlook the strategic value of Blue Chip Accounts. Those accounts become a platform for the buyer’s entire product suite being sold post acquisition into an installed account. It is far easier to sell add-on applications and products into an existing account than it is to open up that new account. These strategic accounts can have huge value to a buyer.
Finally, you can use a customer acquisition cost model to drive value in the eyes of a potential buyer by calculating the 100% sales person yearly quota salary, divide it by the typical number of deals which could be closed per year, you will have the cost of new customer acquisition, then multiply it by the number of clients you have, by this you will know your company valuation based on your customer base and this could be one of the methods used in valuation and negotiation.