Valuation Snapshot - Autumn 2015

Q2 2015

Valuations Snapshot Welcome to our fifth edition of Valuations Snapshot. In this regular publication we look at the trends and issues behind business valuations, and provide bite-sized advice that can help you and your clients when valuing a company.

Key valuation indices to Q2 2015 Our overall “poll of polls” for the indices shows an uplift in earning multiples of around 3% between Q1 and Q2 of this year. Once again the constituents have moved differently, and the driver of the increase is the, often volatile, PCPI which has spiked upwards.

However looking ahead to Q3, for which only the PCPI is currently available, the PCPI shows a matching decline to around the same level as Argos. It’s tempting therefore to suggest that prices are holding rather than rising thus far in 2015.

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Valuing start-ups and early stage businesses Valuations are quantitative and we rely heavily on financial and other numerical inputs. Business valuations get better the more financial information is available.

Lake Falconer lake@pemcf.com

This is why start-ups and early stage businesses can be difficult to value. For a valuer, there is a death-zone somewhere between seed funding and the emergence of sustainable financial performance. As anyone doing business in and around Cambridge will tell you, most start-ups have a spell when there are few reliable numbers to work with. So how can we value businesses when they are in the data death-zone?

Comparable transactions As no two companies are identical, acquisitions of “somewhat” comparable start-ups can provide useful reference points. Without usable financials we can compare other metrics i.e. IP portfolios, number of subscribers, or drug pipelines. It may feel like horse trading and exact matches are rare, but a couple of close comparables can support a relatively accurate valuation.

Cost approach While some entrepreneurs might not agree, until a company passess a meaningful proof-ofconcept milestone, a start-up is valued on a time and materials basis, if that. A potential purchaser might add a premium for timing and the cost of trial-and-error, but will mostly view early stage technology as something they could recreate internally.

Transactions in start-up’s own shares This is a bit like calculating the market cap of public companies; start-up valuation can be derived from the value of its individual shares. To use this approach one has to assume that the transaction was fairly negotiated at arm’s length and by a professional investor. Not all equity shares are equal and simple multiplication, while widely used, won’t often work. But a well-negotiated funding round can provide a usable value indicator.

Rules of thumb This method can sometimes be useful, but this is best left for corroboration of other methods. For example, the Berkus Method (invented by US business angel, Dave Berkus) seeks to “price” different qualitative stages of a start-up’s development such as having a sound idea, a protoype, or a decent team and ascribing a fixed $500k value to each step.

One could defend this slightly arbitary approach because if enough business angels use this thought process it effectively becomes the market pricing for start-ups.

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Vendor loan notes in business valuations

Quite apart from this how should one treat the effect of liabilities included in the Net Asset position? Net bank debt/cash is relatively straightforward although the calculation of net cash/debt after working capital adjustments can be tricky. In contrast “loan notes” issued to parties other than regular banks will often have non-standard terms. And the funder could have a different agenda - it may be the former owner who has issued Vendor Loan Notes, or perhaps the Loan Notes arose as part of a management buyout. So how should they be treated?

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Loan notes could be considered to be a positive if they represent “soft funding” yet they are still a debt to be deducted in the equity valuation. This was considered in Findlay’s Trustees v IRC (1938). Lord Fleming said “the circumstance that a considerable part of the capital required to run the business can be raised at a low rate of interest cannot depreciate the value of the goodwill - it might increase its value. But this does not mean that their existence is to be disregarded in fixing the value - they are a debt of the business and must be deducted from its value.”

To judge whether the notes are a postive or negative, it’s even more important that the valuer reviews the financial impact of the terms. Are there provisions to roll up interest?

Or redemption premia? Either could bust the business if they build up to onerous levels, and at any rate, need proper consideration in any cash flow calculation used in an Income Approach valuation.

loan notes issued to parties other than regular banks will often have non-standard terms

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If one is using the Asset Approach to value a business, possibly as corroboration of other methods, it’s important to adjust the assets. Just looking at company’s balance sheet can be quite misleading - are there property assets that need revaluing, what about costs to realise, tax, unrecorded liabilities, and treatment of intellectual property?

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PEM Valuations From time to time, your clients may ask you how to value their business. Such requests could be triggered by: ■■ ■■ ■■ ■■ ■■ ■■

shareholder exit disputes restructuring business planning tax and accounting regulatory reasons

Yet for many advisors, valuations are not the day job.

This is where the PEM Valuations team can help.

Why refer your clients to us?

Focused Our valuations are produced by a specialist, multidisciplinary team with a valuations focus.

Commercial Our real world experience in company sale and purchase negotiation means we don’t just claim to be commercial, we have the transaction record to prove it.

Personal We have a flat structure so clients always receive cost effective senior level attention.

Tailored We do not use a software driven or “form-filling” approach. Our reports are based on a thorough understanding of the business to be valued, and tailored to the specific needs of the owner.

PEM Corporate Finance LLP is authorised and regulated by the Financial Conduct Authority, registered number 212875.

Registered in England & Wales, company number OC302288. Salisbury House, Station Road, Cambridge, CB1 2LA. If you no longer wish to receive this publication, or if you have had a change of address, please email info@pemcf.com.