Valuation Snapshot Winter 2019
Welcome to the latest edition of Valuation 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.
A slight dip in multiples paid We’re reporting a 2.1% downturn in Q3 2019 which is mostly driven by an 8.3% fall in the UK-based PCPI and offset by an upturn in the more broadly European based Argos Index. Perhaps Brexit is finally hitting UK prices? Certainly the latest ICAEW Business Key valuation indices Q3 2009 to Q3 2019
Confidence Monitor for UK firms fell to its lowest level since 2009. There are several factors, and Brexit is clearly at the forefront, which are creating difficult conditions for businesses. We should know if this is a trend or a blip by the time we publish our Spring 2020 Valuation Snapshot.
Valuing a SaaS company The core method of valuing any business is to apply a multiple to its underlying EBITDA. This also applies to SaaS (Software-as-a-Service) companies. Earnings should be adjusted for any one-off costs or income, and usually focus on a current and forward view of trading. Multiples should be benchmarked against market data. And for a decent business, double digit EBITDA multiples are not unusual, which can equate to a decent multiple of revenue. Higher multiples are merited if the fundamentals of the business are strong. We’d look at factors like intellectual property, quality of management, customer base, cash flow dynamics, development route map and scalability. SaaS valuations For SaaS companies it can be worth looking at revenue multiples particularly where a business has been investing heavily in growth and this has depressed profits. Two important metrics to measure SaaS companies by are Churn and Annual Recurring Income. Customer Churn is the number of customers leaving each month as a
Lake Falconer lake@pemcf.com
percentage of the overall customer base. Revenue Churn measures how much customer revenue is lost each month as a percentage of overall revenue. Annual Recurring Revenue or ARR is basically the “run rate”. This is useful for all SaaS companies but especially so for early stage businesses where heavy investment in new customer acquisition may be depressing profits – measuring monthly recurring revenue growth can indicate momentum. The need to balance investment, growth and reporting profit are neatly tested in this market by the ‘Rule of 40’ which says that a SaaS company’s combined growth rate and profit margin should exceed 40%. It attempts to balance the conflicting priorities of growth and profitability. If growth was all that mattered, one could invest every last penny in growth and disregard profitability. On the other hand, many SaaS companies could make significant short-term profits if they just stopped investing and focused on generating profit from their existing business. But growth and profit are of interest to investors and buyers of SaaS companies, and so the Rule of 40 is a neat way to balance these potentially conflicting objectives.
What is surplus cash, how to determine it and what impact does this have on valuation? Surplus cash is often an overlooked variable when it comes to valuing a business, but it’s an important one. The typical way we value a sustainably profitable business is by using the ‘market method’. By calculating and arriving at an adjusted normalised level of profitability and multiplying the profit figure (adjusted EBITDA) by a selection of multiples from comparable listed companies and comparable transactions (in addition to other selected indices), we then arrive at the enterprise value of the business. The enterprise value needs to be adjusted to reflect its balance sheet to arrive at the equity value of the business, the value attributable to the shareholders. In simple terms, you add the cash balance and subtract the total debt figure from the enterprise value. From this you then get to a net cash or net debt position. But what important factors are there in determining surplus cash? Free cash versus trapped cash Start by looking at the balance sheet and calculating how much of this cash is ‘free cash’ and how much is ‘trapped cash’. There may be cash that is held as security or deposit or on behalf of a customer. All this trapped cash should not be included in the surplus cash calculation.
When we value a business, we tend to look at the last 12 monthly balance sheets as this helps calculate a normalised level of working capital. This is compared to the working capital figure as at the date of valuation; any shortfalls should result in an adjustment to a decreased surplus cash figure and vice versa. However, this ultimately comes back to understanding, in detail, the business being valued. There may be several genuine factors and clear business rationales contributing to a change in the working capital dynamic of the business, for example, they have changed to a supplier with more advantageous payment terms etc. In conclusion Ultimately there is no precise method or rule on how surplus cash should be calculated. However, there is a general rule of thumb which is could the cash theoretically be paid out to the shareholders via dividend? The overarching message is that an adviser really needs to understand the business, and all its intricacies, when making a valuation.
Working capital This is a crucial factor in determining the surplus cash figure. For instance, is the cash balance artificially inflated due to the business owners aggressively collecting its debtors unusually quickly and delaying payment to creditors?
Ned Brown ned@pemcf.com
PEM Valuations From time to time, your clients may ask you how to value their business. Such requests could be triggered by: ▪▪ ▪▪ ▪▪ ▪▪ ▪▪ ▪▪ ▪▪
Divorce Shareholder exit Disputes Restructuring Business planning Tax and Accounting Regulatory reasons
Yet for many advisers, valuations are not their 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.
Personal We have a flat structure so clients always receive cost effective senior level attention.
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.
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.
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