Valuation 301: The DCF and Forecasting

In my last post, I reviewed the various discounts and premiums to be applied in the market comparable approach to valuing a company.  Other approaches that use company specific earnings and cashflow include the capitalized earnings and the Discounted Cashflow (DCF) method.

A DCF requires a forecast of the company’s revenues and earnings and then a terminal value is established (to represent the value beyond the forecast period), all of this is then discounted to arrive at present values to be added up.  The discount rate must reflect the inherent risk in generating the cashflows and the terminal value must reflect the growth rate beyond the forecast period.  The cashflow used is “free cashflow” which requires adjustments for capital expenditures and working capital requirements and is net of taxes. Technically, the DCF is the more sophisticated valuation methodology but practically speaking the determination of the discount rate and the terminal value are highly subjective and small changes in assumptions can result in large changes in value.

Irrespective of the discipline brought to the process, multi-year forecasting can be challenging for any company and is particularly hard for early stage, new product/service companies.  I want to note three things about emerging company forecasts: (i) they should be bottom-up, (ii) they should be integrated, and (iii) they should sync with valuation expectations.  Many investor presentations will say: “…look, I only need to capture 1% or 2% of the market and I will reach $100M in sales”.  There are two problems with this statement, one you end up being a small market participant when VCs are looking for the sector winner and, two, you don’t say how you will get the 1%. 

Forecasts should be bottom-up, meaning, they should reflect specific actions such as: (a), we will hire Joe and he is going to call 100 prospects and he will close 5 deals and generate $1M in sales in the first year; then, (b) in six months we will hire Mary and she will...etc.  Forecasts should be integrated, meaning an income statement should feed a cashflow statement which should feed a balance sheet on a monthly basis for at least three years.  Based on this investors can clearly determine the use of funds and impact on the cash position.  Lastly forecasts should result in the expected valuation.  For example, if you are looking to raise $5M for geographic expansion and you are willing to sell 33% equity for this, your forecast better illustrate an aligned use of proceeds and justify a pre-money value of $15M. 

Once a sound forecast is prepared and the valuation math is solid, the question for the investor becomes; do I believe this team can, and will do a, b and c.  If they are comfortable with this, then the due diligence moves on to other items such as management’s past accomplishments, credentials, relationships etc.  While the value proposition and competitive differentiators are the primary attractions in a business plan, a sound, logical forecast is a core component needed to close a successful transaction.

While there are complexities in all valuation methodologies, it is perhaps most important to remember that value is relative and of the moment.  Whether that is relative to recent market information or relative in the context of an appropriate discount rate and terminal value.  It is affected by macro-economic factors such as public sentiment and company specific factors such as patents.  A valuation, like a balance sheet, is a representation at a moment in time but value changes on a daily basis.  Value does not naturally accrete with time.  When profit growth is accelerating there may be hubris but when it decelerates it will go away just as quickly.  When the collective wisdom decided that Apple’s growth would slow, it lost over 30% of its value in just three months.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.

Valuation 201: Comparable Company Analysis

Ever since I wrote “TheBasic Math of Valuations”, which explains the valuation differential between different asset classes, I have been meaning to write a follow-up on specific valuation techniques. There are market based approaches such as public company trading multiples and comparable transaction analyses and cashflow and earnings based methodologies such as the Discounted Cashflow (DCF) analysis.

 

In this post I’d like to look at market based approaches.  Let’s start with the easier one to explain; comparable company transaction analysis.  This is just like when your real estate agent shows you what houses sold for in your neighbourhood.  You compare your neighbour’s house in terms of number of bed and bathrooms, lot size, etc. and then you figure, well, if that one sold for $500K then, since mine is better, mine must be worth about $600K.  If you have a $200K mortgage you end up with net $400K after the sale.  The logic is the same for companies however it is very rare that you find: (i) a truly comparable company transaction, (ii) completed very recently (or else different economic conditions will have to be considered), and (iii) there is full information available on consideration components (i.e. cash, earn-out, amount of debt assumed, working capital adjustments, deal exceptions, etc.).  Public company trading analysis can provide trending and current day valuation comparisons but the challenge of assembling a good representative sample remains.

 

Both market approaches need subjective adjustments in order to derive at an attributable value range. Comparable transaction data and public company shares are typically available from larger public companies which means that, in order to attribute this data to a smaller private company, two types of discounts need to be applied, a small company discount and a private company marketability discount and, in addition, public company shares trade at a minority discount which raises the question of how much of a control premium to apply.

 

How are these discounts and premiums determined? Large public companies benefit from easier access to capital, lower cost of capital, in many cases a strong brand and generally scale, diversification of suppliers and customers and many more risk reducing attributes.  Small companies typically have higher customer concentration, a less established brand, less access to funding sources (be it banks or equity investors) and, private companies are illiquid; it takes a lot of time and effort to find the right buyer.  As such, small private companies are riskier than large public companies.  Every comparison is unique but generally speaking, more risk means a higher required rate of return.

 

Minority Discounts and Control Premiums are two sides of the same coin.  Public company shares trade at a minority discount because any individual shareholder does not have enough influence (i.e. votes) to change the direction of the company.  However as soon as a control block is in play, the minority discount disappears.  Control premiums are tracked by Mergerstat and were on average 50% in the first quarter of 2012.  So how do the various discounts and premiums stack up?  Generally speaking, small private companies are valued below the trading values of public companies – even without the control premium applied. In other words, public minority share valuations are still higher than small private company control share valuations.

Both market approaches need subjective adjustments in order to derive at an attributable value range.  The question of whether a comparison of a $1 billion public company to a $50 million private company deserves a 30% or a 50% discount requires consideration of many factors and is best answered by an experienced, accredited professional valuator.

 

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.

 

There is Plenty of Investment Capital Out There, Except For...

I have spoken before about the variety and depth of venture capital (VC) and private equity (PE) funds (see: Specialized Funds for Unique Needs).  To reiterate, there are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds; from special purpose acquisition companies (SPACs), to Leveraged Buy-Out (LBO), Growth Capital, Mezzanine and Distressed funds.

Venture capital investors typically take a substantial minority equity position and look for investments that can return 5x to 10x (i.e. if they invest $1 million, they target a realization of $5M to $10M in a sale or IPO exit).  VCs don’t typically look to achieve their goals by acquiring additional companies but rather by betting on, and working with, the expected winner in the space.  Private equity on the other hand, quite often seeks 100% ownership and will then continue to look for add-on or tuck-in acquisitions to grow and increase the market position of its investments.

In Canada there are quite a few start-up or incubation venture capital funds which will invest from several hundred thousand to $1M in promising ideas but, as-of-yet unprofitable companies. Some notable ones include: Extreme Startups, FounderFuel, GrowLab, Hyperdrive, and Version One Ventures.  There are also quite a few VCs and PEs that focus on profitable companies with investments of $5M and up such as Bedford Capital, Clairvest, Huron Capital, OnCap, Torquest and more.  But, where is the capital for companies that are profitable generating EBITDA from $0 to $1M?  This is the black hole of institutional investment.  If you have two or more years at profits of less than $1M, it becomes very hard to attract investment capital. 

What motivates the incubation funds is the possibility of a home run; the $5M folks are looking for typical private equity returns of 25% to 30% and find this area one where they can put some carry, or yield, into the structure to pay the bills, and they can grow to a ready exit either through IPO or sale.  The less than $1M profit, modest growth segment just doesn’t tick the boxes as well as the other segments.  Anyone that starts in this segment tends to move on to bigger deals.  One reason for this is (and I have heard this one a thousand times so I hate to say it) it takes as much work to close a small deal as it does to close a big deal (but the bigger deals just earn way more money); but also because it is a transition phase between the conceptual incubation funding, that relies on vision, and the proven entities where the valuation looks to cashflow.  Once cashflow is generated it tends to define the company.

Many good companies will have windows of equity financing opportunities.  They may be presented when the company is pre-revenue and has technology or customer commitments that put it ahead of the crowd; or it may be presented when the company is in accelerating revenue growth mode and, at that moment, the stars align with respect to market position and owner and investor value perception.  When the growth rate starts to decelerate and the owner’s value expectations continue to increase, that is when the window begins to close.  Entrepreneurs may act or pass on these opportunities, that is their choice, but just know that when you pass on an equity financing opportunity it may be gone forever.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

2012 Year-End Summary

As another year comes to an end, I thought I would organize a topic reference page around themes.  The following are select blog posts from the last two years.  Happy Holidays and if you have any thoughts for a topic in 2013, please let me know.

Terminology and Documentation
M&A Acronyms

An Overview of NDAs

What Does a CIM Include and How Do You Position It?

M&A Process

How Much Information (and when) Do I Share With Potential Buyers?

Attracting Foreign Buyers: The Benefits of M&A International

Milestones in the M&A Process: How Long Does it Take?

What is Due Diligence and What Does it Consist Of?

Winner’s Remorse: Does the M&A Process Lead Buyers to Overpay?

Preparing a Business For Sale

Normalization Adjustments for Private Companies

12 Situations to Avoid When Selling Your Business

How Do I Attract a High Multiple for My Business: The Business Factors

How Do I Attract a High Multiple for My Business: The Sale Process

Buyer Selection

Constructing a Buyer List

What Makes a Good Buyer?

Finding a Buyer: It is Rarely the One You Expect

What Will a Strategic Buyer Pay?

What Will a Financial Buyer Pay?

Is There More Than One Buyer For My Business?

I Have a Buyer For Your Business

Buyers are Currently Paying High Prices for Businesses Like Yours

Valuation

Why is a Tech Company Worth Three Times Revenue?

The Basic Math of Valuations – Why Mid-Market Companies Are Valued Lower Than Their Public Company Peers?

Why is Instagram Worth 1 Billion?

Is Instagram Worth 1 Billion… only to Facebook

More Thoughts on Price Expectations

A Multiple of What (and When)?

It is all About the Platform

Choosing an Advisor

What Exactly Does an M&A Advisor Do?

How Does an M&A Advisor Add Value to the Divesture Process?

How Does an M&A Advisor Add Value to the Divesture Process: the Intangibles

M&A/Corporate Finance Options

When is an MBO a Good Idea?

Specialised Funds for Unique Needs

What About the Form of Payment?

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

A Multiple of What (and When)?

I discussed the pitfalls of relying on publicly available value comparisons in a recent post but what if an owner of a similar business to yours says “I sold my business at a 10 times multiple!”? or you hear, the tech sector is trading at a 25 multiple.  Early stage companies trade at 2 to 3 times.  The question is a multiple of what?

For public companies the most noted multiple is that of after tax net income.  For early stage companies it is quite often a multiple of revenues because, either they are not profitable or, they are in high growth mode, where profit levels are depressed as a result of higher than long-term average spending on R&D and product/service marketing.  For established private companies, the most commonly cited valuation metric is a multiple of EBITDA. 

EBITDA stands for Earnings Before Interest, Taxes and Depreciation and it allows for comparison of profitability by canceling the effects of different asset bases (by cancelling depreciation), different takeover histories (by cancelling amortization often stemming from goodwill), effects due to different tax structures as well as the effects of different capital structures (by cancelling interest payments).  The drawbacks of using EBITDA are that it doesn’t account for maintenance/required capital expenditures (CAPEX) to sustain the business and, because it is a non-GAAP metric, it is often presented on an adjusted basis excluding (sometimes questionable) one-time items thereby boosting profitability.

The relationship of an EBITDA multiple to other multiples can vary widely across industries.    For consulting or software companies, that typically don’t or can’t carry long term debt and have little investment in fixed assets, EBITDA is often the same as earnings before tax.  For capital intensive companies, an EBITDA multiple of five might be the equivalent to an EBIT multiple of seven.  When we speak of a five times EBITDA multiple for a private company, the value may actually be the same as 15 or 20 times net income after tax for a profitable public company.

The period the multiple applies to is also important. While valuation is conceptually a forward looking principle, the standard is to use a historical multiple as a result of the difficulty of predicting what the next 12 months of earnings might be.  Some variants of timeframes used are “run-rate” (annualizing the last month or quarter), “latest twelve months” (LTM, typically calculated on a rolling four quarters basis), or last calendar or fiscal year.  Why does the timeframe matter?  Let’s look at a fast growing public company such as Apple.  On August 20^th, its market cap was approximately $620 billion.  Its latest fiscal year ending (EBITDA was $35.5 billion and its 12 month consensus forecast EBTIDA was $55.8 billion.  People will say Apple is trading at 17.5 times EBITDA but the more proper metric is that it is trading at 10.7 times forecast EBITDA, a difference of 70%.

Finally, in addition to the specifics around the multiple, there are many bigger picture questions such as: did the buyer assume the debt; were there working capital adjustments; was the amount paid in cash on closing or will it be paid over time? Different answers to such questions will also measurably impact the net multiple paid.  So the next time someone tells you they sold their business for a great multiple, think about a multiple of what and when.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Winner’s Remorse: Does the M&A Process Lead Buyers to Overpay?

When managing a company divestiture, there comes a point when interested parties are requested to provide non-binding expressions of interest (this is the first indication of value based on reviewing the CIM and answering select questions, see: How Much Information (and when) Do I Share With Potential Buyers? ).  An expression of interest outlines a value range, structure and other criteria, on which potential buyers are prepared to move forward.  It is requested so as not to waste the seller’s time with potential offers that will not meet the needs of the seller.  When there are multiple expressions of interest for a company, they typically form a normal curve around the company’s notional value. 

Non strategic/financial buyers are typically at or below notional value (E1..E4) and strategic buyers are typically at or above the notional value (E4..E7).  The parties engaged to go forward in the process will be the ones above notional value (E6..E7) suggesting that they may be ready to pay a higher price than fair value, however, fair value is very much in the eye of the beholder.

A strategic buyer may pay more than the notional value for a business for reasons of competitive strategy (i.e. prevent your competitor from strengthening its footprint) or when the seller has certain assets that complement the buyer’s assets thereby allowing for the potential to create value through synergies. The value of a business is different to every potential buyer.  To a financial buyer (one that does not have the potential for synergies, but may nevertheless be able to bring special expertise to the table) a business may be worth the notional value which maybe six times EBITDA, generating a 17% non-levered ROI (maybe more  than 30% with 50% debt); but a strategic buyer could pay seven times EBITDA and expect to generate even more based on synergies.

So does the M&A process lead buyers to overpay?  Not necessarily; the process extracts the highest price for the seller by appealing to potential buyers that will benefit most from the purchase.  The buyer has to weigh the risks and benefits of the price they will pay versus not getting the business. Overpayment has been in the news lately with HP writing off $8 billion of goodwill from its $13 billion acquisition of EDS and Microsoft writing off $6.2 billion of goodwill in its Online Services Division where it houses the acquisition of aQuantive (which it acquired for  just over $6.3 billion).  The onus is on the buyer to correctly estimate the realisable cashflow from a purchase and then to execute on its plan.  Many things can go wrong in execution but the fact remains that if there is more than one buyer at the table it is highly likely that the winner will have paid more than notional value.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

More Thoughts on Price Expectations

I noted recently that it is very difficult to predict exactly what a business’s selling price might be as a result of a well managed auction between two or more highly motivated strategic acquirers.  Outside of a competitive environment, a buyer will pay based on historical performance and not the incremental value they believe they can create.  Competitive tension is the situation M&A advisors seek to achieve and, personally, I have seen many competitive situations result in very good prices for sellers of mid-market private companies.

Because it is hard to predict what price might result, a discussion about price expectations should start with the notional value (the price a proper valuation will assign a business independent of what a particular strategic buyer might benefit from; see: What Will a Strategic Buyer Pay?) and then estimate the potential price increase based on the selling company’s attributes (i.e. complementary customers, products, brands, patents, etc.) and market attributes (no. of possible buyers, their financial strength, growth rate of the sector, etc.).  This typically results in an indicative range.

Discussing price expectations is a delicate dance between being realistic and optimistic, between the likely and the possible.  Some sellers want to hear a high number even if it is not likely achievable.  Others will worry that if you don’t pitch a higher sale price than the next advisor, you won’t fight for the best price on their behalf.  Sellers are often guided by publicly announced data points. Headlines where one market leader buys another for a tremendous amount (i.e. Facebook buys Instagram for $1 billion or HP buys 3PAR for 11 times revenues).  Such metrics don’t typically translate to smaller competitors yet, if you don’t account for the leading transactions in a business development presentation, you can be perceived as either not being in touch or not being the aggressive marketer the seller is looking for.  While I see the point, and I have lost mandates where other advisors led selling companies to believe they would achieve a higher sale price with them, I prefer to establish a reasonable expectation and over-deliver rather than over-promise and under-deliver.  The point I want to underscore here is that, regardless of whether one advisor promises to deliver a higher price than the other, if they both follow a thorough process and manage the auction as per the seller’s guidelines then both should end up pretty much at the same price.  Note, I say “as per the seller’s guidelines” because often the seller will guide the M&A advisor in the direction of a preferred buyer (and away from a potentially stronger but more hostile bid) for various reasons.  The point is, look to the material differentiators between advisors such as integrity, sector experience and international reach rather than promises of high prices.

I have talked before about aligning seller and advisor interest through compensation based on a successful transaction.  One mechanism that really awards over achievement is setting a base compensation rate up to an agreed level and then providing a substantially higher commission above that number.  For example, 3% up to $20M and 10% above that.  If the company sells for $24 million the seller would have generated $4M more than expected and the advisor would secure a healthy fee.  I am happy to subscribe to such models but the issue I have with them is that it is implicit in the arrangement that the advisor would not push for $24M otherwise.  The ideal situation is one where the seller has confidence in the advisor to do everything he can and the advisor in fact does everything he can.  If you are more cynical than that or need the additional assurance, then the extra incentive structure is something that can work for you.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap CorporateFinance in Toronto.

Is There More Than One Buyer For My Business?

I have come across several niche businesses lately where they have received unsolicited interests from potential buyers and this leaves the owners wondering, are there any other buyers for my business?  Should I bother with hiring an agent and engaging in a process that could take many months to complete or take the bird in the hand?

If these companies were publicly traded there would be no question.  The board of directors of a public company would undoubtedly reject the first unsolicited offer and engage an investment bank to explore alternatives.  Assuming normal operating circumstances, a board would not fulfill its fiduciary duty if it accepted the first bid.  Due process would require at least an independent fairness opinion, but even this would not assure the shareholders that they will realize the highest share price in a transaction; only a thorough and diligent auction process can do that.

Back to the question at hand; could there be other buyers?  When a potential seller operates in a very specialized vertical with only several competitors - that may spread unfounded rumours of the company’s demise as soon as they hear of a possible transaction - it is tempting to go with the bird in the hand.  But, as I have noted several times, the best buyer is not likely to be a direct competitor.

The best buyer is likely to be a “platform buyer”.  A platform buyer will be interested in the business for one of three reasons, its customers, its personnel, or its technology.  As an example, we were engaged to sell a pattern recognition technology company in the field of product quality control.  This technology would scan a production line and “kick-out” products that did not meet certain criteria.  In this case, the ultimate buyer was the US defence department, who paid a strong premium for the business and then used the technology for facial recognition for national security purposes.  Who would have predicted that? ... but having approached large technology companies that also served defence contractors ultimately led to this outcome.

The point is, even if you feel that there are only one or two competitors that could potentially be interested in acquiring your company, we can likely find additional buyers that you have never thought of as per the example above.  It is extremely rare that we have not been able to source at least several expressions of interest for a company for sale.  In the end you only need two interested parties to create that competitive tension.

So what is a company to do?  Private companies, where owner-entrepreneurs own majority control can do as they please.  This is the luxury of owning a private company.  Company owners may not want the hassle of preparing a business for sale or they may feel the value being discussed is fair but, in the end, going to market with an experienced advisor is the only way to secure the best price for your company.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Why is Instagram Worth 1 Billion?

There are many reasons why Facebook would pay a lot of money for Instagram.  Reasons such as: to improve its mobile revenues (of which it had none), to eat Twitter’s lunch, to eliminate a potential future competitor, and basically to maintain its growth and market value momentum.  Remember, Facebook is the internet's largest photo sharing site and it knows the power of photos very well but what I really want to tackle here is why 1 billion as opposed $500 million?

The simple answer is it was a privately negotiated transaction and Instagram had just recently raised money from Sequoia Capital at a reported $500 million valuation, so they weren’t going to sell for less.  Well done to get to 1 billion.  This means that Sequoia Capital and other firms that contributed money were essentially able to double their money in a very short timeframe.

Prior financing round valuations and existing investors’ requirements are value pegs but here is some theory around what price is possible.  In cases like this companies are paying a scarcity premium.  The argument being that, either by way of market position (i.e. if all your friends are on Facebook there is no point being on Orkut) or by way of proprietary technology, these targets have something the acquirer can only attain by buying them.

At this point a buyer is paying a price beyond the notional value of the target and encroaching on the value to the buyer.  The notional value is a company’s value independent of the potential strategic benefits to a particular buyer.  The value to the buyer is that amount of value the acquirer can produce with the target.  Not something they typically pay for unless forced to in a competitive situation.

To consider this by way of a generic example, let’s assume a billion dollar revenue company is paying 10 times revenue for an early stage company generating $1 million in revenues.  The target company’s technology will allow the billion dollar revenue company to increase its market share by 10%; a value of $100 million in revenues.  You can understand why the acquirer might pay $10 million for this company.

The conclusion is that a buyer paying a price below the value to the buyer is something that makes economic sense, even though the price may sound astronomical…. and if you are being approached by Facebook (estimated value of $100 billion) then there is a lot of room to pay a lot of money.  In my next post I will examine what Facebook could have paid.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

VTI Profit Margins Underwhelm

In the Spring issue of the Veracap Technology Quarterly we took a closer look at technology sector profitability.  While valuations have improved substantially, many mid-market technology companies still struggle with profitability.

On average only 55% of the technology companies included in the Veracap Technology Index (the “VTI” includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million) were EBITDA positive and, of those companies, the average margin was 12.1%.  The subsector with the most profitable companies was the IT Consulting & Services sector and the sector generating the highest margins was the Internet Software & Services sector with an average EBITDA margin of 15.3%.   In looking for an explanation of these results we believe the answer lies in the average size of the companies.  The average market cap of the VTI is only $81 million.  Of the companies not generating a positive EBITDA, 84% had a market cap of less than $100 million.  Canadian technology companies go public at a relatively small size and need to grow larger to achieve scale and improve efficiency.

The most profitable companies in the VTI were Mediagrif Interactive Technologies with an EBITDA margin of 33.6%, Enghouse Systems with an EBITDA margin of 27.2% and C-Com Satellite Systems with an EBITDA margin of 23.9%.  While nowhere near world leaders like Google and Microsoft which have generated EBITDA margins in the 40% range for years, these are nevertheless our strongest performers in the quarter. 

So do high margins translate to the best valued companies in the VTI?  In general yes, the above noted companies are in the top quartile in terms of an EBITDA multiple but there are exceptions as well such as C-Com Satellite Systems which ranks 3^rd in profitability but was valued at less than four times LTM EBITDA.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Tech Companies Explode Out of the Gate in 2012

The Veracap Technology Index (“VTI”) composite share price has been on a tear since December 2011.  The VTI has more than quadrupled the S&P/TSX Composite Index, with a return 20.8% versus 5.0% for the period from December 1, 2011 to March 1, 2012 (and this excludes the stellar premiums awarded such take-over targets as Gennum and RuggedCom).  

To refresh our readers on the VTI, it includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million (Veracap’s area of focus).  As at March 1, 2012 this included 79 companies and of these 53 were up an average of 38%.

Technology sector valuation multiples have also increased sharply from 7.4 on December 1, 2011 to 9.8 on March 1. 2012.  The strongest subsector, in terms of valuation multiples, was the Software sector where companies such as Nightingale Informatix,  Redknee Solutions, and Posera-HDX contributed to an average last twelve month (LTM) EBITDA multiple of 13.2.   The Hardware & Equipment subsector brought up the rear with companies such as COM DEV International Ltd., Smart Technologies Inc. and LOREX Technology Inc. trading below five times LTM EBITDA.

Technology sector lifters and drags for the period from December 1 to March 1 include:

Lifters                                                 Subsector                                             %

Aastra Technologies Ltd.                    Communication Technology              Up 44.7%

Glentel Inc.                                          Communication Technology              Up 40.0%

Enghouse Systems Ltd.                     Software                                             Up 39.9%

Drags                                                  Subsector                                             %

Smart Technologies Inc.                     Hardware & Equipment                     Down 29.0%

Sandvine Corporation                         Communication Technology              Down 12.0%

DragonWave Inc.                                Communication Technology              Down 5.9%

Note: for companies with a December 1 share price greater than $1.00

For more M&A information on the Canadian technology scene please see our Spring issue of the Veracap Technology Quarterly.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Has it Been Three Years Already?

In my last post I noted that now is a good time to pursue a divestiture or private equity transaction based on: (i) coming out of the recession in 2009 and seeing a general return to growth and profitability, (ii) historically low interest rates, and (iii), a tremendous amount of investible capital at private equity funds and on corporate balance sheets.  So how good is it?

The following is a chart of the S&P500 over the last three years. Since March of 2009, after reaching a low in the 675 area, the S&P500 is now 100% higher and flirting with recent highs.

The 10 year US Treasury yield index is below 20 (at a three year low resulting in a yield of 1.87%).

The facts are as follows: we are near a three year high in the S&P500; S&P500 earnings have improved every quarter since Q1 of 2010, interest rates are at three year lows and a recent study by the Wall Street Journal highlighted that "cash accounted for 7.1% of all company assets, the highest level since 1963."  In short a strong foundation for a healthy M&A market.

BUT, people are worried.  Worried about the European debt crises, US budget deficits, an ineffectual Congress, falling house prices and an unemployment rate of over 8%; hence the contradiction of improving earnings and historically low interest rates.  The expression “the market is climbing a wall of worry” reflects a scenario where the market goes up despite uncertainties.  This is positive in my mind because it represents a healthy tension between the bulls and the bears; no over exuberance with the potential of a crash but steady as she goes. According to Standard & Poor’s, the current consensus 2012 earnings forecast for the S&P500 is $103.70 which, at current levels, equates to a multiple of 13 times. Quite reasonable and therefore we are in a positive environment for M&A activity.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

The Window is Open

I noted in my last post that private company divestitures or equity financings can take between seven to nine months to complete (a financing can be quicker depending on the structure).  This may seem fast or slow depending on your perspective but that timeframe is typically not the whole story. 

Veracap's Value Enhancement Framework^TM (see “How Does an M&A Advisor Add Value to the Divesture Process?”) notes that an important part of the process is the planning stage.  For example, while preparing for sale it is critical that personal goodwill be transferred to intangible, company goodwill.  What this means is that owner-entrepreneur responsibilities and relationships are migrated to a management team that will stay with the business for an extended period of time.  The planning process may take several years to complete.

The next phase that can take years to complete is the transition phase.  Unless the owner-entrepreneur is no longer active in the business, the buyer will likely seek a period after the closing where the seller remains engaged to ensure a smooth transition and delivers on earn-outs, etc.

The planning and transition phases can add a number of years to the process, but here is the real kicker, investor sentiment and the economy.  In fact, a great opportunity to sell or raise equity at a premium may come along only once in a lifetime.  We all remember the internet bubble of 2000 and the more recent US real estate bubble in 2008.  If you assembled a good tech team and had a web related idea in 1999 or early 2000, you could fund a start-up at a significant valuation (I personally had an idea that was funded at a multi-million dollar value). 

The internet bubble crashed in 2000 and the US real estate bubble crashed in 2008 taking the whole world with it.  When a recession hits and profits are diminished, demand drops off and values naturally become depressed.  You could arguably sell your business in the 2009/10 timeframe but not at 2007 valuations.  As an owner-entrepreneur, when you thought your business was worth $20 million but you are told it is now worth $12 million, you are going to think twice about going to market.

We have seen many businesses return to strong profitability in 2010 and 2011 (depending on their fiscal year end) and with a number of years of sales and margin growth, strong valuations can yet again be achieved.  While bubbles are extremes there are always hot and cold sectors from time to time where strong valuations are realizable.  Some current examples of hot sectors include cloud based virtualization such as Software as a Service (SaaS) and Platform as a Service (PaaS), social media, mobile marketing, penny auction and deal-of-the-day web sites.  A once hot but now cold sector, ironically, is the solar sector.

We cannot predict when the next recession will begin.  The finance community refers to IPO windows; when they are open an IPO is possible, when they are closed it is not.  The process of preparing and positioning to sell your business, or equity in your business, can take many years and an economic downturn can add several more years to that.  As for right now, based on: (i) coming out of the recession in 2009 and seeing a general return to growth and profitability, and (ii) historically low interest rates, plus a tremendous amount of investible capital at private equity funds and on corporate balance sheets, I would say the window is open.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Milestones in the M&A Process: How Long Does it Take?

Milestones in the divestiture or private capital raising process are similar and generally as follows:

Milestone	Timeframe
Preparation of the marketing materials (by the advisor in concert with the seller) and due diligence materials (by the seller).	The documentation including a teaser, CIM and buyer list, while iterative with the seller, can be completed within four weeks. Preparation of the due diligence materials is highly company dependent and can take from several weeks to several months.
Engaging potential buyers and securing expressions of interest.	Potentially to many parties; up to 2 months.
Management meetings and supplemental information provisioning; securing and negotiating the final LOI.	With the top 3 to 5 parties; up to 2 months.
Due Diligence and drafting/negotiating the purchase and sale agreement.	With the final party; 45 to 60 days.
Total	7 to 9 months

Having said that, the following is an actual example of a divestiture of a private company.  In this case, the owner and 100% shareholder wanted to retire and was well prepared to initiate the process.  The business was a very profitable software business operating out of one location servicing a diversified customer base.  In short, an attractive acquisition opportunity supported by a motivated seller.

The engagement letter to commence the process was signed May 11^th, a Wednesday.  That Friday we met with the company for an information gathering and strategy session.  One week later we met again, this time having completed a first draft of a potential buyer list, a Confidential Information Memorandum (CIM) and the teaser.  First emails and calls to potential buyers commenced on may 26^th; first books (CIMs) were sent on June 10^th; and expressions of Interest (EOIs) were requested by June 30^th. 

Getting a sense of market interest and indicative value can be a fast process; in this case about seven weeks.  Key contributors to a speedy process are client readiness and working as expeditiously as possible on the factors that the selling team can control.  While only half-way through the process (with management presentations, requesting and negotiating LOIs and due diligence yet to come), the selling team will have a good sense of the market interest and whether a good deal is possible at this point in the process.

Many things, both economic and company specific, can change during the selling timeframe and it is strongly in the seller’s and advisor’s interest to complete the process as quickly as possible.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.