A Life In Numbers

We’ve recently closed a funding round of just under £2m for a client and it struck me that with all the negative press around it’s easy to assume that all the positive growth stories have dried up. This tends to lead people to think that the time is not right to take action and consequently they put their head down and hope all the nasty stuff goes away. In their minds they tell themselves that they’ll start taking more action when the time is right.

It’s true that many more businesses are becoming insolvent and going into Administration. And many more may be trading insolvently (a criminal offence with personal liabilities) without even knowing it. It’s also true that there are many more people going into personal bankruptcy or IVA (Individual Voluntary Arrangements) in the false belief that after 2 years this will be wiped from the records (check any mortgage application for the question that says (have you ever been made bankrupt or entered into an IVA) to see that your credit record may never fully recover.

However, amongst all this there are still some companies that are raising money, expanding and growing as fast as ever. Admittedly it’s not easy and has the potential to get harder in the coming year but with the right guidance and the right business plan there’s still a huge amount of opportunity in the market.

The investment community is still sitting on considerable cash reserves and there’s more demand than ever for the right deals. This is balanced by an even higher level of paranoia and focus on cashflow that requires the investors to have a huge amount of faith in the abilities and plans of the management team but a strong team and a coherent plan can win through and the extra focus is on the right things.

Even the banks are willing to help those businesses who can clearly show they know what they are doing, keep the bank fully informed and manage their finances tightly.

Any business owner in this market has to make some tough decisions right now. You must know where they stand financially right now and for the foreseable future. If you don’t know that then you’re treading a very dangerous path that could lead to losing everything you have, including your personal assets.

Next, you need to decide where you want the business to go. Are you going to just knuckle down and tough out the the current market conditions or are you going to look at whether there are changes to be made to the business and strategy that could take you into new markets and consolidate and strengthen your current customer base?

Whichever direction you choose you will have to take some action. The most essential factor you’ll have to manage right now is your cash and that may mean some hard decisions such as reducing costs. You’ll also have to look at your business critically and understand what is working and what’s not. The absolute worst thing to do right now is to freeze like a rabbit in the headlights and wait to get run into the road.

This has turned into more of a motivational rant than I was planning but it would be really sad to see even more companies fail because they were waiting for when the time is right. Because, frankly, the time is right now.

I was having a discussion recently with a business partner of mine about whether the value of companies in the Web 2.0 sector is fully understood.

Back in the days of the dotcom boom we sold a company called Smartgroups to Freeserve for £60m. At the time we had very little revenues and certainly no profit. But we had a very good piece of software, a fast growing customer base and a great idea about how to generate revenues off the back of the service. Luckily, in Freeserve, we found a number of key individuals who completely understood what our company and service could bring to their business. Applying our software and service to their customer base could generate huge value for the business and that changed the way that the value of the company was viewed.

Now it would be easy to write off this deal as just another (for a change successful) example of internet euphoria. However, the priciples are still intact today and companies are still being valued and acquired on the basis of the future value they can bring to the acquiror.

If you read any academic or financial books on valuation of companies (and I’ve read a lot!) they invariably go down the route of valuing companies through variations on discounted cash flows (with or without terminal values), NPVs, revenue and profit multipliers (with much debate about the relative appropriateness of EBIT, EBITDA, EBITDAR, PBT or PAt), p/e ratios, betas and other more complex calculations involving variants of the Black-Scholes model or the Modigliani-Miller theorem.

However, in the past 20 years of working in this field, I’ve found there is a more fundamental valuation technique that seems to be known only to a handful of financial alchemists and some of the highest performing sales people.

A company is worth whatever the buyer is to prepared to pay for it.

All the financial analysis is generally used to justify the valuation (or at least give it some credence) after the event. Sometimes it stacks up, sometimes it doesn’t.

If you’re a large company, especially a quoted plc, who is looking to acquire a company that will simply add revenue and profit to your bottom line then looking at your own p/e ratio and applying that to the profit that will be added through the acquisition is a perfectly rational method of valuation.

However, if a company is being acquired because it brings new technology or IPR, because it solves a problem that has been holding back sales or development or because it brings a business advantage that can be applied across a much wider customer base, then the value needs to be considered in terms of the additional value it can bring to the acquiror.

A company like Oracle, for instance, with a Market Capitalisation of over $100bn may see that buying a company with a technology or business application that could enhance their profits by 0.5% could add $500m to their market value. This means that, although there would doubtless be some shrewd negotiation, the value of that acquisition and the price they might be willing to pay could rise up to $499m and they would still come out on top. Of course in practice this would be unlikely given all the risk factors involved but it allows you to see acquisition values in a different context. And if you have a software company that is just breaking even then it might encourage you to think wider than just achieving a high multiple of your profits.

After all this, the conclusion we came to (following the discussion at the start of this post) was that many people, even experienced financial experts and business people, still don’t fully understand how valautions are achieved. And after last week’s episodes in the financial markets they might be even more confused.