Valuing Companies

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A startup technology company?s three founding partners found themselves at a loss over how to value their business when angel investors expressed interest in investing in it. ?We haven?t a clue how to value it as we don?t have sales or profits yet,? one said.

Their company had developed a Web-based software application and filed a patent application for some of the software algorithms.

Normally, a business is valued as a multiple of pretax earnings (earnings before income taxes, depreciation and amortization, or EBITDA) or gross sales, averaged over a number of years. In this case, the company has no revenues or profits, just some technology that may or may not be patentable. Stanley Feldman, chairman and chief valuation officer at Axiom Valuation Solutions in Wakefield, Mass., says the right price for a business like this will fall between two numbers. The first number is the cost of developing the technology ? the legal and accounting fees; the patent-filing fees; the cost of having someone prepare the mechanical drawings or prototypes that are part of the patent application; and, perhaps, the value of the labor the three partners have put in.

Feldman says that you have to be careful, though, when putting a value on your own labor. ?The question is not what you would pay yourself but rather what it would cost to hire employees to do the work, on an after-tax basis,? he says. ?So, for example, I may pay myself $250,000 a year, but if it would cost $100,000 in after-tax base salary to have an employee do it, it?s the $100,000 that counts, not the $250,000.?

John D?Aquila, founder of D?Aquila and Co. L.L.P., a leading CPA and financial advisory firm in Jacksonville Beach, Fla., and New Rochelle, N.Y., takes a more conservative view. ?When valuing a company like this, the most common method is the actual cash spent on acquiring the patents, trademarks and other intellectual property. We?re getting little or no value for sweat equity from the marketplace today,? he says.

Feldman?s second number in evaluating the business in question is a three-year projection of future revenues from the intellectual property. Once costs and taxes are subtracted from projected revenue, the resulting after-tax cash flows are then discounted to the present to arrive at a conclusion of value. But how do you predict revenues for a product that hasn?t yet been launched? ?Most people put revenue projections in their business plans, but they don?t do it in sufficient detail,? Feldman says.

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The proper place to begin, he continues, is to make a list of potential buyers for the product. ?Let?s say that a company develops a box that will speed up people?s Internet service. The most likely customer for such a thing would be a big cable company, such as Comcast or Cox Communications, who would offer this as an upgrade to its existing subscribers. By looking at government databases, as well as private data sources such as Pratt?s Stats (PrattsStats.com), you can find out how many subscribers these companies have and what percentage of those subscribers regularly purchase upgrades when they are offered. Then, you can build in a reasonable royalty on sales ? say, 5 percent to 10 percent. The resulting number, while an educated guess, is probably a pretty good prediction of the revenue you would get from each of those relationships.? (A list of available databases can be found at the Business Valuation Resources website, BVMarketData.com.)

So, for example, if a cable company has one million subscribers, 10 percent of whom regularly purchase upgrades; the box retails for $100; and the agreed-upon royalty rate is 10 percent, a reasonable projection of revenue from sales of the box by that cable company would be $1 million (1 million x 10 percent x $100 x 10 percent). Once projected cost is subtracted from projected revenue and the result is adjusted for taxes, the present value is then calculated. This is the value of the intellectual property. At this point, the value that actually emerges is determined by negotiation with each investor.

Feldman?s books on this subject are What Every Business Owner Should Know About Valuing Their Business (McGraw-Hill, 2002) and Principles of Private Firm Valuation (Wiley, 2008).