Valuation Basics

VALUATI
ON
BASICS
and …. Practical Tips

Contents

Valuation
Valuation approaches and models
Arriving at valuation
Valuation in special cases
Negotiations and valuation
In summary

Anjana Vivek

VALUATION

Valuation of an enterprise … the price of a share

Let us look at an example now and consider the case of an offer by Hello Corporation for
Buy Inc. Hello initially offered $18 per share to shareholders of Buy. This offer was first,
increased to over $22 per share and then to $30 per share. All these offers were within the
space of a few months. How does one look at this issue? Did the value of Buy, increase
dramatically over the months in consideration? Do you really perceive that the
fundamental value of Buy increased so rapidly - over 60% - from the first offer to the
third? Or was it something else?

On going into more detail, we find that there were some rival bidders in this case. So
would you like to say that the 60% rise in offer price was because of the rival bidders?
Can this likened to an auction, where each person bids for a prized item? We are talking
about purchase of a business in this case; enterprises cannot be bought and sold as if they
were items in an auction. Or can they?

Let us now take a look at the valuation of a company in India, some years ago. If we look
at the IPO, we find that the floor price was taken at a little over Rs.100 per share. Analyst
reports observed that the floor price might appear high, if one looked at the existing
earnings. However, they added that if one took a long term view, one might expect
improvement in the earnings in the coming period. Subsequent to the listing of these
shares, the share price saw a general upward trend, moving towards almost 5 times this
floor price in about seven months.

Does this mean that the IPO listing price undervalued the company? Or again is it
something else? There is in fact one school of thought, which says that if the IPO price is
marginally below the expected value, one can expect to see the price go up on listing.
This would lead to increased interest in the company, which would in turn generate more
trades, which would further increase the value of the company after the IPO. This
marginal undervaluing is then a strategy route that some companies take, when they are
deciding on the listing price.

In the last few years we have seen stock market prices fluctuating widely. Often we talk
of valuation and pricing of company stock in the same breath. This paper is an attempt to
look at some of the popular methods of valuation and trigger thinking.

Initial thoughts on valuation

What we can see from these examples is that valuation of an enterprise involves many
factors, including data collation and analysis. Other factors which impact valuation
include elements of the strategy of the business, understanding the position of the
company in the industry, understanding the impact of general economic trends on the

©av Valuation Basics: Class Notes 2

business and so on. In fact, most of the time, it is these latter points, such as strategy and
economic environment, which impact the valuation more than anything else. Further, in
the case of a transaction between two or more parties, it can also sometimes; boil down to
what price the buyer is willing to pay for the stake in the company versus what price the
seller is willing to sell the stake in the company for.

We all can therefore see that valuation is not something that is fixed and constant. It
varies, from time to time, depending on the transaction and the need of the buyer or
seller. It depends on the negotiation skills of the buyer or seller.

Valuation models use a substantial amount of data and quantitative information as inputs
to arrive at the final valuation numbers. There is, however, also room for a lot of
subjectivity in these numbers. For example, if we take a relative method of valuation,
how do we select companies that are comparable? Do we select companies in the same
industry or those which have the same size as the company we are trying to value? The
selection of our sample and application of this method may lead us to different values in
both these scenarios. Further, valuations are a function of time. A company, which has a
very high value today, may have a different value tomorrow. Much of the valuation is
because of assumptions about the future of the business, which itself is uncertain.

Valuation of a company is undertaken with an eye on the future. We value a company
because of its tomorrow, in most cases. This estimate of the future carries its own risk.
The valuation models provide for the risk to be built into the numbers in different ways.
Some of this is by taking a higher discount factor, by having an appropriate risk premium
or by performing a sensitivity analysis by making slight variations in the key value
drivers of the enterprise being valued.

In brief, valuation is a perception of the value of a business at some point in time. It
depends on the purpose of the valuation. It depends on whether one wants to buy or sell
or is looking for equity investors. Bankers value a company differently for lending as
compared to a venture capitalist (VC) who is willing to take a higher risk. Both the
banker and the VC are interested in financing future operations of the investee company.
Both the parties, want to get a financial return from such a transaction. However, both
will approach the project with different views.

So, is valuation a science or an art? This debate can go on. The question and answer are
not as important as arriving at the fair value of a business. What are the elements to be
considered, what data is important and how does one arrive at a final value of a business?

VALUATION APPROACHES AND MODELS
At the start of any business valuation exercise one has to look at the various methods of
valuation which are possible and then try to select the method(/s) that could be
appropriate.


The difficulty is that there are actually too many models to choose from. In addition,
some methods can be modified and used with slight variations, depending on the situation
and requirement of the valuation. As a result, valuation is sometimes a complex exercise.
In this section, we try to look at some of the methods that are used and the special aspects
of these methods.

Environments Impacting Valuation

The value of an enterprise depends on a variety of factors, key among them being the
industry environment, both in the country or countries of operation, the socio-political
environment and the company specific environment.

Industry
Global Value
Company of
Busines

Figure: Factors impacting valuation

It is not unusual to find two companies, in the same industry, operating in the same
region, with approximately the same number of people, having different values. The
difference in the value could be for a variety of reasons. In fact this is to be expected. No
two businesses are alike, and this is captured in the difference in the valuation.

The differences in the two businesses could be due to the experience of the key
management team, it could be due to the customers that one company has as compared to
the other, or could be due to certain patents or intangible assets held by one company and
not held by the other.

Sometimes, this advantage which one company has over the other, maybe be perceived,
and may or may not exist in reality. This is because of the intangible "Brand-image,"
enjoyed by one company as compared to the other. A good valuation model should be
able to capture this intangible. For example if a Discounted cash flow model is used, the
"Brand-image" may be captured by increased future revenues of one company as
compared to the other, which will in turn lead to increased cash flow.


To expand this further, let us take an example of two (hypothetical) IT companies in
Bangalore, Gyan Technologies Private Limited (Gyan) and Wave (Wave) Technologies
Private Limited. Assume that both are in the same segment of business, with almost
identical current year revenues. Further, assume that the key management team of Gyan
as compared to Wave, has more experience and domain knowledge.

It is therefore, not surprising that, in the future, the performance of Gyan is expected to
be superior to the performance of Wave. Of course, this is with the underlying
assumption that the two companies are quite similar in all other parameters of
measurement currently. These parameters include measurable assets and intangibles.

In this case, it is expected that this superior performance of Gyan will lead to better
appreciation from existing customers, and as the word spreads, will lead to increased
assignments from existing as well as new customers. This will translate into higher future
revenues for Gyan, as compared to Wave in the future, and will be reflected in the
increased value given to Gyan as compared to Wave.

To sum up, though currently, if measured on current performance, the two companies
appear similar, in the future, it is expected that one company will outperform the other.
As a result, there will be a difference in the enterprise value, which is based on future
expectations, rather than current performance.

Factors that Impact valuation

Prior to an exercise in valuation, the enterprise being valued must be studied in depth. In
an existing company, historical data and other information, would be reviewed. As
mentioned earlier, this would include company specific information, industry related
information in the context of the global environment for business.

In a start-up, the future expectations from the company and industry would be used as
reference points. When a start up is set up to take advantage of emerging opportunities in
a new market, in the initial phase several assumptions and estimates are made regarding
the future. The valuation model should be one, which attempts to capture these
expectations in one form or other.

Sometimes, in a nascent, yet to become stable industry, the initial phase is very volatile.
Valuation can reach absurd heights and depths, in these situations. This is what happened
in the case of the valuation of the first few so called 'Dotcom' companies. Valuations
models were based on a variety of non-standard assumptions. Many companies were
valued based on page hits. A multiple was applied for every page hit.

Different new technology industries, have tried different valuation models. It has been
said that some biotech companies have been valued based on the number of PhDs in the
company. ITES companies are often valued at a multiple of revenue. This base revenue
could be either the current year revenue, or future expected revenue. Further, the multiple


could be as little as 0.8 times the revenue or could go to many times the revenue. This
multiple would depend on a variety of factors, including inter-alia, the specific company
characteristics and other factors such as whether the previous year's revenue is considered
or the future revenue.

We can see from the above as to how variations of valuation models are used to arrive at
the value of an enterprise. Let us now look at some basic valuation models.

Valuation Models

Valuation models are forward looking. A valuation exercises is an attempt to capture the
expectation of the future of the business in a numerical form.

Valuation models can be broadly classified into three types:

Valuation Methods

Cost Based Income Based Transaction Multiple

Figure: Broad Classifications of Valuation Methods

These methods do not get tied into watertight compartments. One does sometimes see the
use of hybrid models that are a combination of more than one of these methods.

Cost Based Methods

In the cost based method for valuation, assets of a company form the basis for arriving at
a final number. Broadly, we can classify this into the following methods:

• Net asset value or Book value method
• Replacement cost method
• Liquidation method or Break up value method

Net asset value or Book value method

The book value method, takes the value of the assets as per the balance sheet of the
company on the date of valuation. This method can also be used with some variations.
The value of the business can calculated as a factor of the net assets, plus a mark up or
reduced by a mark down factor. As an example of the mark down, consider an enterprise,


which has some possible concerns, and issues that are not reflected in current financials.
This could be the possibility of technological obsolescence or expected changes in
statutory regulations, which may affect future profitability etc.

Replacement cost method

In the replacement value method, assets in the financial statements are taken at current
values to reflect their 'true" or 'fair' value. The prime consideration in this case is the cost
of setting up an enterprise similar to the business being valued.

Liquidation method or Break up value method

In the liquidation value method, the value of a business is that amount which is realizable
on sale of the enterprise, either as a whole or in parts.

This model has to be applied with care. It is important to know whether there could be
buyers who would come forward to purchase the assets of the company. If there are no
expected buyers, assigning the assets a value would be a meaningless exercise. There
could also be a situation where a company is split into parts and sold. Here the liquidation
value will not be a simple summation of the different values of the individual parts. The
other costs of liquidation would also have to be deducted from the value of the enterprise.
Ultimately, the value should be a realistic, realizable value of the enterprise on
liquidation.

Income Based Methods

Income based methods are the most widely used. These are further classified into the
earnings capitalisation method and the discounted cash flow or Net Present Value
Method.

Earnings Capitalisation Method or the Profit Earnings Capacity Method (PECM)

In this method, the earnings of the company being valued are capitalised at a rate which
is considered suitable. This method is profit based and values the company in terms of the
profit earning potential.

For example assume that Company Profittee Limited is earning post tax profit of Rs. 5
crores and we would like to capitalize this at 10%. The value of the Profittee Limited
under this method is equal to Rs. (5/10%) crores, ie Rs. 50 crores. This is a simple
method of calculation of the corporate value.

Discounted Cash Flow Method

In the discounted cash flow method, the net present value (NPV) of discounted cash flow
is calculated. It is typically assumed that the business being valued will have a growth


phase, followed by a steady phase. In the growth phase, the business will be expanding
and may have high capital expenditure. Revenues may grow steeply or jump to higher
levels, as capacities are built up in the company. In the steady phase, the business growth
may be slower than and not as volatile as in the earlier growth phase.
The DCF model is a summation of the value of the company in the growth phase and the
steady phase. The value in the steady phase is usually captured in the form of terminal
value of the company. In some cases, the growth phase in turn is further split into two or
more phases, with differing growth rates. In such cases the NPV is calculated as a sum of
the value in the different growth phases and the terminal value of the company. The
figure below, illustrates this, where a company has two growth phases, followed by a
steady phase.

Discounted
Value: Phase 1
Discounted
NPV of Value: Phase 2
Enterprise

Discounted Terminal Value

Figure: Net present value

The cash flow model assumes that the enterprise is a going concern and that the value
drivers of the company are also the drivers of the cash flow of the company.

Transaction Multiples Method or Relative Method

In the transactions multiples method (TMM) or relative method of valuation, the value of
a company is calculated based on the values of similar companies. The difficulty is in
identifying similar companies. Some common ways of selecting comparable enterprises
is by identifying companies by way of size, ie in terms of revenues, number of employees
etc. The other way is by looking at companies in the same industry, irrespective of the
size.

To illustrate this, let us take a company, Pleasant Services Private Limited (PSPL) in the
ITES (IT enabled services) industry, with a revenue of Rs. 35 crores in the current year.
PSPL expects revenues of Rs. 50 crores in the coming year. Some investors are interested
in valuing PSPL.

To arrive at the value of PSPL, one first tries to identify comparable transactions that
have taken place in the past few months in the ITES industry. Out of the transactions that


have taken place five are selected. It is observed that the average value of these
companies, in the transactions, was between one to two times the forward revenue.

This input is used to value PSPL. One can directly use a multiple of 1.5 on the expected
revenue in the following year to value the company. This will give us a value of Rs. 75
crores for PSPL. One can also make an adjustment to this multiple. Assuming that PSPL
is superior to the companies being valued, one can even try to justify a higher multiple,
for example, 1.75. This will give us a value of Rs. 87.5 crores for PSPL.

On the other hand, one may feels that it is preferable to discount the multiple to 1.25,
because of the size or nature of business of PSPL as compared to the other five
companies which were used as the base for comparison. This will lead to a value of Rs.
62.5 crores for the company.

Thus, using the relative method leads us to a value of the company based on its position
relative to the other comparable companies in the industry.

ARRIVING AT VALUATION
As seen above, there are different options available to someone who is undertaking a
valuation exercise. Selection and application of a valuation method is an important part of
the process of valuation. How does one try to select from the various options for
valuation? The valuation process has different stages, shown below:

Data Validation Selection Valuation Validation
Collection of Data of of the of the
Valuation Company Value
Model

Relook at Finalise
the the value
valuation No Does the Yes arrived at
exercise value stand
starting up to
from data scrutiny?
collection

Figure: The Valuation Process


A typical valuation process can consist of the following stages:

i) Gathering information and data about the enterprise and the global environment
ii) Validation of information
iii) Selection of valuation models based on the data collected and preliminary
analysis
iv) Arriving at the value range of the company, based on the numbers that are used as
input in the valuation models selected
v) Review of the calculated value of the enterprise in the overall context of the
transaction proposed

Collation of Data

In this stage, one has to understand the business environment in which the company is
operating. One should collect information about the industry trends, in India and in the
global environment. This includes data on expected future growth in this line of business,
expected market shares, margins in the business and analysis of the competitive
environment.

It is at this stage that one tries to understand the underlying expectations of the company,
in terms of its strategy viz a viz that of its competitors. This is of course assuming that the
company has some strategy or plan for the future. This analysis is to be used in
developing a business forecast. While forecast prediction can never be wholly correct,
such analysis helps one get a clearer picture of the company and its position in the
business environment. This in turn helps in getting a good valuation model in place.

Validation of Data

In this stage, we look at the business forecast and try to understand whether it is
reasonable or not. The numbers and data must stand up to scrutiny.

To illustrate this, let us consider the case of Swifter Private Limited, which is expected to
have a growth rate of 20% every year for the next 5 years. If the industry growth rate is
expected to be 12% in the next five years, then this growth rate of Swifter Private
Limited is to be questioned. Is the company really in a position to deliver such super
growth as compared to other companies in the industry? If so, then what is the reason
underlying the superior performance? Is it better quality of products or service or cost
efficiency or some Intellectual Property that the company has? What will happen to the
value of Swifter if we reduce the growth rate to that of the industry, ie 12%? What will
happen, if we take a rate of 15%, which is better than the industry rate, but still far below
the super-optimistic rate of 20%? In essence, such deviations from industry performance
are to be validated; otherwise, the valuation exercise will not hold credibility.


Selection of Valuation Model

The selection of an appropriate model of valuation is sometimes easy, at other times,
complex. A structured approach will help at this stage. One should first list out the
possible basic models of valuation that are available and eliminate models that will not be
suitable in the case in question. For example, if the enterprise is a start up, with negative
cash flows in the first few years of business, we will not use the DCF model.

The methods we select must reflect the methods used in the industry. In the IT enabled
services industry in India; companies have been valued at multiples of revenue. While
valuing a company in this industry, one must therefore, necessarily, value the company at
a suitable multiple of revenue.

If possible, one should try to select more than one valuation model, to arrive at the value
of the company. If the value of the company varies with different models used, this can
be a cause of concern. Either our calculations are flawed or one of the models is not
suitable for application in the case under consideration. We should then look at our data
and assumptions closely and go a step further to understand how we could address such
discrepancies.

Once one has narrowed down the models that can be used, one may try to do a quick
ballpark calculation of the value of the company under the different methods. This will
give the valuer some understanding about the appropriateness or otherwise of the models
in question.

The example below has two companies that are to be valued. We try to use the relative
method in both cases. In Case A, we find that we can use the relative method for
calculating the value of the company, Meadows Private Limited. In Case B, however, we
find that the relative method is not appropriate to value PencilPens Private Limited.

Example

Application of the relative method of valuation to an enterprise.

Case A
In this example we try to arrive at the value of Meadows Private Limited, based on
the enterprise value of three listed companies, Garden Limited, Parkland Limited and
Plantation Limited.
Garden Parkland Plantatio Average
Limited Limited n Limited

Enterprise Value/Sales 1.5 1.2 1.2 1.3

Enterprise Value/EBIDTA 18.0 16.0 17.0 17.0

Enterprise Value / Book 3.4 2.8 3.1 3.1
Value


Solution:

Application to Meadows Private Limited.

Meadows P Ltd. Average Enterprise
of three Value of
relative Meadows
Rs. crores companies Rs. crores
Sales 180 1.3 234.0
EBIDTA 14 17.0 238.0
Book Value 74 3.1 229.4

The value of Meadows could be in the range of Rs. 229 crores to Rs. 238 crores,
based on the above.

Case B
Let us now try to arrive at the value of PencilPens Private Limited, based on the
enterprise value of three listed companies, Papers Limited, Documentation Limited
and Printing Limited.

Papers Documentation Printing Average
Limited Limited Limited
Enterprise Value/Sales 1.5 1.8 0.9 1.4

Enterprise Value/ EBIDTA 14.0 21.0 10.0 15.0

Enterprise Value/ Book 2.1 3.0 1.8 2.3
Value

Solution:
Application to PencilPens Private Limited.

PencilPens P Ltd. Average of Enterprise
three Value of
relative PencilPens
Rs. crores companies Rs. crores
Sales 160 1.4 224.0
EBIDTA 10 15.0 150.0
Book Value 85 2.3 195.5

The value of PencilPens, using this method, ranges from a low of Rs. 150 crores to a
high of Rs. 224 crores. Perhaps one may come to a conclusion that one cannot use
the relative method for valuation in such a case and needs to look for an alternate
method. Do you think that is the right conclusion? What is your view? Perhaps the


companies selected are not appropriate, the method may be fine. Thus in each specific
case of valuation, one has to look beyond the obvious and come out with solutions,
which are meaningful and practical to use.

To trigger thinking
• Where could the problems arise in this method of valuation?
• If you were valuing the two companies in the above examples, how would you
go about selecting the sample companies?
• Faced with the problem in using this method in the Case B above, how would
you proceed? Would you drop this method altogether? If not, how would you
address this concern?

These above examples illustrate broadly how one can select valuation models, to be
applied in a given situation. The use of the method or methods of valuation also depends
on the nature of the proposed transaction and requirement for this valuation exercise. For
example, if an acquisition is proposed, the valuation should reflect the synergy expected
from the proposed transaction. The future expected cash flows post the transaction will
reflect this synergy of the combined new enterprise and will automatically therefore get
reflected in this value of the combined business. However, if the two companies are
valued separately, on a stand alone basis and their values summed up, this may be
different as the synergy may not be reflected when they are treated as independent
business units.

The choice of valuation model and its application is critical to the valuation exercise
and must be done with due care and thought.

Valuation of the Company

Once the valuation models have been identified, data is input to obtain the value of the
company. We are all aware that there are many uncertainties in the business environment.
While due care may have been taken while valuing the business, it is a fact that some
assumptions have to be made. These get reflected in the data used in the valuation models
and impact the valuation.

To reduce the impact of subjectivity in the corporate valuation exercise, one can look at
alternate scenarios. Assume that a company does not perform as well as projected in one
case, the pessimistic case. In another case, the optimistic case, assume that the
performance exceeds expectation. In the pessimistic scenario, revenues will be reduced
and some costs may be cut as the company tries to work with reduced cash flow. In the
optimistic scenario, both revenues and certain expenses may be on the higher side. One
could perform a sensitivity analysis and calculate the change in corporate value due to an
increase (or decrease) in sales of say 10% and some other elements of cost, such as salary
costs or marketing expenses.


Such an analysis will highlight and help understand the possible impact of variations in
the value drivers of the company. The value drivers would depend on the industry and
nature of business. The sensitivity analysis would thus, provide a value range of the
company for different levels of performance.

In some cases, weightages are assigned to the different scenarios. These weightages are
supposed to reflect the probability of each scenario occurring in the future. For example
let us take three possible scenarios, optimistic, normal and pessimistic, where the value is
expected to be Rs. 200 crores, Rs. 180 crores and Rs. 150 crores respectively. If the
probability of each of these occurring is 50%, 20% and 30% respectively, the expected
value of the company is calculated as:

Value (expected) = (200*0.5) + (180*0.2) + (150*0.3)
= 100 + 36 + 45
= Rs. 181 crores

The valuation of the company, which is the key objective of this exercise, is to be done
carefully. The final valuation of the company or the valuation range has to effectively
capture the story behind the enterprise.

Validation of Final Value

Once we arrive at a value of the company, we need to again raise some questions such as:
• Does the value reflect the expected future performance of the company, based on
its strategy?
• Does the value reflect the position of the company compared to others in the
industry and other competing companies?
• Does the value reflect the quality of the management?

The answers to questions such as these will help us get a comfort level on the value
arrived at.

Let us take an example of the value of Seels Private Limited (Seels), which has been
calculated to be in the range of Rs. 95 to 103 crores. If a similar company, PS Private
Limited (PSPL), was acquired by another enterprise for Rs.85 crores three months prior
to this valuation exercise, we would need to question our valuation of Seels. One could
either question the valuation model, or the inputs to the model, or both. If however, we
feel that the higher value in the region of Rs.100 crores, is justifiable, we need to explain
why this is so. This may be because Seels is superior to PSPL, or perhaps because there is
a buyer, Buuy Private Limited (Buuy), who is willing to pay this higher value. This in
turn may be because of the strategic requirement of Seels, which could be anything from
wanting to increase capacity within a short period to wanting to enter a new market.
Thus, we would validate the increased value assigned to Seels as compared to PSPL, by
looking into the reason for this.


If the value arrived at appears incorrect or inconsistent with other available information,
one needs to take a relook at the enter valuation exercise. For e.g. if the value of a listed
company is significantly below its market value, one would try to understand where the
difference could lie. Is it that the
• data is not correct, or that
• data has not been correctly input in the valuation model, or is
• the valuation model itself not suitable for this exercise?

Another reason could be that the market is assigning a higher value to the company, not
based on its intrinsic worth, but based on the general market perception of the industry. In
this case, one would actually need to revisit all the five valuation stages, listed earlier.
Additional information and data, which may be obtained at this point, would be fed into
the valuation model.

There are many factors that affect the value of a company and need to be kept in mind
while reviewing the enterprise value arrived at using valuation models. Some of these
are:

• Strategic requirements - These can override other considerations. For example, an
IT company in India may be willing to pay a premium to buy a small company in
US, because it wants access to some new markets in this country and perceives
such acquisition as a means to achieve this object. Can you think of such
examples?
• Many interested buyers - If there are many bidders for one enterprise, the value of
this company will be higher than what it would have otherwise been sold for
• Flavour of the season - Sometimes select industries are perceived to be on a
growth path. Others who want to enter this industry may prefer to purchase an
existing company, albeit at a higher value, as this may be easier than starting a
new company. This will in turn lead to increased values for all companies in the
industry in question
• Control premium - Sometimes persons who are investing in a company may want
a controlling stake in the company in order that they can influence the future
directions of the company. In such a case, they would be willing to pay a
premium on the value of the company, which is arrived at based on the valuation
model.
A value is not necessarily a fixed, well-defined number. The overall value of the
company is dependent both on the intrinsic value of the enterprise and the reason behind
the valuation exercise.

VALUATION IN SPECIAL CASES
Standard models of valuation cannot always be applied. There are some situations where
the valuation models discussed in earlier chapters have to be modified to take into


consideration the special nature of the situation. We take a look at some of these
situations in this section.

Valuation for Mergers and Acquisitions

The majority of the valuations for M&A activity is done keeping a possible deal in mind.
In case of such valuations it becomes important to understand the strategic rationale
behind such a deal. M&A transactions are proposed when synergy is perceived between
the merging companies. This could be in terms of increased revenues, reduced costs or
other intangibles.

Prior to the valuation exercise, it is useful to raise some questions on the proposed
transaction. For example if an acquisition is being made to enter into a new area of
business, one would value the target company keeping the following factors in mind:

• What are the advantages of entering this new business segment?
• What are the costs of setting up a new unit from scratch?
• How much time and effort is saved by buying this company as opposed to setting
up a new business
• What is the competition for the target company?
• How is this company more suitable for acquisition as compared to others in the
same area of business? Is it because of the management, the infrastructure or
something else?
• Is there any other alternate company one could acquire or purchase?
• Is it necessary to acquire this company, or some other company in this industry, or
can one just look at a controlling stake?
• Will getting into this new area, provide the acquirer an edge over competition?
Are any soft issues such as HR integration likely to be faced on acquisition?
• Are there any possible acquisition issues such as IT policy integration of the two
companies, integration of administrative processes etc. likely to negatively impact
the deal?
• Are there any legal issues that can impact this transaction?
• What could be the tax related issues in this transaction?

The above questions are illustrative and not exhaustive. Regulatory and tax issues are
also key deal issues, particularly in the case of cross border deals where regulations
of more than one country are involved. These must be factored into the valuation and
deal structuring. Once we have some answers to questions raised and some understanding
of the rationale of the proposed transaction, we can proceed to valuing the business.

The example, below illustrates the impact of expected synergy on the valuation of a
company which is a potential target for acquisition in three situations in Case A, Case B
and Case C.


Case A

Sw Technologies (Sw) proposes to acquire Hardwiring Company (Hw). The following
are cash flow projections for the next 5 years of the two companies, on a stand alone
basis.

Sw Amt. in Rs. crores
Year 1 2 3 4 5
CF 20.0 23.0 30.0 38.0 50.0

Hw Amt. in Rs. crores
Year 1 2 3 4 5
CF 2.5 4.0 6.0 9.0 12.5

The following is the expected cash flow of the combined business, due to operational
synergies envisaged:

Sw and Hw together Amt. in Rs. crores
Year 1 2 3 4 5
CF 23.0 28.0 38.0 50.0 67.5

Please note that in the above example, the value of the cash flow of the combined
business is shown as being greater than the sum of the cash flow of each of the stand
alone companies. Do you think this is correct?

What is the value that Sw can pay for Hw, assuming a discount factor for the cash flow,
provided below for convenience? The net present terminal value after the five years has
been calculated as Rs. 132 crores for Sw and Rs. 32 crores for Hw. The net present
terminal value of the combined business after 5 years is calculated to be Rs. 170 crores.

Year 1 2 3 4 5
Discount 0.833 0.694 0.578 0.482 0.401
factor 3 4 7 2 9
@20%

Solution

In the first step, we calculate the synergy expected by subtracting the cash flow of Sw on
a stand alone basis from the cashflow of Sw and Hw together. This works out to:

(Sw and Hw together) - Sw Amt. in Rs. crores
Year 1 2 3 4 5
CF 3.0 5.0 8.0 12.0 17.5

Next we calculate the Net Present Value of the synergy expected in the next five years
with the 20% discount factor. This works out to Rs.23.42 crores.


Third, we add to this we the expected synergy on account of the terminal value which is
Rs. 38 crores (170 - 132). This results in a value of Rs.61.42 crores, which is the total
value of the synergy in the combined business.

Therefore, the maximum amount that Sw can consider paying for acquiring Hw is
Rs.61.42 crores.

Case B

In the example above, assume that the two companies had several rounds of negotiation.
The final price offered by Sw was Rs. 55 crores . Do you think that the shareholders of
Hw should accept this price?

Solution

The proposed deal is now viewed from the perspective of Hw. For this we need to
calculate the stand alone value of Hw. The NPV of Hw for five years is Rs.17.70, based
on the discount factor of 20%. To this we add the terminal value of Rs. 32 crores. Thus
the NPV of Hw on a stand alone basis is Rs. 49.7 crores. Since the price of Rs. 55 crores,
offered by Sw, is higher than this price, the shareholders of Hw can accept this offer.

Example

Continuing with the case of Hw and Sw, consider three scenarios where the deal price is
Rs. 45 crores and R.s. 52 crores and Rs. 65 crores respectively. In each of these cases,
who benefits from the deal Sw or Hw?

Solution

If the price is Rs. 45 crores, all the benefits are with the shareholders of Sw. If the price is
Rs. 52 crores, both the companies get value out of the deal. If the price is Rs. 65 crores,
the deal has been over priced and the shareholders of Sw will not realize any deal value.

A point of caution is that, in reality, monetary concerns are not the sole drivers of M&A
transactions. The case of Hw and Sw above illustrates only monetary benefits. If there are
strategic reasons for the acquisition, the price while an important issue, may become a
secondary factor. The deal maker or breaker issue, could be something else.

Another factor that can also play a crucial value in determining the final price at which a
deal is closed is the negotiation skills of the parties to the transaction. A skillful
negotiator may be able to get more value out of a deal than someone else.

Valuation is also impacted by whether transaction are all cash deals or cash cum stock
transaction or stock swap transactions. The value arrived at will be impacted by the


nature of the consideration. In some deals, the payment is structured based on future
performance. For example, some cash payout could be promised after a period of time,
such as a 20% additional cash payout if performance targets are met. This breaks down
the valuation into two components, a basic fixed price and a flexible payment, linked to
future performance.

Valuation for Multi-business

Sometimes one has to value a company, which has diversified into several industry
sectors. Each sector will have its own risks, rates of return and growth and other special
factors.

In such a case the company can be valued by the "Sum of Parts" method. Each business
unit is independently valued, based on the industry in which it operates. For example a
company may have one unit in IT services and one in textiles. The two are in totally
different sectors of operation. Obviously we cannot have the same growth rate and
discount rates for the two areas. The two units are valued separately as if they were two
separate, independent, enterprises.

To get the final value of the enterprise, we take the arithmetical sum of the independent
business units and then, reduce from this, the unallocated enterprise costs. Examples of
unallocated costs are corporate overheads, advertisement costs of the company which are
not specifically related to a business unit, listing costs of a publicly listed company etc.

The advantage in this method is that it helps understand which of the business segments
drive the value of the corporate group, in other words, which units are more valuable to
the company. One can actually get some understanding on whether the units are
independently more valuable, or whether there is some synergy which makes the
company as a whole more valuable than the individual parts. This can be particularly
useful in restructuring exercises.

Valuation in cross border transactions

As we see many global companies coming up, cross border transactions are increasing.
Handling such transactions can be complex due to many factors, including:

• Foreign exchange fluctuations
• Difference in statutory regulations
• Tax related issues
• Difficulties in ascertaining cost of capital
• Country risk, including political risk
• Multi country transactions
• Differences in accounting standards and policies


Let us take an example of a US company, which has subsidiaries in UK, Italy and Japan.
If the UK company does business with the companies in Italy and Japan, then the foreign
currency transactions have to be translated more than once during the valuation exercise.
As valuation is generally based on forecasts for some years in the future, this involves
forecast of exchange rates in many countries, some years into the future.

Statutory regulations and tax issues such as transfer pricing rules and regulations, impact
of tax treaties and tax planning strategies can impact cash flows. Some countries also
have restrictions on transfer of currency by way of a cap on the amount of funds that can
be moved out of the country freely. Regulations can, therefore, significantly impact
valuations.

Accounting standards vary from country to country. Some areas where accounting
standards differ are accounting for provisions such as pension, goodwill, revaluation of
assets, deferred taxes, foreign exchange, non operating assets and taxes to name a few.

When companies operate in different markets and regions, it becomes very difficult to
estimate the cost of capital. Capital can be raised in one country and used in another.
Other difficulties arise when trying to calculate risk premium in different countries and
the impact of illiquid capital markets, inflation and political risk.

In all these areas, suitable adjustments are to be made for valuations. Assume that one is
trying to value a company in US that has a UK subsidiary, which has international
transactions. One would first prepare the financial statements and business forecast for
the UK company, making all the adjustments and forex translations that are required.
Subsequently, this would be converted into US dollars for valuation purposes.

Valuation for Venture Capital Investment

Venture capital (VC) investment is typically in high risk companies with high growth
potential. Investors in such companies are willing to take a substantial risk if they
perceive that there is an opportunity to get extraordinarily high returns.

Many risk investors use the market multiple method for valuation. A popular method is
valuation based on a one year forward revenue multiple. This involves a) forecasting the
revenue of the immediate year ahead and b) arriving at the value by multiplying this one
year forward forecast with a suitable multiple. The multiple will be arrived at based on
comparable deals that have taken place in the market in the immediate past. This is the
base value for negotiations. The difficulty arises when the deal multiples are not easily
available as these are closely held companies. The difficulty also arises when the
investors and promoters disagree on the revenue forecasts.

Another method that is used by VCs is using an Exit Table in which they start with a
forecast terminal value. VC investment is for a short period in a company, typically
ranging from three to seven years. The Exit table assumes the period after which the VC
will exit from the company and a value at this point of exit.


In order to look at different possibilities, VCs can change the parameters in the Exit Table
to arrive at different valuations. There could be changes in the Exit value, there could be
changes in the exit period and there could be changes in the discount rate. The value of
the company is calculated for different scenarios to give insights into the potential risk
and returns from such investment.

Let us illustrate this with an example.
Arc Ventures (Arc) wants to invest in a company, Entrep Private Limited (Entrep). The
following information is provided:

Expected terminal value $ 50 million
Investment amount $ 4 million
Exit period 5 years
Discount rate 50%

The post money and pre money valuation of Entrep is to be calculated along with their
shareholding in Entrep at these values. The post money valuation is the term used by VCs
to denote the value of a company after their investment. The pre money is computed by
deducting the investment amount from the post money valuation.

Solution

We first discount the expected terminal value after 5 years at 50%. The Net Present Value
of $ 50 million after five years at 50% discount rate is $6,584,232. This is the post money
valuation.

The pre money valuation is $ 6,584,232 less $4 million, ie $ 2,584,232.

The stake of Arc in Entrep is $ (4,000,000 / 6,584,232) , ie 60.75%

There are generally two key factors that drive the valuation in a VC backed start up. The
first is the amount of cash burn in the initial period and the next is the stake in the
company that the entrepreneur is willing to give up for this investment. The cash burn is
something which has to be provided for as the company will otherwise not be able to
continue in business. The VCs fund a substantial part of this requirement. The promoters
of the company, however, cannot give up their stake in the company to the VC, beyond a
certain point. Such an action would reduce their incentive to work in the company. Hence
these two constraints become, in some sense, the value drivers of the valuation exercise
in an early stage venture.

The factors impacting pricing and valuation in a VC investment is explained well in this
note on investment in Wireless Software Inc. prepared by Abraham Mathews, FCA, for
the Akshara Study Circle, Bangalore. An extract of this is given below:


Wireless Software Inc.

Wireless Software, Inc. was started by a technologist in February 2000. The company
received start up funds from a venture capitalist - VC1. The initial seed round funding of
Preferred A by the founder and VC1 was $ 4 million. A few months later came the
Preferred B round for $12 million that brought in VC2 and VC3. The valuation post-
Preferred B was $32 million.

• Over the course of the next 18 months, Wireless changed its business focus
• The global fall in valuations in its area of business, made the company rethink its
strategy. Wireless shifted its market focus from the US market to the Asian
market.

The Preferred B venture capitalists continued to support the company, and brought in an
additional $2.6 million in the Preferred C round. The valuation post-Preferred C was
$8.8 million.

Financing Rounds

Investment Stage Investment Series Share price Funds raised in
round
Seed Preferred A $0.05 $ 4.0 million
Round 1 Preferred B $2.00 $12.0 million
Round 2 Preferred C $0.25 $2.6 million
Total funds raised $18.60 million

Equity Ownership

Share holders Percentage of ownership Value of holding
Post Preferred C round
Technologist 15% $1.32 million
VC1 15% $1.32 million
VC2 and VC3 55% $4.84 million
ESOP 15% $1.32 million
Total Company 100% $8.80 million

Pricing and Valuation

Theoretically, while doing valuations, the guidelines that venture capitalists use are ratio
analysis, price earnings ratios, discounted cashflow models, comparisons with recent
transactions, etc. The more mature the start-up, the more likely these tools are going to
give results that are closer to reality. However, for the very early stage companies,
since the probability of the numbers being close to reality is quite low, venture capitalists
are guided more by qualitative factors, such as the quality of management, similar deals
that have taken place, etc. A rule of thumb used by some VCs is to value private
companies at 60% of the valuation of comparable publicly listed companies.


If there are multiple rounds, in the first round, the valuation is likely to be largely based
on qualitative analysis as there may not be comparable companies. In the second
round, the VCs would look at the previous round valuation, how the company and the
market have changed between the two rounds. Between this round and other filler
rounds leading up to the IPO, VCs would question unreasonable increases in valuations
between rounds. Most VCs know one another, and they normally club deals, hence,
ensuring that they pay the same valuation.

Finally valuation is more of an art in the initial rounds and becomes more scientific
towards later rounds. The guiding principle is that there should be enough of an
incentive for all the stakeholders – the founders, the employees and the investors.

One technique that the VCs used in this case, was an exit table to compute their likely
cash inflow on their exiting their position in the company, at different exit valuations.
There were several rounds of negotiations between the various stakeholders, to decide
upon an acceptable valuation, which would have an impact on the issue price per share
of Series C, and would also result in the triggering of anti-dilution provisions of Series A
and Series B stock. The agreed upon valuation changed the percentage holdings of the
various stake-holders in the company, hence, the negotiation also centered around the
final shareholding pattern. As it was a down-round, the VCs wanted an enhanced
liquidation preference, since this would provide them with a far greater return on the
later investment, as compared to the earlier investors. Hence, this brought in a pay-to-
play situation, where existing stakeholders had to make fresh investments if they wished
to protect their earlier investments. The concepts in this case were:

• The Preferred C round VC looked at maintaining a certain % shareholding in
the company, in order to control future operations.
• The Preferred C round VC was extremely particular about keeping a priority
in liquidation preference.

Otherwise, the amount brought in was predicated by the burn rate that the company was
expected to achieve, till it broke even. This imposed fiscal discipline on the company to
reduce the burn rate. Valuation was effectively, incidental to the achievement of these
objectives. The company had no option other than to accept the valuation fixed, in order
to stay afloat.

NEGOTIATIONS AND VALUATIONS
Negotiations also have a key impact on finalizing deal values. Below is a write up which
was originally published in the blog “Entrepreneur’s Corner” at www.citizenmatters.in;
available online at http://bangalore.citizenmatters.in/blogs/show_entry/1112-negotiating-
insights . This is a post on a role play in negotiations for sale/purchase of a business. The
participants took different sides, some were buyers; some were sellers.

There is an interesting incident on the impact of this role play. A day after the session,
one of the participants was involved in negotiating the sale a unit of a family venture. She
said that this role play helped her think through and plan for the deal, as a result of which


the family was able to get a significantly higher price for the sale of the unit than initially
estimated.

Negotiating Insights: From IIMB’s MPWE Programme

Background: Negotiations are a part of life, whether it is in business or in the political
arena, whether it is in selling a company or buying a stake in a business or raising
venture capital for your company. In the last week of sessions of the MPWE 2009 at
IIMB (Management Programme for Women Entrepreneurs) there was a negotiations
role play for purchase/sale of a business. The participants were divided into 8 teams, 4
representing the buy side and 4 the sell side. There were therefore 4 sets of
negotiations. The insights on valuation and negotiation were of high order.

Rules: The rules were simple; a one page sheet of the case was given to the
participants with a background of the company being sold as well as a sample set of
companies. This was to help them arrive at a valuation range, prior to the negotiations.
The groups were also given initial preparation time to plan and decide on their
negotiation strategy.

The 8 teams were instructed that they had to close the deal within the given time. They
were also told that they had to really feel the part of the buyer/seller side and had to get
into the role. The idea was to simulate a real life situation in a limited time period.

Analysis: It was interesting to see the different permutations and combinations that
came up regarding the sale price and deal structuring and the post deal plan. Three
deals were struck, and the fourth set could not agree to a deal price in the time
available. There were variations in the negotiating strategies and the deal price,
however, some points were common across the eight groups and below are the key
takeaways:

• The fact that different persons negotiated differently came across very clearly.
Some teams were able to take leading positions early on in the game, because
of the way they took control over the whole process.
• Negotiations are the starting point, many times if the deal goes through; the two
sides have to work together in the future. It is therefore important to avoid getting
into personal traits and offensive or overly aggressive stances. If one party feels
it has been cheated or perceives unfairness, this will impact the future working of
the combined entity, if the deal does take place. Therefore, it is important that the
two parties realize that they should not perceive this as a battle with two
opposing sides, but rather as a joint work to come to some agreement which is
seen as fair to both parties.
• Ultimately, the teams are made up of individuals and people may be sensitive to
different things. Negotiators need to be aware of the signals sent out by these


individuals. Negotiations is about understanding or attempting to understand the
needs of different people, in your team as well as in the team on the other side.
• If team members of one group disagree in the meeting or give conflicting views,
this can lead the other party to suppose that there is some problem to be
addressed and can directly impact valuation and deal structuring. Thus teams
need to be careful about what messages they are giving out, in their words as
well as in their actions.
• Sometimes, giving the other party a few options helps. Some examples: taking a
certain percentage upfront for a certain value, taking some money now and
some later, an option of keeping a board position, or an option to change the
management of the company such as the CEO and CFO.
• Sometimes news flashes about the business and industry are received and can
change the whole tone of the negotiations. In the role play, there were two
interruptions which announced some changes in the business and environment.
These influenced the negotiators and the deal structuring changed as a result.
For example, at one point, the buyers were given a message about a rumour that
there could be a disagreement in the key team of the sellers. As a result, in one
deal, the buyers decided to bring in a change of management and a part of the
deal money was brought in as a severance package to the CEO of the selling
company.
• The side that was more prepared came out of the deal stronger. They went
prepared not just with a valuation range, but also with a list of questions and
answers to questions that they could be asked. These related to the company,
the business and industry environment and the future plans post the deal, if it did
go through.
• Despite this being a simulation, for a period of time, participants actually felt that
they were buying or selling a business and they felt pleased when the deal was
finalized. This is of course to the credit of all participants who went into this role
play with all seriousness and the outcome showed this. Many times, human
emotion influences us to work towards deal closure, even though the financial
aspects may not be very favorable. We need to be conscious of our emotions in
addition to the financial and business aspects.
• One of the participants summed up this set of sessions very nicely. She said,
prior to this excercise, I thought I could just value my company and go out and
raise funding for this, by offering an equity stake at a certain price. I now realize it
is not like say ...one trying to sell something at a certain price point. There are
many dimensions to sale/purchase of a business and negotiations play a key
role in the price we can get.

Conclusion: At the close, the learnings in the 4 different sets of negotiations were
summarised and contrasted. The participants opined that these learnings and
negotiating insights could help them, not only in instances where they had to sell a stake


in their company or raise capital, but also in other negotiations such as transacting with
a customer or a buyer.

FINALISING VALUATION
Valuation is dependent on the nature of transaction and the reasons driving the valuation
exercise. Valuation is also driven by market conditions. A business worth a significant
amount at a certain point in time may suddenly lose much of its value a very short while
later. This is what happened in many companies commonly referred to as ‘dot-com
companies,’ which were valued at amounts which may seem absurd now…. in hindsight.

Many persons look on valuation as a mathematical exercise; one inputs some numbers
into a spreadsheet and hey.. magically we see a value of the company as per the
spreadsheet. Is it really that simple? Is it really complicated? You can decide.

This paper is an attempt to touch on some of the factors that impact the numbers that go
into the spreadsheet. This is a vast subject, and the more one investigates, the more
complex it can look. At the end of the day, this is a key component in any deal as the
initial ballpark valuation is the starting point for any discussion between two parties. The
author hopes that you have some answers to these questions and more:

To trigger thinking:
• Why do values of companies change from time to time?
• Does value depend on whether one wants to sell a company, to buy a minority
stake or to buy the entire company?
• Will a strategic investor (for M&A) value a company differently from a financial
investor (such as a venture capitalist)?
• How can a company which is losing money have any value?


Valuation Basics

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