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| “We have a history of losses, expect to incur future losses and may never achieve profitability...” (CacheFlow Inc. NASDAQ Prospectus). So why is a company like this worth US$4.4bn?, asks Michael Flynn |
There was a time when a prerequisite to maximising shareholder value was an earnings record of sustained growth. Not any longer it seems, particularly when one looks at the dynamics of technology and internet valuations around the world. Ireland has seen its share of enormous valuations for technology stocks; witness Horizon Technology, ESAT Telecom, Trintech and Smartforce to name a few.
For any buyer, the key objective is to identify where the real sustainable value lies and to avoid those internet companies which are just a fad. With international commerce now so closely linked with the internet, web based companies and their suppliers can no longer rely solely on an edgy image or an innovative idea to attract investors and customers. The customers of today demand that e-businesses either deliver on their promises or move aside. As the internet space is changing so quickly anybody involved in internet M&A transactions must firstly understand the issues affecting the industry, then identify their potential impact and then plan to address them.
Profile of technology companies
Internet companies have a different profile to non-tech companies and their unique characteristics should be examined prior to any transaction. Look out for:
• High valuation expectations
• High R&D spend
• High number of new product lines (mostly developed internally)
• Highly qualified/educated young management with a strong entrepreneurial spirit,
• A focus on the global marketplace
• Wide share ownership with stock options given to key employees
• A focus on exit strategy/ realisation of value from outset
How we do business
The internet is having a fundamental impact on how we interact and transact. E-business simply uses internet technologies not only to create new sales channels but also to enhance relationships with and between customers, suppliers and employers. The following trends should be kept in mind.
• E-business globalisation is becoming a reality and impacts how companies penetrate new markets and develop external trading networks.
• Many industries are experiencing disintermediation as manufacturers go directly to the consumers. While the B2C (Business to Consumer) market is potentially larger than the B2B (Business to Business) market, B2C is far more difficult to crack thus most business will initially be B2B.
• Supplier relationships are changing, as companies source the cheapest supplies on a real time basis.
• Alliances and partnerships are increasingly prevalent as companies pool their skills to go to market.
• New competitors are emerging and challenging existing players and business models.
These market changes have spawned a new generation of companies who exploit technology; equally, the changing world poses threats to corporates that fail to adapt.
Factors affecting internet business
Factors contributing to the growth of e-business include:
• Lower barriers to entry - opportunity for businesses to sell their products 24/7 to a wider market without the need to establish a physical presence.
• Media convergence - the convergence of technologies such as the telephone, PC and television enables increased access to the internet from a variety of mediums.
• Affordability - the technology required to create an internet distribution channel has become more affordable.
• Increasing computer usage - through accessibility and affordability of PC’s, society is becoming more computer literate and more willing to transact via PC’s having become more comfortable with security and authenticity issues.
• Telecommunications infrastructure and PC power - advancements of telecoms networks continue to improve speed and reduce costs of transferring data.
• Successful e-business is not only about technology - a thorough understanding of the current and future dynamics of the market is required to assess a company’s role in the supply chain, how it will exploit its brands to secure maximum value going forward and how its product and service range evolves.
Acquiring internet companies
Developing an internet capability through acquisition breaks all the rules of traditional acquisition criteria. These companies are highly rated by the market and do not follow traditional valuation techniques. The key issues include:
• Is the business model robust enough to generate profits in the medium term.
• Quality of existing management. Are they committed to growth or looking for a quick exit?
• The nature and value of the existing customer base and the relationships with them.
• Alliance or joint ventures existing for supply, distribution and marketing of brands and product/service
• The quality, scalability and security of the technology platform versus the competition.
• Presence of proprietary technology, ideally patented. Is there scope to license the technology?
• Methods of financing development to date may have an impact in the future.
The most successful companies with real sustainable value are those that have moved on to the practical concerns of e-business. These companies are coping with burgeoning bandwidth needs, formulating new web-based customer relations processes and analysing web site traffic with an evermore sophisticated eye.
Valuation
Internet companies have been valued at staggering amounts defying most traditional valuation methodologies e.g. P/E’s, dividends etc. Most of these companies have limited historical trading figures and are valued on the business infrastructure, prospective business models and web usage. Valuations are sometimes determined using multiples of revenues, click throughs, subscriber count, mind share and a host of other proxies for net profit. While these are useful methods of assessing a valuation, they are not ideal for calculating the valuation payable and reflect the real difficulties in coming up with meaningful valuation methods for these companies. A review of comparable public company valuations or precedent transactions may be useful however given the diverse nature of internet companies it is often difficult to get direct comparisons. The use of discounted cashflow techniques for valuation purposes while correct, are often difficult to apply, as the levels of growth included may be implausible. In doing a deal, it is preferable, to use deferred consideration or equity participation to protect the acquirer however this is not always possible.
Few real winners
The internet will change the world and the way we do business, but today’s pioneering companies may never earn the profits to justify their current share prices unless they enjoy unprecedented growth in sales and margins.
Share prices will not rise inexorably in the future and only a few of the companies will eventually be real winners. In the future, it is argued that there will be no internet companies, just companies, as all companies in the future will be internet companies. The question today is how do you pick the winners, avoid getting burned and how long can you stay away? |
Michael Flynn is a Senior Manager in Deloitte & Touche Corporate Finance with responsibility for the technology sector
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| Article appeared in the March 2000 issue.
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