Sunday, August 9, 2009

Small firms should go global for a shot at better valuation multiples

Economic Map of the World: Emerging Markets an...Image via Wikipedia

I was recently watching a presentation delivered by a Tepper School of Business Alum (my alma mater) and was throughly impressed by how much growth and expansion is happening in emerging markets. The speaker mentioned the importance of local knowledge using a nice anecdote - grasshoppers are considered pests, say, in the US and China, but is considered a tasty delicacy in northern Thailand. Venture-financed firms today need to have a global plan with a global marketing workforce. With IPOs and M&As in emerging markets having higher multiples, it is extremely profitable to add a global component to your business as it could push up the value of your company. More than half the world's population live in countries whose GDPs are growing at a rate greater than 7% . There are 60 million babies, say, in India that are NOT on diapers. Does anyone smell an opportunity here? Another example given was only 25% of population in Eastern Europe and Russia have a washing machine - seems like a huge potential here as well. By 2020, Africa will have more mobile phones than North America - mobile applications in Swahili, anyone? Another interesting factor - more than 2/3rd of world population is non-bankable. Maybe micro loan and micro insurance companies are the next biggest things in financial services.
The point I want to communicate is that purely North American based companies - start-up or otherwise - will command conservative valuation multiples. Valuation multiples are largely based on market share, operating margins and sustainable free cash flow. Today, we have a sizable IPO/M&A market in emerging markets to use for comparison purposes. Selling to conservative consumers in these economies also forces a firm to operate in a lean and efficient environment - key ingredients that command higher valuation multiples.
As competition in developed economies becomes more costly, small businesses, by their very nature, face operating costs that may become unsustainable. Developing economies enable an organization to learn how to become lean and efficient in the delivery of services to extremely competitive customers. Technology, by definition, helps deliver such services and therefore technology companies have a greater obligation to reach out globally. That key learning aspect is critical for the growth of a small business, especially venture-financed technology companies, in the US. While health care reforms and labor reforms will aid a little bit in managing small business budgets, the key is to understand that flat to negative growth is here to stay in saturated and demographically disadvantaged economies such as the US and western Europe.
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Sunday, August 2, 2009

Newer Patent and IP Valuation Approaches

Patents provide valuable rights to its holders to exclude others from gaining from something the inventor has already accomplished. Companies and individuals hold patents to financially gain from their ideas. In recent times, however, companies have been founded that hold patents just like a portfolio and maximize the revenues generated from them through various techniques - including arm-twisting corporations through legal means to cough up excessive sums. While, these awards are being offered by the legal system, the costs of running a business has increased substantially. It is in this climate that fair valuations of patents become absolutely essential.
Patents are a strange asset. They can be held to make money or prevent others from financial gains owed to you. Therefore, the valuation strategies have to be tuned to the purpose for which patents are being held. Clearly, when patents are held like a portfolio, there is a trading element to this and the goal of the portfolio is to make profits by buying low and selling high. Calculating this spread is easier said than done, as the value discovery process, as indicated before could be through legal means, which may not be all that fair, and several times could be classified as an induced or distress sale. A company that has already infringed upon a patent only to be hauled up in a future litigation will be forced to pay for that patent at a panic price. This clearly would not constitute the fair value of that patent. That is the inherent issue with valuing a patent - the timing of the usefulness of the patent is largely indeterminate. Moreover, most patents (75%) are worth less than $300K. Therefore, there is a vast pool of patents that are indeterminate in value and potential up-trades later on. The trend now is to determine if these patents are undervalued and to trade them at a perceived fair value. The demand to institute a trading market in these assets clearly would put downward pressure on the prices of patents as portfolio managers try to pick up undervalued patents and sell them for a profit. Analyzing market conditions, timing of revenues, maintainability of the patent, review of prior art, review of citations/references, calculating implied maximum profit potential, assessing technological obsolescence, measuring the useful life of the patent, validating the ability of the management to optimally use the patent, among other things, become key areas of analysis. A patent is worth nothing if it is not maintainable or if the idea will not gain fruition unless newer enabling technologies are discovered. Along with the trend to trade patents, comes the idea that some patents could be worth more than what they should be.
To cater to such business models, new valuation techniques have been gaining ground in the patent valuation business. The IPScore model developed by the European Patent Organization (EPO) provides a comprehensive model for factor scoring a patent on multiple testing criteria. The output of such models can be fed into transference functions that can translate the factor scores into valuation numbers. For instance, a patent's value can be measured as the present value of a stream of maximum profits (i.e. using company-independent discount rates and no consideration of management's ability to implement the patent). Then, the scores from the factor model can be used in a transference function to allocate a portion of the maximum profit value as the fair, realizable value of the patent. Several such transference functions have been developed. Another newer way to look at a patent's value is to adopt the criteria used by search engines. Search engines value a page based on how many times the page has been referenced or linked to by other pages. Similarly, a patent's value increases as it gets cited by more and more publications or research materials. A sudden, mushrooming of citations can be interpreted as signs of an idea whose time has come. Innovative thinking along such lines can be applied to valuing patents. For more details about such valuations, please contact us. We will be happy to explain in detail.

Monday, July 6, 2009

Diversified Venture Investments Still Beat Public Markets

Welcome to the new world where business plans suffer higher scrutiny, are probed for possible infusion of government capital, are examined for whether they would displace any US jobs and excruciatingly bracketed under one of the three areas the government wants to promote - energy, health care and education. The first thing to note is why someone would be interested in investing in a venture-financed business at all. One could argue that, given the current credit conditions, it is harder for small businesses to survive, as is. But, that is the beauty of venture-financed businesses. They dont depend on credit for growth and expansion - they depend on equity investments (which sometimes is so fortified that they might look like debt instruments) from investors and high net worth individual, who are adept at measuring and rewarding relatively higher risks. According to Thomson Reuters and the National Venture Capital Association (NVCA), the one year all venture Private Equity Performance Index (PEPI) declined significantly to -20.9%. Venture returns declined, in fact, across all horizons (3,5 and 10 years) and only the 20 year horizon remained in the black. While, this may look like a sad tale for the venture capital market, it is worth noting that the venture returns across all horizons outperformed public market indices, the NASDAQ and the S&P 500, through December 31,2008. The 20-year all-venture returns are around 17%, whereas the 20-year early seed VC returns are around 21% - the well-entrenched high risk, high reward position. It is pertinent to note that the 20-year return for the balanced and the later-stage VCs were the same at 14.5% each. It is clear from this analysis that investors who can gauge early stage companies successfully tend to reap better returns. It is in this context that diversification becomes important.

In a recent online presentation of opportunities available for VC investment, I was delighted to find an array of opportunities available out there for investment. The opportunities ranged from an agro-bio company in the US to a financial services data provider in vietnam to a cell phone provider who wants to enhance value-added services in Africa. As with stock picking, it is important for early stage investors to diversify their portfolios. Today's business environment is global - the opportunities to spawn small companies at standardized risk is available in several countries across the world. More so than ever, several countries and new markets have understood the importance of leveraging private equity capital to seed and grow companies.

New portals such as and allow investors to get to know about opportunities in early stage markets. More such exchanges are in the making. While the value of being an insider on Sand Hill Road in Menlo Park, California cannot be underestimated, it is also worthwhile to understand that diversified investment opportunities are being made available to more of us. An early-stage/diversely invested asset class is perhaps a good addition to your investment to your portfolio, given the prevailing risk-reward situation in the economy.

What Gets You Better Valuations?

In a recent examination of publicly traded stocks using MorningStar screens, we noticed that even in these depressed market conditions there are at least three dozen healthy domestic stocks with market capitalizations greater than $500 million trading at a greater than 6 price to sales (P/S). Google had a much better P/S multiple than Yahoo; Visa topped out MasterCard; Alnylam topped out all other siRNA therapeutics companies; Dolby Technologies topped out its peers like DTS Inc., First Solar topped out other semiconductor companies; RedHat topped out its open source counterparts; QualComm topped out other wireless equipment manufacturers. What makes these companies tick? Our first observation was the market shares. Companies with the largest market share and with proven barriers to entry tended to be rewarded more. Holding unsurpassable intellectual property was also greatly rewarded.

Google has a 62% market share in the paid-search market compared to Yahoo, which has just 13% - a distant second. Visa's logos are carried on about 63% of the worldwide credit and debit cards, while MasterCard's share is only 31%. Alnylam holds the rights to nobel-prize winning technology and licenses that to several siRNA therapeutics companies. Alnylam's IP allows the firm to create an entirely new class of therapeutics for tough-to-treat diseases.Similarly, Dolby's technologies continue to be included as new digital broadcasting standards are rolled out internationally.First Solar is the undisputed leader in cost-per-watt solar cell production with its competitors a distant second.Red Hat has more experience distributing and supporting Linux than any other company does. Again, in the IP leadership area, Qualcomm's patents are central to the CDMA technology for 3G mobile communications.

It is important to note that strong market leadership and unsurpassable barriers to entry - be it branding or holding central intellectual property that is sessential for the growth and development of a whole market - is what attracts P/S multiples in excess of 6.0. Unless your business model is designed to make your company the overhwelming leader in market share or IP rights, there is very little chance that the market will value your firm at 6.0+ P/S multiple.

When we come across small companies that request us to classify them under this 6.0+ leadership category, we calmly tell them what it takes to get there. When starting out, it is important for entrepreneurs to understand their return on investment 8 to 10 years down the line, so they can structure their external financing requirements in a way that optimizes their RoI. Entrepreneurs need to have a good understanding of what their exit multiples are likely to be to align the financial risk/reward system better within the company.

Monday, June 15, 2009

Facebook investment valuation

Facebook headquarters in downtown Palo Alto, C...Image via Wikipedia

DigitalSky Technologies, a prominent Internet investor in Russia and Europe, has invested $200 million in FaceBook, in return for a 1.96% stake, effectively implying that the company's valuation is $10 billion. Can we call this a fair value of the company, especially given that Microsoft earlier invested $240 million for a 1.6% stake, pegging the company's value at $15 billion? FaceBook had about 307 million visitors in April, implying a $32.57 per visitor valuation. At Accuserve, our read is that when companies and individuals invest in companies to acquire lower stake or invest in small amounts, they are willing psychologically to accept enhanced valuations. When the stakes are small, so to speak, the risk associated with not achieving that enhanced valuation is rather small, in the minds of the investor. When you have a lot of money in a company, the risks of not achieving that valuation becomes quite big. The other issue is how the investor gauges exit routes. In IPO markets, the listing price requires high disclosure requirements - implying a valuation that could be significantly less than when exiting in M&A markets. Perhaps, the investors realize that Facebook may only opt for a private exit, where such high valuations can be maintained with relatively less scrutiny. At Accuserve, our philosophy has always been to look beyond the numbers. Several Internet related transactions require a reverse thinking of established valuation concepts. For instance, valuation specialists argue that when looking at minority investments, a discount be applied on the fair value of comparable transactions that happened at a so-called premium. We argue differently for Internet companies. We argue that, in the Internet industry, several transactions have occurred in a flipped manner i.e. majority stake acquisitions have happened at a discount to valuations seen during minority stake investments. The primary goal when an enhanced valuation is being assigned during early stages of a company's development is for the founders to retain control of the company and not give away so much that it disincentivizes the founders. We have to account for this thinking and this is best done by thinking about Internet valuations in a different way.
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Friday, June 12, 2009

California digitizing textbooks?

In what maybe a decent move to usher in some semblance of fiscal management of the California Budget with its gaping hole, as wide as the recently discovered Borealis Basin on Mars, Gov. Schwarzenegger is talking about introducing digitized textbooks in schools - K1-K12. By some estimates, California Government's share of the textbooks comes to around $300 million (smaller than the cost of building a B2 bomber) but large enough to warrant discussions to reduce it. It is pertinent to note that digitized textbooks have already been introduced in some schools in China and other parts of the world. One of my clients is a leading promotor of digital education services in China and the company was able to profit rapidly from the Chinese government's deregulation of the Chinese education industry. Tons of paper is saved as well, which will net the California Government a large amount of carbon credits that can be further off loaded and traded in the green exchanges. Finally, information can be updated on the fly so that students do know that the Borealis Basin in the Northern Martian Hemisphere has replaced the Hellas Basin in the Southern Martian Hemisphere as the largest impact crater in the worlds we know of or that Pluto is no longer a planet in our solar system. Wait! How would the creationists react to the digitized era? That's a question best left to anyone's imagination.

Thursday, June 11, 2009

Pressures on the dollar as a reserve currency

Recently, Brazil and Russia announced that they will be parking about 5 to 10% of their foreign exchange reserves in IMF bonds whose underlying currency is the Special Drawing Rights (SDRs). The amount is expected to be $10 billion each. China is expected to contribute about $50 billion and India about the same as Brazil or Russia. The BRIC (Brazil, Russia, India, China) countries seem to want to start exploring alternatives to the US dollar as a reserve currency for global trade. While it is very premature to consider whether the US dollar will be ultimately replaced by the IMF's SDRs as the world's reserve currency, we can speculate that the BRIC countries want a bigger voice in global affairs and would probably contribute to IMF programs only based on how the value of their vote grows. More the say these countries get in the IMF financing process, the more they will contribute. While China holds the world's largest foreign exchange reserves, India holds the third largest and Russia the seventh. Together, these countries can make a significant impact on how the dollar continues to be used as the world's reserve countries. What that means for most of us is that, as the long-term US treasury yields inch up when the treasuries get dumped in the market, the mortgage rates which track LT treasury yields will spiral upwards. For people who refinance in a declining home value market, this is awful news as they'd have to pay higher monthly payments on a declining home value market. For new buyers, the price reduction of homes has to be steep enough to allow them to be able to afford the monthly payments. The US mortgage market will work only as long as the LT yields are in control. Do we see another crisis here? 

Sunday, June 7, 2009

A wealth of search

There appears to be momentum gaining for newer types of search engines - engines that pay people for how much their words have been looked at and/or used as a reference by other folks. The more the attention you get, the more you get paid. Topsy (, a search engine, that is focused on redefining search by not only looking at how many times your pages are linked but also who is linking it and how it is linked, may be trying to usher in an Internet version of getting paid for the influence one commands among a community. While the scale of such search engines may not match the generic engines such as Google or the redesign MSN engine Bing, there exists a reasonable business case for such engines to coexist with or within large search engines. The question is how far will this paradigm be extended? Will we see a day where search results are returned based on precisely how the author of the content wants it to be shown - to the most relevant community and to the persons commanding the higher influences within it?

Saturday, May 30, 2009

IP Valuations - a tricky issue

My prediction is that buying and selling IPs is an area where America may still lead the world. We live in a new America where there is price pressures on everything from private jets and yachts to a bar of soap. So, we need to ask ourselves, in which sector would there be better price discovery, a good real return and a marketplace where smart investors can make money. I am not so sure about trading in the green energy certificates as I still dont know where the spread would come from, but I am more optimistic on buying and selling intellectual property (IP). IP is a tricky area - unlike commodities, it does not have a form or a shape - it is an idea and essentially we are looking at how much an idea is worth now and how much will it be worth a few years from now. We trade on those premises. While IP trading is not exactly new, valuation methods that help value these intangible assets are subject to plenty of government and legal interference -  a trend that should be avoided but nevertheless exists. In an IP world, a new IP that is patentable is always substantially different from anything existing right now. Ergo, by its very nature, the new IP poses a valuation issue. In the absence of public and financially deep trading markets, there is no market pricing to use. We, at Accuserve, think a lot on how to use various techniques to narrow in on a range but we've seen that calculation methods return a wide range of results. How does one determine that an IP right now will be useful, say, 10 years down the line? That is the tricky question. 

Monday, May 4, 2009

Small business M&A transactions drop precipitously

According to the State of the M&A Markets, First Quarter 2009 Update, compared to 4Q08, transaction levels decreased in all valuation segments except deals with values above $250 million. The most dramatic decrease was in the $50 to $100 million-valuation range, which dropped 52.1%. When 1Q09 is compared to 1Q08, deal activity is down at all levels, with the most significant decrease [again] taking place in the $50 to $100 million-valuation segment. During this period, the number of transactions dropped by 70.4%. 

Monday, April 13, 2009

Health Care reforms - cuts in R&D budget?

We are entering a very interesting phase in the history of governance in America. The democratic federal government is all set to usher in health care reforms - the core of which is offering a public option for insurance and playing an increased role in setting price limits for various medical services ala the NHS of the UK or the services in Japan. How will all this affect the flow of dollars to R&D grants for small companies? I believe that small companies will have to compete harder to get government grants and will have to operate under significantly reduced R&D budgets to achieve even break even revenue models. Generally speaking, despite active price controls in the Switzerland, their drug companies still lead the world in innovation. But, this was largely financed by revenues from markets such as the US. Will we see an outsourcing of R&D to places outside of the US and more outsourcing of clinical studies to outside the country? Time will tell but all indications are that a public option for health insurance will put a serious dent in the R&D budgets of the small drug discovery and biomedical devices companies. We for one will increase the discount rates when valuing such companies as there is a greater risk of achieving break even cash flows.

Saturday, March 21, 2009

Wi-Fi in Virgin America planes

I am traveling from NYC to San Francisco right now and I wanted to test the Wi-Fi service that Virgin offers on its planes. My idea is to stream a movie - Red Rock starring Nicholas Cage -  from Netflix that I have been wanting to watch for some time now on my laptop. Everything started out hunky dory as we hovered over JFK and I actually got to watch about 15 minutes of the movie at regular speeds. But after a while, the speed started to dive. I had just finished telling a steward that the speeds were good enough for me to stream movies. That jinxed it I guess. I am going around the plane and seeing that plenty of people are on their lap tops. I can bet that a significant portion of them are accessing the Internet through the onboard Wi-Fi service. The onboard Wi-Fi service, called GoGo, costs $12.50 and hopefully will go down as the technology matures. I wonder if there just isnt enough bandwidth for all of us to access the Wi-Fi or its just that the W-Fi is faster when passing over cities and drops as we fly over unpopulated areas. But I believe the days are not far off when steady Internet speeds onboard a plane are a reality.

Friday, February 27, 2009

Venture financing poll

I have created a poll in LinkedIn to measure the impact of the economy on the recent post-money valuations secured by venture-financed firms. Please vote. It will help us summarize a general understanding of the conditions in the VC/PE financing market. Follow the link below to vote.