2017 was a harbinger of times to come. Reported PE exits in India hit an all-time high crossing Rs. 80,000 crores across over 300 deals (Rs. 377,000 crores in the US). This is apart from the thousands of stake sales which occurred across the country in the VC and Angel Investment space and thousands more not covered by the media houses owing to their private nature. Interestingly the Indian Government was also a significant participant as divestment measures were at an all-time high in 2017. But how different is a valuation for a stake sale? What does one need to do differently?
Valuing a running business for investment is slightly different from valuing a business for a stake sale. The fundamental difference being an understanding of partnership in the future as against liquidating a position today. While an investment transaction may be quite satisfied in a multiple or DCF valuation, a stake sale/ secondary transaction requires establishment of a reasonable price for a transaction. While reasonability is a factor of the high price of ownership or auction fever (Research published in the Journal of Consumer Research) and buyer-seller expectation management, practitioners deploy more than one method to ensure that reasonableness can be as less subjective as possible.
Picking the right methods
Valuations are only part science. While the tools are scientific, they are always based on certain assumptions and representations of the management and the ability of a valuer to be able to identify non-financial metrics and laterally relate them to the value of a business. Each valuation method employed may provide a completely different range of valuation numbers. Cherry picking the right valuation methodologies that showcase the relative value of a business requires:
Picking the right methodologies – MPM (market price method)/ CCM (Comparable Companies Multiple Method) and subset CTMM (Comparable Transaction Multiples Method) & CEM (Comparable Exit Multiples Method) / DCF (Discounted Cash Flows)/ TV (Terminal Value)
Choosing the right multiples under the methodologies that are indicative of the value of a business
Choosing the right combination of methodologies
Adjusting the valuation to factor in specifics of the transaction
Applying the right weights to factor in specifics of the transaction
Picking the right methodologies
Owing to the nature of a valuation exercise itself, different methods of valuation may yield different results for the value which may not be in similar ranges unless the business has reached a mature stage in business. Comparability with the public companies on all parameters, stage in the lifecycle and uniqueness of the business can throw up deviations which require use of multiple methods. We can delve separately on how to pick the right methodology in another article dedicated to the purpose. For the limited purpose of this article, we should move on.
Choosing the right multiples
Let us take 2 examples of unlisted securities based on my practice which are secondary stake sale transactions I have advised on in various capacities. Again, this may vary significantly from the nature of the business and the stage of the entity.
Example 1, Table 1:
A 6YO ERP company being acquired by a Strategic Investor where the objective was to enter into the Indian market by capitalizing on their market reach
for CCM methodPE MultipleBook ValueEBITDA MultipleRevenue MultipleWrong
Company had spent years in product development and Revenue – Cost relationship was significantly changing each yearWrong
Asset light business that does not require significant investments on assets to scale furtherMaybe
Business in technology space tend to have high EBIT margins when intangible assets are still being capitalisedRight
Business had achieved continuity revenue and broken into the market which would flow in over the next few years
Example 2, Table 2:
A 10YO IT services company being acquired by a Strategic Investor where the objective was to consolidate and achieve cost and talent efficiency
for CCM methodPE MultipleBook ValueEBITDA MultipleRevenue MultipleMaybe
Company had been able to achieve stable growth and convert them into cash flows consistently.Wrong
Asset light business that does not require significant investments on assets to continue stable growthRight
Business’s return on capital deployed was stable and predictable as any CGU is.Wrong
Business had already achieved stability and was in a mature business environment.
*CGU means Cash Generating Unit
It may be observed from the examples above, within the same industry, you could have completely different method under the same methodology being deployed in arriving at the value of the asset. In many cases, there may be a non-financial metric involved as well (such as gross profit per full-time employee in business services or EV (Economic Value) per sft. of completed development in real estate).
Once the right multiples have been agreed upon, the next step is opting for the right methodologies to be employed.
Picking the right combination of methodologies
This is where practice takes a slight deviation from text books. Typically, a valuer may choose to employ more than one method for the valuation in the interest of fairness for all the parties and to reduce the skewness of variability between one method and the other. An example of this is the First Chicago Method/ Venture Capital Method, elements of a discounted cash flow as well as multiples are employed is in vogue in the North American markets.
Example 2, Table 3:
Let’s take the example of the case of the company in Example 2 above, DCF, CTMM, CMM & CEM were employed together to generate a weighted average valuation which provides the best of all worlds.DCFCTMMCMMCEMWhy? The core reason for existence is generation of return for stakeholdersWhy? There have been transactions in the past which can establish the value more clearlyWhy? Acceptable methodology backed with less subjective evidence of relative valueWhy? There have been transactions in the past which can establish the value more clearlyDCF onlyEBITDA Multiple
of businesses that have had a similar transaction in last 18-24 monthsRevenue Multiple
of businesses that have comparable size, stage of lifecycle, level of diversification etc.Revenue Multiple
of businesses that have had a majority/ minority stake sale of comparable size, stage of lifecycle, level of diversification etc.
Adjusting for specifics
Now that the methods that need to employed have generate their expectation of a value, you would need to adjust it (discount/ premium) to factor in for the specifics of the transaction.
These adjustments may include:
A control premium to factor in the benefits of controlling the business operations, directly or indirectly or the opposite, discount for lack of control
A discount for lack of marketability of the unlisted securities or illiquidity risk
A discount for size of the business as it may have not reached the stage where the business risk/ organizational is relatively low or small stock risk
A discount for secondary transaction as the transaction is between shareholders only and do not mean providing the company with growth capital, as in most other cases that warrant a valuation
Any other specific adjustments such as synergy gains, cost of post transaction integration, etc.
Example 2, Table 4:
Continuing from Example 2, Table 3 above, there were specific adjustments to be done in each method.DCFCTMMCMMCEMAdj:
+ Control premium
+ Small stock risk
+ Illiquidity premium
= Adjusted COE
– Cost of integration
= EV (adjusted)Adj:
x small stock discount
x secondary discount
= EV (adjusted)Adj:
x illiquidity discount
x small stock discount
x secondary discount x control premium
= EV (adjusted)Adj:
x illiquidity discount
x small stock discount x control premium
= EV (adjusted)
Applying the right weights
Once the EVs have been generated with the above exercise comes the trickier part that requires experience and detailed knowledge of the transaction. The most subjective among the steps, each valuer needs to create their own calculator for why and when to apply a specific weight. This checklist-based approach can help justify and ensure that subjectivity can be reduced with an internal policy.
Example 2, Table 5:
Continuing from Example 2, Table 4 above, the weights assigned for the valuation based on the checklist of factors prepared and identified were:DCFCTMMCMMCEM34/10018/10022/10026/100
The easiest part of the exercise is now deriving the weighted average enterprise value with as less subjectivity as possible.
The fundamental premise of any valuation exercise is to arrive at a reasonable, less subjective financial number for a non-financial asset (a running business made of real people, tangible assets and intangible relationships they have accumulated). When any business approaches a valuer, it is the implicit responsibility of the valuer to be able to gauge, understand and translate this to financial terms in a manner that ensures that due credit is given to what makes the business as well as the transaction unique. This is the reason that valuation is still for the most part, an art that is mastered with years of experience and deliberation. The introduction of standards is a bold step in the right direction to avoid subjectivity and educate the fraternity to be able to deal with the dynamic world of transactions and collaborations.
Disclaimer: The views and opinions expressed in this article are those of the author and based on his experience and not necessarily those of the Institute or any other regulatory body. Examples of analysis performed, methodologies and approaches described within this article are only examples which have been truncated with a lot of specifics omitted in the interest of brevity for this article. They should and must not be utilized ‘as-is’ in the real-world without having sufficient guidance or experience or otherwise consulting a professional valuer.
About the author:
A member of the Institute of Chartered Accountants of India, Pradyumna Nag also holds a post graduate in International Business Strategy from IIFT, Delhi. He is currently a director of Prequate, a strategic finance advisory and works extensively in the transaction advisory domain. Prior to Prequate he worked with KPMG, in assurance and corporate finance. He has been a part of 100+ valuations and is also a speaker in forums and universities on technology investments, private equity, investment banking, finance and entrepreneurship.