“Show me the beef!” Well, this can also be said for technology companies in their infant stages as well. Emerging enterprises must be able to demonstrate sustained positive cash flow. The how, how much, and when, will vary widely based on a multitude of factors. So, the question that presents itself is, how am I going to get from where I am today to that point over there, and what will it cost to get there?
Oftentimes it takes substantial digging to find the real answers … a potential treasure, buried beneath many layers of people, time, grants, research, development, testing, rework, trial and error, personnel changes, more investment, debts, bonds, chasing one benchmark after another. So, where is the value?
Well, we need to look deeper. Not deeper into the company as it is today, but look out, out into the future. Place yourself out several years, let’s say five years, and now what do you see? How is the company positioned? What did the company achieve? What is the company’s new vision?
- How will the company and its products look?
- Are the products accepted in the marketplace?
- Are we profitable?
- Do we make money delivering our technology to the consumer?
- How much profit are we generating?
- Can we sustain this profitability?
- Who are the customers and where are they located?
- Why do they buy our product or service?
- How many and what kind of employees do we have?
- Where do our team members come from and what are their duties and responsibilities?
- What are our cost structures to deliver our promises to our customers?
- We must be profitable, how are we doing it out here in year five?
Did we become successful? And define success. From an appraisal and business perspective, future, sustainable, and dependable cash flow is what drives value. The value of an early-stage technology company is not in what you are, but rather what you can be someday. Don’t lose sight of this. If you first define what constitutes success, and you understand how long that will take, you can then begin to understand, calculate, and substantiate the value of the company today.
Forecasts, forecasts, forecasts!!
For the most part, third parties who will finance these processes do not exist for charitable purposes. Some do, but they are usually only able to help you get just so far. Almost all companies will need the help of funding sources who are not really angels, despite their occasional use of the moniker. They expect a profit. And they also know they will lose on occasion. But they never enter a transaction without an expectation of a substantial profit … a very large profit.
The answers to the questions we posed earlier, along with the intermediate steps, involve many estimates and forecasts, which represent the backbone of any valuation. So, forecasts, estimates and projections, all of this work, will be the focus of questions by outsiders.
Initiation and development stages
Once you determine where you need to be in several years, you can then begin the process of how to get there. What will it cost, and how long will it take to get to that “success” point? The answer is often several years, and it takes many people with a variety of talents and knowledge who will work as a team to bring the concepts and visions to life.
So, what will it cost, and how quickly will costs be incurred (this is cash burn) to achieve success? The task of quantifying the costs is the easy part. The hard part is estimating the quantity of effort that will be needed to move the concept towards feasibility and market. You may know that a team will cost you $250 per hour, this is the easy part, but how many hours will it take the team to overcome the challenges along the way? And how many challenges will there be? Estimates are never actually perfect, and some people have a problem performing an exercise that is doomed to imperfection. However, many times, the exercise itself helps company personnel gain a better understanding of what really needs to be done, how and when, and what it should cost.
The failure to quantify challenges and truly understand the magnitude and solutions to the problems that may be encountered can lead to even greater problems, and problems that cannot be overcome. The concepts and processes may be sound, but if you can’t bring things to fruition, then you really don’t have anything yet.
Rates of return and expectations
Your partners in getting you through years of development-stage processes all have different views and expectations as to what value is and what they look for in the value of a developing company.
The financial institutions make loans, they do not invest. As such, they are concerned with the security of the loan, which includes the company itself, as well as the stability of the collateral behind the loan. This is their first concern. They also expect an interest rate return, anywhere from 4 to 16 percent, which is risk-rate adjusted, for the most part. However, if the principal is at risk, there is no rate that will satisfy them. They just want their money back.
At the other end of the spectrum are the venture capital groups, the VCs. These people will take risks. However, they offset these risks with a variety of terms, conditions, convertible features, guarantees, etc. These complex arrangements may add an additional level of complications for the appraiser, but we’re used to dealing with these.
Because the VCs deal in riskier investments, they experience losses. But that doesn’t mean that they are ever OK with a loss. They aren’t OK with a loss. VCs expect profits, and also expect to be highly compensated for taking risks that others would never touch. These expected returns are usually in the neighborhood of 40 percent.
What do I need to do?
The answer is to pay attention to your forecasts. They are a road map, use them. Forecasts can help day-to-day operations as well as the outside appraiser. You may not have all the frills and bows on the work, but look at where you think you will be and how to get there, like a GPS for the company. Paint a picture of the future with words and numbers, estimates and expectations.
Anthony Duffy is the managing director of ValuQuest based out of our Albany, NY office.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.