A small company in New Jersey recently received a patent for an interesting variation of a commonly used chemical additive. Within days they had received numerous phone calls seeking everything from field-of-use licenses to outright ownership of the underlying patent. When an inquiry came in with a price significantly larger than their to-date investment, they basically put their business and lives on hold and tried to decide how to sell the company or product line. Since they had spent virtually all of their available capital developing the patent in the first place, this boon/potential exit point was a godsend, and for the most part the conversation focused on what part to sell and whether an additional 10-20% could be gotten out of the transaction, not really whether to sell, nor anything resembling true analytics.
Tell the preceding story to any small-firm CEO who has been struggling to survive for a couple of years and they nod knowingly, and under their breath whisper a small prayer wondering why such boons don't happen to them. Tell the same story to a top manager at a high-performing firm, or a heavy-hitting consultant from one of the major strategy firms and the response is more likely to be ridicule than respect. The jokes could go either direction - selling a twenty-dollar bill for $10, or paying $50 for the same bill. Nine out of ten times an IP seller is giving up gold in exchange for lead, but rarely do they understand why, nor what to do about it.
Our second basic example goes the other way - a large, profitable firm evaluated a business proposal that started as a fairly naive idea from a promising MBA hire that was massaged thoroughly by an expensive evaluation team led by an expensive group of consultants, and the standard complement of miscellaneous managers from finance, sales and operations, none of whom were particularly senior. The nominal sponsor was a senior VP... who attended perhaps four meetings and contributed an additional 6 hours reading, reviewing and nodding knowingly over the course of the evaluation project. A very impressive spreadsheet was developed to determine the IRR of the project - actually, a very impressive spreadsheet from a prior engagement was modified to determine the IRR, and after a few revisions it finally demonstrated the appropriate savings and returns to make the project appear justified. The IRR from the spreadsheet exceeded the WACC, not to mention the current treasury funds hurdle rate, the net investment proposed was fairly modest, so the project was assigned a high priority, launched, and after exceeding budget, both time and money, was completed a couple years later...promotions to be had by all sort of thing. However, despite the resounding success, a small boy with an inquisitive mind might have asked about the bottom line of the company - how come the unit was less profitable after deployment than before? What's wrong with this picture?
In both of our examples, the fundamental problem was something covered in the first semester of business school - valuation, or more specifically, failure to perform a proper valuation. In this series, we will cover the essential components of the valuation process, and show how effective enterprise valuation can and should be used as fundamental tool in the business decision process. We will review the basic "back of the envelope" strategies to support course decision making, and look into the deeper analysis necessary to make more precise choices, including risk analysis, probabilistic outcome assessment, etc. It is unlikely that you will be ready to hang out a shingle as a valuation consultant after reading these posts, but at least you will have a better set of questions and an understanding of how these types of decisions and choices should flow to the enterprise value, and interpret proposals in light of this understanding.
So to conclude this introduction, let's revisit our examples:
Our chemical additive inventor should have done a course valuation of the end-user industry to determine the potential value created by the invention. In this particular case, the potential value was roughly 1-3% of the total consumption of the substances to which the chemicals were added, which implied a potential gross value in excess of $1billion per year for one particular field of use (the industry served by the potential buyer). Customers will not change processes and formulations unless they participate in the value pool, and achieving a 40% penetration, regardless of technological superiority is generally an upper bound, so a gross market share of $200 million was probably the upper bound, and $100 million a realistic goal for a well capitalized entrant. Allowing for manufacturing, distribution, sales, and related costs, the expected EBITDA would have been between $10 - 20 million per year, suggesting an enterprise value of $50-100 million, significantly (i.e. an order of magnitude) above the purchase offer for the company... and this was not the dominant field of use. However, for an undercapitalized entrant the probability of generating a profit was slim, so the lower bound of profit opportunity would have been zero, but was now the offer price divided by the field of use ratio. Since this was a competitive industry with multiple well-capitalized incumbents, and this invention was a substantial and meaningful advancement of the current performance level, the bottom line was that the offer wasn't particularly good - so the right answer was either pass, or narrow the deal as far as possible to generate capital for development of alternate fields of use.
In our second example, the problems were fairly common: First, projects are almost always considered in terms of their local scope and impact, as opposed to their enterprise impact. Few organizations actually understand their critical paths as enterprises, so they often don't notice or don't properly assess the enterprise impact of projects that seem to be locally scoped. Second, teams working on project evaluations might as well be wearing blinders in regards to the organization as a whole - executive sponsors who do not have time to get their hands dirty should automatically delay or kill such projects until such time as they are of sufficient priority to warrant proper attention. In the first case, activity-based costing would have revealed that this project would result in an increase in demand of a resource that was already a constraining resource. This resulted in decreased response time for a fundamental departmental function that impacted several product lines. This wasn't a cost problem, it was a constraint problem. As a consequence, there were delays in unrelated activities, and therefore more management attention diverted to handling the rise in problems, which in turn decreased efficiency of the organization as a whole. This example was complicated, but it is analagous to installing new computer equipment, which puts a strain on the help desk and the support staff. Since a lot of staff have to be trained, there is a period of inefficiency for a few weeks. This causes problems everywhere else as well, so the knee-jerk prioritization response includes more meetings, more reports, etc., all of which tend to be permanent, and tend to decrease efficiency and performance. Also, adding knowledge requirements to staff tends to make them less efficient across the board, so their basic response times increase, again warranting more problem resolution and more attention, further constraining an already stressed resource.
Weak sponsorship is a fundamental flaw. Most senior executives who see poor initial return calculations will be extremely wary of subsequent revisions. When you change assumptions to make the numbers work you need a serious reality check before continuing. Younger staff tend to define evaluation project success as proceeding to implementation, rather than making the appropriate enterprise decision. In our example, the initial assumptions were conservative, the revisions were not... they weren't exactly in the "wishful thinking" category, but they were, at a minimum, optimistic. We generally encourage our clients to treat optimism as equivalent to magic - it's nice when it comes, but don't count on it. Therefore, the busy sponsor only saw the revised assumptions, accepted the footnoted vetting by the consultants that assumptions were provided by incumbent staff, and never once questioned whether the underlying model, which was developed for a different client in a different industry, was really an appropriate tool for this particular project, particularly since different companies have different critical resources, and different cost structures... not just different costs. This result is a subtle version of the Business 101 agency problem. Consultants make money from follow-on engagements. Junior staff gain significance via participation in executed projects, not through properly killing proposals. Neither junior staff nor consultants are directly incented for aggregate unit performance. The sponsor could and should have cared - he had actual skin in the game - but the project was fairly small and was never suspected as having the potential to powerfully impact overall business unit performance.
So now that we've talked a bit about what can go wrong, let's start at the beginning and look at the essence of valuation, and how to turn the process into a tool that assures that things go right.
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