The Art & Science of Valuation

CleanTech

North March 25th

Bryan J. Watson

[email protected]

Agenda

3:00 - 3:30pm Registration and Networking 3:30 - 3:40pm Opening Remarks 3:40 - 4:40pm Presentation:

The Art & Science of Valuation Feat.

Steven Hacker, Partner at MNP LLP Ian Palm, Partner at Gowlings

4:40 - 5:30pm Networking

Thank You To Our Partners:

Upcoming Dates:

• April – TBD

• OCE Discovery

• May 20th

• June 23rd

• June 8th – Think Asia – BDC

Membership Structure

Total Company Size

(Staff Number) Annual Corporate

Membership Fees Membership

Type

Per Delegate $40.00 + HST

(Per Event, Max of 2) Trial

1 Employee $199 + HST Lone Wolf

2-4 Employees $375.00 + HST Tier 1




101 + Employees $2500.00 + HST Tier 5

The Art & Science of Valuation

Steven Hacker

Partner at MNP LLP

Ian Palm

Partner at Gowlings

Thank You To Our Partners:

Presented by:

Date:

Steven Hacker, CPA, CA, CBV

March 25, 2015

The Art & Science ofValuation:Understanding TechnologyValuations & Value Drivers

PRESENTER

Steven Hacker CA, CBV

• Steven is MNP’s Business Valuations and Litigation Support Leader forthe Ontario Region. He has 20 years of business valuations andlitigation support experience

• Provides advice and valuations in connection with:

• financing

• strategic planning

• disputes (employee, shareholder, partner, customer/supplier)

• mergers and acquisitions

• income tax and estate planning

• financial reporting

MNP: A NATIONAL FIRM

Key Facts Founded in 1945, we have grown to become the 5th largest public

accountancy and business consulting firm in Canada

Over 70 offices strategically located in urban and rural markets

throughout Canada

Over 3,000 team members and 550 partners dedicated to delivering full

service solutions

Financial Advisory, Consulting, Specialty Tax, etc. with a strong presence

in the technology sector

OUTLINE AND OBJECTIVE OF THIS

PRESENTATION

1. What is a “Valuation”?

2. When do you need a valuation / why should you get a valuation?

3. What is involved in a valuation?

4. What drives value – how can you grow value?

5. How do we value a business or its intellectual property?

Provide Answers to the Following Questions

CAVEAT / DISCLAIMER

The Fine Print

1. The material presented today and contained in these slides:

• Is provided for education purposes

• May not be applicable to a specific case, set of circumstances or facts

• Is based on laws and practices that are subject to change

• Is based on the general views of the presenters and may notnecessarily represent the views of MNP LLP

2. The presentation and material should not be relied upon in connectionwith a particular matter as a substitute for qualified professional advice

3. We do not accept legal responsibility for the contents or for anyconsequences arising from its use

WHAT IS A VALUATION

Provides a Conclusion on the Notional Fair Market Value

Fair market value is typically defined as:

• the highest price

• expressed in terms of money or money’s worth

• obtainable in an open and unrestricted market

• between informed and prudent parties

• acting at arm’s length

• under no compulsion to transact

Fair market value is not always equivalent to price paid in an openmarket transaction

NOTIONAL FAIR MARKET VALUE

Fair Market Value is:

• Prospective or future oriented

• Determined at a point in time

• Influenced by business-specific factors

ELEMENTS OF VALUEComponents of Business Value, Risk Levels

IdentifiableIntangible Asset

Value (IP, contracts etc.)

TangibleAsset Value

Monetary Value

Bu

sin

ess

Valu

e

Unidentifiable IntangibleAsset Value

Ris

k

WHEN DO YOU NEED A VALUATION

What Are the Benefits

Provides an independent and objective view on value for:

• Strategic Planning

• Transactions

• Disputes (infringement, employee etc.)

• Income tax planning and compliance

• Financial reporting

Also can provide useful information for benchmarking, goal setting,negotiations and feedback on merits of business plans, forecasts etc.

WHAT’S INVOLVED IN A VALUATION

Typically a three stage process

Depends on the type of valuation (level of assurance)

Stage 1: Gather understanding of business, documents.

Stage 2: Select and apply appropriate valuation methodologies

Stage 3: Prepare written report, present draft and discuss with client.

Technology/start up business valuations typically involvereview and analysis of business plans

WHAT DRIVES VALUE

Grow Value by Addressing These Factors

Value drivers influence risk and determine the degree ofvalue

Categorized as:

• Functional/Technological

• Commercial/Financial

• Legal (protection related)

• Specific external/economic indicators

• Uniqueness, differentiation

• Ease and breadth of use

• Lifecycle status/remaining useful life, rate of decay

• Functionality

• Revolutionary versus improvement

• Complexity, ease of replication

• Competitive advantages, threats

• User/market resistance to change

• Scalability

• Applicability in other contexts

VALUE DRIVERSTechnology value drivers: a sample

• Incremental profit margin, excess earnings

• Market potential, growth

• Strength, depth and quantity of customer relationships / user base

• Switching costs and effort

• Quality of distribution/retail network

• Competitive edge, barriers to entry, competition

• Market demand or acceptance

• Extent of further/ongoing investment in upgrades, maintenance, R&D

• Quality of management – do they have the vision, and can theyexecute

VALUE DRIVERSCommercial/financial value drivers: a sample

• Customer recognition(and does the customer believe in the brand, trust the brand,associate the brand with the product, service, company)

• Differentiation

• Is the intangible important to the product or service purchasedecision

• Age, longevity, lifecycle status, remaining useful life

• Potential for expansion or exploitation

• Means of promoting

• Advertising

• Geographic appeal, use

• Association

VALUE DRIVERSMarketing intangible value drivers: a sample

• Ownership rights

• Protection status, ease or likelihood of infringement

• Is it patentable?

Patent Value Drivers

• Scope of patent

• Is there overlapping technology?

• Potential for legal challenge

• Foreign jurisdictions

VALUE DRIVERSLegal value drivers: a sample

External industry and economic trends and circumstances also influencevalue, for example:

• Innovation spending

• Employment stats – firms in the industry

• Government policy, grants, tax breaks

• Consolidation trends

• Competition

• Availability of capital

VALUE DRIVERSExternal industry & economic indicators

VALUATION METHODOLOGYValuation Approaches

VALUATION METHODOLOGY

Asset approaches

Asset approaches typically involve the restatement to fairmarket value of the balance sheet. They can be appliedon a:

• Liquidation basis – forced or orderly

• Going concern basis


Discounted Cash Flow Approach to valuing a business

• Used when the business is expected to grow in a non linear mannerbefore achieving steady-state

• Requires a reasonable forecast

• Need to understand inputs, assumptions and support forassumptions

• Value is the net present value of the stream of future net cash flow

• Present valued using risk adjusted rate of return


Discounted Cash Flow Example – Business ValueCAD Thousands

Year 1 Year 2 Year 3 Year 4 Year 5 Terminal

Revenue 2% 15% $25,000 $28,750 $33,063 $38,022 $43,725 $44,600

Cost of Goods Sold 60% -15,000 -17,250 -19,838 -22,813 -26,235 -26,760

Gross Margin $10,000 $11,500 $13,225 $15,209 $17,490 $17,840

Operating Expenses:

G&A (excluding depreciation) 2% (500) (575) (661) (760) (875) (892)

Pre-tax Operating Income $9,500 $10,925 $12,564 $14,448 $16,616 $16,948

Income Tax 26% ($2,470) ($2,841) ($3,267) ($3,757) ($4,320) ($4,406)

After-tax Operating Income $7,030 $8,085 $9,297 $10,692 $12,296 $12,541

Adjustments:

Changes in working capital (15) (75) (86) (99) (114) (17)

Capital expenditures (50) (58) (66) (76) (87) (101)

Net Cash Flow $6,965 $7,952 $9,145 $10,517 $12,094 $12,423

Terminal value $69,019

Period Discounting 1 2 3 4 5 5

PV Factor 20% 0.8333 0.6944 0.5787 0.4823 0.4019 0.4019

Present Value of After-Tax Cash Flows $5,805 $5,522 $5,292 $5,072 $4,860 $27,737

Enterprise Value (rounded) $54,288

December 31, 2014

• Basis of the market approach

– Market value is derived by analyzing similar intangible assetsthat have recently been sold or licensed (in arm’s lengthtransactions), and then comparing these transactions (involving“guideline” assets) to the subject intangible asset

– Adjustments are made for any significant differences betweenthe guideline asset and subject asset, to the extent thedifferences can be identified and quantified

– May involve comparing metrics other than earnings

MARKET APPROACH


Market Approaches

• Valuation metrics implied by transactions in the subjectcompany’s shares (recent financing rounds)

• Most frequently used for valuing intangibles that are somewhatportable from one business to another, such as regulatory assets(FIT contract), or as a corroborative approach

• Multiples of earnings, based on comparable publicly tradedcompanies or past transactions involving same or similarbusinesses

• Adjust for differences in size, risk, growth potential, taxattributes, diversity, stage of development, non-cashconsideration (earnouts etc.)

• Caution re: Multiples of Revenue

VALUATION METHODOLOGYMarket Approach Example


Rules of Thumb

• Use only to verify conclusions reached under other methods

• Rules of thumb tend to:

- Oversimplify

– Provide only guesstimates which are not reliable

– Be based on revenue or book value, as opposed to futurecash flow streams

– Be applied without consideration of specific risk, growth

– Lead to misleading value estimates

• Basis of the cost approach:

– The economic principles of substitution and price equilibrium

– A prudent investor would not pay more for the subject intangible asset than theprice to obtain an intangible property of comparable functionality and benefits

– Cost is influenced by the marketplace

• Can be used when the cost to replace is lower than the expectedpresent value of net future cash flows

• Sometimes used to value internal use intangible assets

• May be only approach that can be used or may not be relevant orpractical to apply in many cases

• May yield a much lower value than earnings/cash flow basedmethods

VALUATION METHODOLOGYCost approach to valuing technology, IP

Situations where it may be appropriate to use the cost approach:

• Internal use technology, software (not commercially exploited, notdriving the business)

• Where the asset is readily replaceable

• Where there is uncertainty about commercial or technologicalviability

• In process R&D (in the earliest stages)

• Customer lists, databases

• Trademarks and other marketing intangibles

• Websites

• Workforce

VALUATION METHODOLOGYCost approach: when is it typically used

VALUATION METHODOLOGYCost approach: reproduction cost, replacement cost

Reproduction Cost

Based on the construction (or purchase) of an exact replica of the subjectintangible asset.

Replacement Cost

Based on the cost to recreate the functionality and benefits of the subjectintangible asset, but in a form or appearance that may be different from anexact copy of the actual asset being valued. Uses know-how, techniquesetc. in existence at the valuation date, as opposed to remaking exact copy

VALUATION METHODOLOGYCost approach: obsolescence adjustments

• Adjustments should be made to reflect obsolescencecompared to original creation

• Adjustments include:

- Functional Obsolescence

- Technological Obsolescence

- Economic/Financial Obsolescence

• The value of an intangible is based on the future cost savings itearns, in the form of avoided payments of royalties or license fees toa third party

• The present value of the future stream of after-tax savings iscalculated using a risk-adjusted capitalization rate, if a constantannual savings is projected, or a discount rate, if the future projectedannual savings vary from year to year

• The approach is mathematically simple however the keyassumptions are subjective

VALUATION METHODOLOGYRelief from royalty method – IP Valuation

• Complete analysis of value drivers, economic benefits of thetechnology

• Complete a qualitative scoring of technology value drivers (e.g.rate as positive, negative, neutral)

• Determine the life of the technology

• Determine appropriate revenue stream to which the notional royaltyrate will be applied (maintainable, forecast)

VALUATION METHODOLOGYApplying the relief from royalty method: preliminary steps

• Obtain market royalty rates (from third party data source). Look forcomparables in same or similar industry (SIC or NAICS)

• Assess comparability and adjust transaction data for key differences(market size, profitability, exclusivity, products or technology beinglicensed)

• Consider impact of differing percentage base other than revenue (perunit, percentage of profit, lump sum, combination)

VALUATION METHODOLOGYApplying the relief from royalty method: market royalty rates

Valuation Date

CAD Thousands

Year 1 Year 2 Year 3 Year 4 Year 5

Technology "A" Revenue $28,000 $28,840 $29,705 $30,596 $31,514

Royalty Rate selected 5% 1,400 1,442 1,485 1,530 1,576

Income Taxes 33% -462 -476 -490 -505 -520

After-tax royalties 938 966 995 1,025 1,056

Period Discounting 1 2 3 4 5

PV Factor 18% 0.8475 0.7182 0.6086 0.5158 0.4371

Present Value of After-Tax Royalty Savings 795 694 606 529 461

Total PV of After-Tax Royalty Savings $3,085

Tax Savings Benefit 229

Fair Value of Trade mark (rounded) $3,300

December 31, 2014

VALUATION METHODOLOGYExample: relief from royalty

• The value of the intangible asset is based on the present value of theincremental after-tax cash flows attributable only to the subjectintangible asset

• Measure conventional earnings or cash flow, and then deduct arequired return on the contributory assets, called a contributory assetcharge. Result is the earnings/cash flow in excess of operating costsand return on supporting assets

• Often used when the subject intangible asset is the key driver of cashflows and when the contribution of the intangible asset cannot bemeasured in other ways

VALUATION METHODOLOGYExcess earnings approach - IP

Calculation:

• Determine the life of the intangible asset

• Identify the revenue and expenses associated only with the subjectintangible asset and deduct income taxes

• Deduct income associated with other assets required to generate theincome for the intangible (deduct contributory asset charges)

• Present value the remaining excess income using a risk adjusteddiscount rate

Contributory assets:

• Support the subject intangible asset in generating cash flows. Alsoreferred to as economic rent

VALUATION METHODOLOGYExcess earnings/cash flow

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

EBITDA $6,406 $5,638 $4,651 $3,411 $1,876 $0

Income Tax 33% ($2,114) ($1,860) ($1,535) ($1,126) ($619) $0

After-Tax Cash Flow $4,292 $3,777 $3,116 $2,285 $1,257 $0

Contributory Asset Charges:

Net working capital 0.8% 100 88 72 53 29 0

Fixed assets 0.2% 29 26 21 16 9 0

Assembled workforce 0.7% 83 73 60 44 24 0

$212 $187 $154 $113 $62 $0

Excess earnings $4,080 $3,591 $2,962 $2,172 $1,195 $0

Period Discounting 1 2 3 4 5 0

PV Factor 17% 0.8547 0.7305 0.6244 0.5337 0.4561 0.0000

Present Value of After-Tax Cash Flows $3,487 $2,623 $1,850 $1,159 $545 $0

Present Value $9,664

Present value of tax benefit 752

Fair Value of Technology $10,416

December 31, 2014

Fair Market Value of Technology

VALUATION METHODOLOGYExercise: excess earnings method

QUESTIONS/DISCUSSION

CONTACT INFORMATION

Steven Hacker, CPA, CA, CBV

Partner – Business Valuation and Litigation Support

416-260-3502

[email protected]

Techniques to Bridge Valuefor Investment and Sale Transactions

March 25, 2015

W. Ian [email protected]

Seller’s View of Value

Buyer’s View of Value

Bridging Different Views of Value

2

of Value of Value

Seller’s View of Value

Buyer’s View of Value

Bridging Different Views of Value

3

of Value of Value

Zone of Possible

Agreement

Factors for Bridging Value

External Factors

Availability of Capital

4

TimeUnique Value

DriversRisks

Preliminary Considerations

• Agreement on Value – Now, Later or Never

• Complexity and Time

• Preserving Flexibility and Agility

5

• Preserving Flexibility and Agility

• Transactional Dynamics

• Resolving Disputes

Investment Transactions

• Convertible Notes

• Preferred Shares

• Other Techniques

6


Investment Transactions - Convertible Notes

• Next Round Conversion Pricing and Triggers

• Repayment Obligations

• Security

7

• Security

Investment Transactions - Preferred Shares

• Liquidation Preferences

• Preferential Dividends

• Anti-Dilution Protection

8

• Anti-Dilution Protection

Investment Transactions – Other Techniques

• SAFE Financings – Simple Agreement for Future Equity

• Hybrid Debt and Equity Investments

• Tranche Investments

9

• Tranche Investments

• Pay to Play Features

Sale Transactions

• Holdbacks and Escrows

• Vendor Take Back Notes

• Rollover Equity

10

• Rollover Equity

• Earn Outs


Sale Transactions – Holdbacks and Escrows

• Working Capital and Other Near Term Post Closing Adjustments

• Escrow Release Conditions

• Escrowed Letters of Credit

11

• Escrowed Letters of Credit

Sale Transactions – Vendor Take Back Notes

• Payment Terms

• Intercreditor Arrangements

• Information and Governance Rights

12

• Information and Governance Rights

Sale Transactions – Rollover Equity

• Management Incentive Arrangements

• Minority Shareholder Challenges

• Dealing with Conflicts on Future Claims

13

• Dealing with Conflicts on Future Claims

Sale Transactions – Earn Outs

• Challenges to Post Transaction Integration

• Getting to Agreement on Triggers and Measurement

• Anticipating Change

14

• Anticipating Change

Sale Transactions – Other Techniques

• Milestone Payments

• Contingent Value Rights

• Collars on Share Exchange Deals

15

• Collars on Share Exchange Deals

• Structured Equity – Hurdle Rate of Return

• Spin Offs

• Royalties

Other Considerations

• Clear Process for Determining Value

• Dispute Resolution Procedures

• Escape Hatches – Shotgun Provisions and Sale Process Rights

16

• Escape Hatches – Shotgun Provisions and Sale Process Rights

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W. Ian [email protected]