While I was still working in Atlanta with Ross Systems, I assisted some colleagues to start a small consulting business in Kansas. I put up half the money, all of $10,000 and two others split the remainder. We acquired the US rights to some application software from NZ based CIMDEC Systems Ltd. The plan was for us to commence activities in about 6 months when my contract with Ross Systems ended.
Some months later, CIMDEC System Ltd. in NZ was acquired by a Scottish public company and we were approached by them to acquire back the US rights. We sold the rights back for $1 million. At no time had our venture undertaken any customer transactions. We had zero revenue and had incurred only some
minor incorporation costs.
If we applied a conventional valuation process to this business, we would have some problems. No revenue and a few expenses hardly provide the basis for valuation and certainly fail to explain our exit value. One could argue that this was an IP sale, but on what basis would you value something which had not been used?
Once again, our conventional valuation theory has come up short.
Shortly after I left Ross Systems, a group of us started a consulting business with all of the gross profit going into software development. Our intention was to build a supply chain optimization software application for process
manufacturing. The consulting income and some founder investment enabled the firm to establish itself and bring the first few software modules to market.
Just as we were beginning to see some success of our software products, a small firm called Red Pepper, the developer of a finite scheduling optimization product, was purchased by Peoplesoft for some 25 times revenue. Red Pepper had very few customers, revenue of about US$9 million and had only generated a small profit. A conventional valuation using a multiple of net earnings would have put their valuation at less than $2 million. Clearly Peoplesoft saw something in the acquisition which was important to them.
We used this opportunity to raise $2 million in venture capital for 20% of our business. At the time our net earnings would have been under $100,000. Three years later, we had finished the suite of modules, acquired about 20 customers, grown to 30 employees and established strategic partnerships with several ERP vendors. Our revenue had grown to $2 million but we were putting all of our surplus cash into product development thus our net earnings were minimal.
Then our world collapsed. The big ERP vendors, SAP, Oracle, Peoplesoft, JD Edwards and Baan, all decided to develop products in our sector. Our marketplace had been their customers and prospects and we lost those. We
plunged into a loss situation and looked like we were heading for insolvency. In about 6 months we would have used up the balance of our VC money.
We decided to sell, but what is a business worth when it is losing $1 million per annum and with no future prospects and 6 months to live worth? What is the valuation when there is a multiple of a loss?
We knew we had little time to act and immediately contacted our strategic partners and competitors to see if we could recover something out of the ashes. By the end of the first week of discussions, we had 5 potential buyers with the best offer being $8 million.
At this time, we were approached by Peoplesoft and opened up negotiations with them. A week later we agreed a purchase price of $12 million.
These three personal experiences convinced me that the conventional valuation methodology was unable to cater for unusual situations. It certainly was no guide to my final exit values, or was it simply that these valuation
methods do not cater for high growth potential ventures.
The common theme running under each of my ventures was that they had the potential to generate high revenues and profits at some time in the future, perhaps in the hands of the buyer more than those of the seller. Surely this is where we have serious limitations in our conventional valuation methods. They don’t cope well with future potential and they see the business as an on-going venture rather than one where the buyer influences the future.
The conventional valuation method, the EBIT multiple, is based on a number of implied assumptions about what the business will look like in the future, even in the hands of the buyer.
What this suggests is that we need a new approach to calculating the sale value of high growth ventures and, especially, high growth potential ventures.
We need a valuation theory which explains how I was able to achieve such significant premiums on sale. Recall that these businesses were sold in the face of losses, declining or zero revenue and poor short term prospects. At the same time, we need a theory which explains why a buyer is willing to pay a premium
in these situations.
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