Valuation of technology. Report from the battlefield   

Ofer Vexler 

 

Why are we buying? In the recent years, we see significant activity in the Merge and Acquisition

(M&A) market of technology sector. According to data of Ernst &Young (Ernst &

Young, 2011), there was more than 2,700 deals in the technology M&A market

with money volume about $119 billion in 2010. However, despite the giant

volume of deals, value of most of the deals was not clearly defined by financial

rules based on cash flow result or market value of real assets. Actual financial

performance, like earning per share or cash flow calculation may not be

considered as a crucial factor in the technology market because acquired

companies mostly have not reached yet their potential at the time of transaction,

and often have no real income. Unlike the other businesses like real estate or

retail, technology business forecast cannot be based on the past record or

performance. Moreover, technology market has very vague estimates, which

further complicates the valuation of a single company or technology. Klepper

notices that high rate of innovation leads to rapid change of the market, its

shares and features (Klepper, 1996) . As a result, we have to adapt our previous

knowledge to permanently changing business reality. So, not only technology

specialists, but also financial managers need to study new features of the

technology market for better understanding the rules for valuation the technology

companies.

Technology deals are very complicated. Indeed, we can recently see that

industrial giants make M&A deals with several start-up companies that have no

any revenue or positive cash flow. These companies do not have a real business

model or client database. What is a point for buying this kind of companies? Only

the magic word “technology”? Or no more magic “Synergy” and

“Diversification”? We hope that driver of these M&A has some real value for

shareholders. For example, big company buys new technologies for improving

their existing products and services and also for introducing to their customers

new opportunities. Thus a final purpose is to increase the cash flow and the

economic value.

Likewise, thousands small companies are working hard with the purpose of

creating a new technology and capturing the world. At same stage, the founders

realize that their technology and potential product may be perfect, however their

resources are insufficient for implementing the product in the market. Hence,

deals between industrial monsters and small inventors are born.

During the valuation process of technology or hi-tech start-up a number of

problems arise. The first problem is so called “lemons” problem (Akerlof, 1970)

which is very familiar to venture capitalists: as the same way you may buy a bad

car, you may also buy a bad start-up. Deal of buying a bad company is much

riskier than buying a bad car, especially when you need to identify just a few

promising start-ups from hundreds of unpredictable companies. In addition, to

sell a bad car is not too much difficult, but to get rid of bad company is next to

impossible. Problem is even more complicated giving the fact that the buyer is

dealing with a whole “basket of lemons”: the people, the product and the

business opportunity. Buying the proper technology (not the start- up company)

may be looking easier, provided that the buyer understands well its business

opportunity and has right people.

The second problem is the possible discrepancy of acquired companies or technologies and the original purpose of M&A. In some case, managers have wrong awareness about technology needs of their companies and wrong assessment of potential financial result of technology acquisition, which may lead to misevaluation of acquired technology.

According to New M&A Playbook published in Harvard Business Review

(Clayton M.Christensen, 2011), “to state that theory less formally, there are two

reasons to acquire a company, which executives often confuse. The first, most

common one is to boost your company’s current performance—to help you hold

on to a premium position, on the one hand, or to cut costs, on the other. An

acquisition that delivers those benefits almost never changes the company’s

trajectory, in large part because investors anticipate and therefore discount the

performance improvements. For this kind of deal, CEOs are often unrealistic

about how much of a boost to expect, pay too much for the acquisition, and don’t

understand how to integrate it. The second, less familiar reason to acquire a

company is to reinvent your business model and thereby fundamentally redirect

your company. Almost nobody understands how to identify the best targets to

achieve that goal, how much to pay for them, and how or whether to integrate

them. Yet they are the ones most likely to confound investors and pay off

spectacularly.”

We can hear here the familiar sound of the magic words: the first reason talking

about Synergy, in the second case, we hear the Diversification. In the first

case, executives have done a bad homework and provided incorrect forecast to

justify a fictional synergy. They have convinced themselves that implementation

of acquired technology may bring more value to the company. In the other case,

executives of both J&J and Boston Scientific have decided acquiring of Guidant

(DePamphilis, 2010), the leader in the market of cardiac devices. It was a real

battle! Struggle ended by the victory of Boston which bought Guidant for $27

billion. However, as it often happens, the winner became the loser: Boston

Scientific lost more than $18 billion of its shareholders because of the trouble

with the Guidant technology.

In the latter situation, disoriented managers looked for unsuitable innovation

without recognizing the real market needs. Intensive R&D or technology M&A

without comprehensive analysis of market sensitivity may to create the market

myopia (Levitt, 1960) and, as a result of the acquiring or developing of new

technology, company will lose the market advantage despite of significant

investment.

The third problem is the high level of uncertainty of the technology market. Most

of suggested technologies are lack of feasibility or competitiveness. Therefore,

wrong technology M&A may bring more losses than benefits. The buyer must be

aware that competitors are also looking for innovative technologies and perhaps

that buyer’s investment may be lost if purchased technology does not meet the

market requirement with respect to its cost, feasibility or usability options. New

technology opportunity may not fit to the way of industry (Drucker, 2002) because

of inconsistencies with today realities.

Despite of lot of complications, due to innovation needs of community, which

require the companies to make more deals, the technology market grows .

Innovation may provide to a company additional value driver. According to

Schumpeter (Schumpeter, 1934), role of innovation is crucial in business world,

especially in the age of technological disruptive change. Innovation

implementation may provide to the company desirable instrument for improving

the financial result, boost the market diversity and make it more sustainable.

Technology provides to producer strategic market advantage. Evolution process

of economic development (Richard R. Nelson, 2002) requires from firms

perpetual innovation in production process:” This strand of evolutionary thinking

leads into a theory of competition among firms in industries where innovation is

important and of firm and industry dynamics.”

Companies that do not recognize its innovative needs may find itself on the list

of outsiders. Therefore, despite the difficulties, the market of technology M&A will

continue to grow. Therefore, the ability to make right valuation of technology for

start-up and patents will be more important and relevant.

What are we buying

In August 2010 Oracle have acquired the Phase Forward. As reported to SEC

(Oracle Corporation, 2010), “The total purchase price for Phase Forward was

approximately $785 million, which consisted of approximately $784 million in

cash and $1 million for the fair value of restricted stock-based awards assumed.

In allocating the total purchase price for Phase Forward based on estimated fair

values, we preliminarily recorded $402 million of goodwill, $370 million of

identifiable intangible assets, $20 million of in-process research and development

and $7 million of net tangible liabilities.” It means that Oracle paid for real assets

less than 1% of the total money paid. What exactly have Oracle acquired? What

is a point to pay such a huge amount for intangible asset, especially intellectual

property?

When we are buying technology, we don’t buy some device or software code.

We buy intellectual property that has a legal form of patent or production secret

(know-how) or technology company shares. We buy the right to use the

technology and complete information how we can do it. We do it according to the

rules of IP management.

Technology deals are integral part of business doing. IP management became

an integral part of the general strategy of corporations. According to Botaro

Hirosaki, Senior Vice President and Executive General Manager of the

Intellectual Assets Operations Unit at NEC Corporation, IP strategy should be

meeting the following goals of organization:

• “Integration with the business strategy by focusing intellectual asset

registration on core technologies and standardization.

• Maximizing technological competitiveness by continuously investing in

R&D and in-sourcing promising new technologies.

• Enhancing profit opportunities with licensing-out and technology transfers”

As a result the IP, especially technology may have the separate life inside the

developing organization or as well outside it. Technology may be sold as a

building in which the organization operates. The technology also may be

purchased just like any other form of property, mainly for increasing the

profitability of the buying organization.

When firm is buying technology instead of developing technology, it buys the risk

of uncertainty. Of course, internal R&D has significant influence to firm

development and absorptive capacity (Cohen & Levinthal, 1990), but ignoring the

external factor may be more problematic. Industry giants must develop lot of

new products. Their managers do not know, whether internal R&D department is

able to create technology, which will be feasible for production and suitable for

the market. They will become responsible for possible failure and loss of

opportunity. On the opposite, purchasing of working production technology for

attractive and desirable for the market product may prevent the unnecessary risk

because only the winner technologies will be purchased. According to recent

research in Georgia Institute of Technology (Palermo, 2011), right R&D strategy

based on integration of internal and external R&D resources may provide more

desirable result: “In most high-tech industries technology buyers conduct

extensive internal R&D which may alter their external investment strategy. If so,

then this creates a potential tension between developing technology internally

and obtaining it externally. This raises the question of whether internal and

external R&D is complements or substitutes. A few studies have attempted to

address this question but there currently does not appear to be a consensus on

whether these two types of R&D are indeed substitutes or complements.”

Indeed, giant companies may spend billions to R&D, but nobody can assure that

R&D personnel will imbue with flash of genius. As it was beautifully written by

John Seabrook (Seabrook, 1993), the genius invention of Robert Kearns was

stolen by auto industry behemoths, despite of the fact, that resources of Ford and

Chrysler were incomparable with Kearns resource (by the way, The Court was

provide to Kearns great valuation of his IP). The example of Kearns

demonstrates that the single inventor achieved the better solution than the

industry giant. Absence of “Genius Flash” could make the R&D work useless

and, as a result, causing significant losses. Acquisition of developed technology

or investment in start-up might be smarter solution and provide better financial

results than the internal R&D process.

How are we buying

Cost approach

Cost approach is the widely accepted method for assets assessment. It’s very

comfortable for accountants because they do not need to perform complicated

analysis. This approach is very useful for assessment of fixed assets that have

clear market price due to its high precision for assets appraisal. However this

method is not usable for intangible assets that did not pass the exam of market

deals. Indeed, cost of intangible assets absolutely cannot explain the assets

value. According to IAS 38 (International Accounting Standard Board, 2009),

intangible asset may be recognized “if it is probable that the expected future

economic benefits that are attributable to the asset will flow to the entity”. If we

can be sure that existing intellectual property may assure the expected cash

flow? Is there any relation between cost of intellectual property and financial

benefit? Definitely not! There is a reason for not recognizing internal R&D

expenditures as an assets because of lack of confidence for potential economic

benefit from the investment, unlike the purchased intangible assets that were

valued before acquisition (Anton Bradburn, 2005). Accord to statistic of Silicon

Valley (Ball-Mason Group, 2010), failure rate of technology companies

established in Silicon Valley estimated as 75%-80%. Contrariwise, value of IP

may rise to tens or hundreds of times with no regard to the initial investment.

Otherwise (Ann-Kristin Achleitner, 2009), “cost approach does not consider the

unique and novel characteristics of IP because costs do not reflect the benefits”.

Because of high level of uncertainty regarding to surviving of technology

companies, there is no function between technology cost and market value.

Some adepts of the cost approach may argue that this method is more

acceptable to the banks as collateral, as well as for insurance companies for IP

insurance calculation. The Issue was analyzed by Canadian auditors from PWC.

As know, Canadian bankers, unlike their colleagues from UK and even US, often

accept as collateral different kinds of IP, like as patents royalty right etc.

According to PWC research (PriceWaterHouseCoopers, 1999), most of

Canadian bankers and insurers prefer the income approach for IP valuation,

especially royalty method. Thereby, the cost approach for technology

appraisement seems to be the least effective.

Market approach - Comparable Deal

Many of technology acquisitions deals are being based on valuation of similar

transactions. It may be comfortable when competitors simultaneously acquire

similar companies or technologies. Let’s investigate the Google’s acquisition of

YouTube in October 2006 (DePamphilis, 2010). Despite the fact that YouTube is

not a proper technology company, it developed the new kind of information

exchange including video and audio communication for its new business model

based on the communication technology. Prior the YouTube deal Google

managers analyzed a number of similar deals like acquisition of MySpace social

media (Intermix Media) by News Corp in July 2005 for $580 million and site

About.com by The New York Times in February in 2005 for $410 million. My

Space had 27 million unique visitors and About.com had 42.6 million unique

visitors per month. Annual revenue of About.com (for one next year) was

estimated around $77 million, Intermix planned revenue was estimated at $81-

$84 million. The New York Times paid for About.com 5.33 times of estimated

revenue and News Corp paid like as 7 times of that. Potential revenue of

YouTube estimated as $61 million derived from 34 million of unique users.

Unlike previous case, Google paid $1.65 billion that is 27 times the potential

income of YouTube. Perhaps, managers of Google made mistake? Actually not!

Google’s manager assumed 225% annual growth rate for YouTube and, 25%

profit margin rate acceptable for Google. Nonetheless these projections seemed

unrealistic for most investors in the market, in the year 2008 YouTube has

achieved the annual revenue of about of $200 million. Subsequently, comparable

deals method cannot be used as reliable valuation model without understanding

of the real considerations of dealmakers. The second problem of the comparable

valuation method is that most technology M&As are not similar deals.

Technology market feather is constrained by the number of buyers compared to

the huge number of sellers. Some specific technologies have no buyers at all, or

one or two buyers only may exist. Liquid market of technologies still does not

exist (Ann-Kristin Achleitner, 2009) “… market multiples are likely to not

sufficiently represent the value of the unique IP of the target company. Identified

comparable IPs may differ in terms of the intended commercializing strategy and

the corresponding complementary tangible assets”. As a result, with all our

respect to comparable deals method, we have to notice, that this approach

should better not be used for the market technology valuation.

Income approach - real option method

Real option valuation method is much more appropriate for financial professional,

like hedge and VC fund managers. We often use the Black-Sholes option pricing

for capital market calculation. However, uncertainty level associated with the risk

of technology development and absence of most important information for

comprehensive analysis makes this method less relevant. Nonetheless,

scientists from University of Virginia (Susan Chaplinsky, 2002), believe that

option pricing model may be used for decision making about technology

valuation. Indeed, we can replace some parameters, such as DCF of technology

economic benefit instead of underlying assets value or systematic risk instead of

dividend yield, and our model may be more or less realistic. For example, Google

seeks to enter the mobile market. In August 2006 Google expects obtaining

economic benefit from Android activity with Net Present Value of $220 million.

Google’s cost of capital would be around 10.5% and market standard deviation is

99.8% with systematic risk of 20% and average product life (duration) of 5 years.

Price of call option for benefit of Android technology calculated by Black-Sholes

model is $80.4 million, so price of $50 million that paid by Google for Android

was more than justified. With all our respect to the option pricing model, it might

be used in very rare business cases and, the model analysis requires specific

skills and understanding of the market reality. We may also notice that the option

(technology deal) must be replicable. According to Fernandez, (Fernández,

2001), “If the real options cannot be replicated, using financial option formulas is

completely inappropriate for valuing real options, as all the formulas are based

on the existence of a replicate portfolio”.

Binomial model of real option model is more acceptable. For example, MedTT

(fiction name), pharmacology industry giant considers to buy new drug

technology. Additional cost related to FDA approval is $20 millions and

probability of failure does not exceed 10%. The technology is suitable for

company business and potential DCF from production of the new drug is

estimated as $580 million. Managers of MedTT also know that competitors may

capture the market with a new alternative drug. Probability of this case is 30%

and it reduces the company DCF from the new technology to $180 million.

According to binomial model calculation, MedTT will be willing to pay for the

technology no more than $394 million.

Similar calculations are often used for M&A, provoked by business wars. When

Oracle CEO, Larry Ellison declared the war on IBM and SAP (Evans, 2010), that

led to M&A escalation including deals of Netezza, Unica and other.

Binomial model calculations may be used by the technology inventor for

choosing a potential buyer. The model may include the potential benefit of the

buyer, its willingness to share and capital cost.

Income approach - royalty method

Royalty approach is most suitable method of technology valuation for companies

that does not intend to establish production process of the product, but are

interested to allow others using the technology. In this case, we may compute the

net value of technology with no relation to other resources of the company.

Therefore the company valuation will be based of discontinued cash flow of the

royalties’ payments. To perform the calculations, we should be mining following

data:

• Reliable sales forecast based market research. The buyer’s

managers, which are interested in purchasing the technology, must

study what is the level and the period of technology usage. They

should learn the potential product life cycle and calculate potential

income and benefit taking into account changes in different levels

of product market development (Day, 1981) , market growing,

consumer purchase parity etc. Let’s analyze the SanDisk-Pliant

M&A. SanDisk announced about acquisition of Pliant (SanDisk

Corporation (NASDAQ:SNDK), 2011) on the base of research by

Gardner. "The Enterprise SSD market is poised for considerable

growth, with revenue projected to reach $4.2 billion in 2015, up

from $994 million in 2010," according to Joseph Unsworth, research

director at Gartner. "This trajectory is fueled by the expanding use

of MLC NAND technology, which will require extensive flash

management expertise to ensure successful adoption in enterprise

applications." According to our analysis, Pliant has almost no real

business activity; its revenue (right to M&A day) is not more than 3

million dollars and the company has not profit. We may conclude

that SanDisk bought the Pliant instead of paying royalty and deal

value was considered based on sales forecast of SSD product.

• Acceptable royalty rate for relevant technology. We have observed

that in most industries standard royalty rates do not exist. It may be

explained by typical relationship between the inventor and the

entrepreneur in different countries and ages. Most important

factors for royalty rank are market size, profit margin, IP strength

and breadth. According to the research of David (McGavock, 2004)

low rates like 4%-5% may be observed in automotive, electronics

and chemical industries, more significant rates like 9%-12%

characterize Internet, media and other software industries. We

noticed that in some cases royalty rate may be as high as 15% and

more.

• Reasonable discount rate for NPV calculation includes retention

value. Most popular discount rate may be calculated according to

CAPM. We may find the free risk rate, acceptable market risk

premium (Fernandez & Del Campo, 2010) and unlevered Beta for

principal players in the industry. For example, some internet

searching solution may be interested for Google or Yahoo, so

desired discount rate will be around 11.2%.

Calculation of the technology value by this method may be very simple:

we need to calculate the DCF of royalty payment during period of product

life cycle. For example, AAA Company developed new communication

technology. Market research shows that after six month of product

implementation, annual sales of the product to user estimated as $50

million. During next three years sales will grow at 50% in year. After the

forth year sales volume will be reduced by 40% and will be stable during 4

years. According to the royalty method, the technology value will be

calculated as $33.5 million. Royalty method is a popular method of

valuation and is often used by financial institutions and investors.

Income approach - Economical benefit or synergy sharing

The most benefit of M&A deals is a synergy creation, as it is usually

explained by companies’ executives. Synergy may reduce the cost of

existing production and lead to the market development for new products

as well. Technology must produce the economic benefit. Therefore, giant

companies are usually willing to share the synergy obtained from the use

of new technology and pay reasonable premium for it. What are

appropriate rules for benefit sharing? According to DePamphilis

(DePamphilis, 2010), the buyer strives to pay to seller no more than 30%

from created economic benefit. WIPO’s position (Turner, 2000) is

arbitrage rules of 25% for IP owner. Our benefit sharing analysis shows

that Hewlett Packard paid for ArcSight (as $1.5 billion) relatively high price

for the synergy (about 27%), but high grow rate of ArcSight may influence

the grow rate of HP. High grow rate and breed cash flow lead to

conclusion that the price may be justified.

In end of 2011, Apple declared about establishment of R&D center in the

Israel. The high price of $450 million that Apple is willing to pay for Anobit

which will be used as an R&D platform of Apple in Israel is justified

because Anobit developed technologies may save to Apple significant

R&D investment and prevent using the existing Anobit technology by

competitors. In our opinion, general economic benefit of Apple estimated

as $2 billion, so Anobit share of synergy is 22.5%.

Share of benefit method was also used in court decisions. In case (Joy

Technologies Inc. v Flact Inc, 1993), the patent infringement of Joy

technologies related the gas desulfurization process was studied.

According to the court decision, the patent user ( Flact) was obliged to pay

25% of cost saving provided by use of the patent. On January 2011,

Federal Court also used the principle of 25% in case Uniloc USA vs.

Microsoft (Uniloc USA, Inc. v. Microsoft Corp, 2011). Uniloc sought

damages equal to 25% of the value of the accused feature for the product

and the Court agreed with the plaintiff’s arguments.

Rule of 25% has been comprehensively analyzed (ROBERT

GOLDSCHEIDER, December 2002) and according to the research

conclusion this rule passed the empirical test. Goldscheider noticed:” An

apportionment of 25 per cent of a licensee’s expected profits has become

one, of many, useful pricing tools in IP contexts.62 And our empirical

analysis provides some support for its use. A comparison of royalty rates

with two proxies for expected long-run product profits (namely, licensee

profits and “successful” licensee profits) yields royalty to profit ratios of 27

per cent and 23 per cent, respectively.”

Therefore, we can conclude that benefit sharing between the inventor and

the technology buyer as of 25%/75% is the most appropriate method for

technology valuation. So, what do we call the economical benefit? In my

opinion, it is present value of the future cash flow derived from the

technology. Cash flow forecast should be based on careful calculations

and include the possible adverse scenarios. The buyer pays lump sum to

the seller, it means that the buyer, unlike the seller will incur the overall

loss in the case of negative scenario.

No less important is right evaluation of DCF rate. The rate may be vary

from WACC of the buyer like 10%-12% up to 40%-60% appropriated for

venture capitalists. It will depend on the level of risk related to the market,

new product manufacturing or establishment of new enterprise.

Valuation technology method may not be so appropriate and reliable

instrument for start-up valuation analysis. Even if we succeed to valuate

working technology it can mislead related to assessment of Start-up

Company that has not yet finished its product development. We should

examine the triple Lemons risk including team risk, product risk and

opportunity risk. Primary important factor is the ability of the team to

develop the technology. Moreover, after the technology was developed,

the team must create competitive business model or to sale the

technology to the right buyer. The risk may be reduced by right

assessment the reputation of team people, their previous record and

control of milestone performance.

 

Resume

According to our research the income approach represents the best

method for technology valuation. OECD specialists (Shigeki Kamiyama

and Jerry Sheehan, 2005) noticed that the cost approach may be used for

accounting and tax purpose and the market approach is very relevant for

internal management assessment, but the income approach would be the

most acceptable for IP valuation. However, three methods of income

approach presented here may not be equally useful in similar situations.

The real option method is more suitable for valuation model in uncertainty

condition characterized by the high level of competitiveness. The royalty

method fits for valuations when the parties may easily get relevant

financial and market information including data about comparable deals.

When technology is disruptive and potential result may change the game,

the synergy (or economic benefit) sharing may be more useful than other

methods.

Technology valuation techniques recently become more relevant because

of the market needs and perpetual developing of the innovation process.

The goal of financial professionals, accountants and bankers is to provide

adequate solution for valuation, accounting and financial analysis of

developing firms and IP assets. Our pre-singularity age requires more

creative and reliable analysis of technology companies as a part of our

economic and society development. Innovation and sustainability

processes have to obtain the suitable form of financial valuation.

Therefore, theory and practice of finance will have to being developed as

well to reflect the actual world business reality. 

 

  

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