I’m working on an M&A model for a privately-held tech. company. They are looking at licensing some of their technology to a third party. Part of the consideration that they will receive is an upfront cash payment from the licensee, in addition to an equity investment (i.e., additional cash consideration, but in exchange for shares of the business). My question is how to treat the equity component from a DCF valuation perspective. It doesn’t seem to correct to simply include this as a cash inflow, because there’s a corresponding dilution to the equity of the company. Said differently, the company may receive $5 million (hypothetically) but, assuming the company is fairly valued, would be giving up $5 million of shares in the business. If this line of thinking is correct, the equity investment would have no impact on the DCF valuation because the $5 million inflow is offset by the $5 million of shares being issued. Not sure that I’ve expressed this very clearly, but is this issue something that others have encountered? If so, your thoughts would be greatly appreciated.
Not an expert but would like to take a shot: You DCF valuation should give you the value of the company’s asset, say V. Then the value of the company will be V + Cash. Now assume the company is fair valued before $5m cash inflow. New value will be (V+Cash+5m). And since the company issued new shares, then per share price doesn’t change.
Hmmm… FSA was always my weak spot, but I can’t resist the opportunity to try to think it through. If I understood correctly, the licensee would pay cash for a license, and then purchase newly issued shares of licenser’s stock (ok, licenser is private, but they get an equity stake) I think on the cash flow statement, the equity would show up as cash flow from financing (CFF), whereas the licensing would show up as cash flow from operations (CFO). On the income statement, the licensing would show up as revenue. I don’t think the equity would show up at all; that portion would be applied directly to the balance sheet. The issuance of new shares would dilute FCFE, which would lower stock values, but if that money is needed for company growth (the ROE figures in here somewhere), it could still be a sensible business decision. As long as ROE is > cost of equity, the company should be profitable. The trick is figuring out 1) what cost of equity ought to be (capm, maybe?), and 2) if ROE is likely to be constant as that new money comes in and gets applied (as high ROE projects get funded, less attractive projects remain, so ROE gradually goes down until it = cost of capital)
The initial upfront fee should not be included in DCF, because that is not a cash flow from operations, nor is it any investment in capital. To model this you would simply adjust each future year cash flow by inflows from this licensing agreement (if there are yearly payments to keep the license). If there are not yearly payments and this is a one time deal, well your cash flows stay the same and that original 5 million is simply added to the PV of your DCF to arrive at the value of the firm… hope that helps?!
I agree with miker2800. Also keep in mind that DCF gives you the firm (enterprise value), so once you factor in the additional $5 million in cash up front that hits the balance sheet, and assuming you’ve constructed your DCF correctly, you then back out the debt on the books to get your equity value, with the minority investor’s share of equity at any given time being equal to their original percentage of ownership at the time of investment (assuming no additional dilution down the line). So, while firm value increases by a total of $5 million plus the discounted top-line contribution from the licensing fees (if applicable), the equity component of the firm that’s maintained by owners of the privately owned company would increase by less than the aforementioned amount because of the equity dilution due to the investment from the outside party.
Don’t overthink this one. This is really a “postmoney / premoney” issue Calculate EV (EBITDA, DCF etc), subtract debt, add back cash (ie cash plus the new 5), subtract minority interest (if applicable) = equity value Note: as this is a private company, it may be appropriate to apply a “liquidity discount” to the EV, 25% seems to be widely used (this is especially the case if you are using public comps to value a private company
operations is generating a stream of license revenues, howsoever recognized over time. the operating CFs are 1. upfront CF, 2. portion of equity infusion CF above MV of equity purchased. then there is a equity financing transaction priced at higher than market value to part compensate for the license. the key is determining the MV of the company AFTER the license sale, because that is what is being purchased. if we call that postxtnMV, you can determine the portion of the equity infusion CF that is excess over the postxtnMV. that amount is the PV of the remaining license revenues, howsoever recognized over time. since we are using the DCF (i.e. income) approach, you can either forecast out revenues or FCFEs and discount using appropriate cost of capital. i think revenues may be easier. for revenues forecast, take preexisting revenue forecast, add the revenues from the license sale as recognized over time. assuming there are no costs associated with these revenues (strong assumption - there’s probably an associated liability for the prepaid revenues), they would drop straight to net income (of course, tax effects must be adjusted). that should give you the postxtnMV. its a little circular, but doable i think.
Gecco Wrote: ------------------------------------------------------- > Don’t overthink this one. This is really a > “postmoney / premoney” issue not if there is a prepaid revenues liability lurking in there. sure, if its a ‘take the license, pay cash, and go away without receiving any post sale support’ then arguably you can just look at it this way.
rohufish, I think I understand what you’re saying, but what you’re suggesting is really more trouble than it’s worth and I don’t see how “portion of equity infusion CF above MV of equity purchased” is even relevant. I think Gecco and I were on the same page here. Figuring out equity ownership becomes a simple matter of percentages once you back out debt and cash from enterprise value to arrive at total equity. Frankly, this is not a complicated scenario and is easy to model.
depends if you want the right answer or the easy answer. if part of the equity infusion is consideration paid for the license, i.e. the equity is sold for greater than MV after the license sale is factored in, you definitely need to address that. it will absolutely affect value. key issue you’re missing is that there are two EVs here - before the license deal, after the license deal. this is a small company, so i would imagine the license deal is material enough relative to the rest of the firm. if its not, sure, you can just ignore it and assume firm value is unchanged pre/post license sale.
rohufish Wrote: ------------------------------------------------------- > depends if you want the right answer or the easy > answer. > > if part of the equity infusion is consideration > paid for the license, i.e. the equity is sold for > greater than MV after the license sale is factored > in, you definitely need to address that. it will > absolutely affect value. What do you mean that “part of the equity infusion is consideration paid for the license”? At least in the deals and companies that I’ve seen, investors don’t actually acquire additional shares of “equity” on a monthly basis based on the performance of outlicensed sales. Their share of ownership remains the same. The investor’s equity value will grow, but their shares don’t change (unless it’s some type of licensing agreement I haven’t seen). The investment of equity is just part of the overall consideration – I don’t see what you mean by it being sold for “greater than MV after the license sale is factored in”. It’s all just part of the same equation. > key issue you’re missing is that there are two EVs > here - before the license deal, after the license > deal. this is a small company, so i would imagine > the license deal is material enough relative to > the rest of the firm. if its not, sure, you can > just ignore it and assume firm value is unchanged > pre/post license sale. No, what I’m missing is an understanding of what you’re saying…
Anonymous Wrote: ------------------------------------------------------- > Part of the > consideration that they will receive is an upfront > cash payment from the licensee, in addition to an > equity investment (i.e., additional cash > consideration, but in exchange for shares of the > business). numi - read this part again. note the words “part of the consideration…”. tech company is selling license. purchaser is making one time payment, plus buying equity (presumably above MV otherwise the upfront cash would not be termed ‘part’ consideration. no one is talking of monthly equity dilutions, dunno where you got that.
I don’t know what you’re talking about then. It’s fairly standard for investors to make an upfront licensing payment in addition to buying an equity stake in the company – not sure where “MV” comes into play. Maybe someone else can respond to this to your inquiry. All I know is that miker2800, Gecco, and I would model this situation in the same fashion, so maybe one of those guys can explain to me what you’re getting at.
Interesting debate. Thanks for the input so far. I feared that I didn’t express the issue clearly in my initial post, so here’s a bit more detail. Fact pattern: 1. Company XYZ is privately held and is developing proprietary technology. It is currently burning money on research and has no revenue streams. 2. XYZ is considering licensing its technology to a third-party and is evaluating draft term sheets during the negotiation. End goal: To determine, on a DCF basis, the value of the licensing deal. Proposed deal structure (all are cash payments from the third-party to XYZ): a. Up-front cash payment (non-refundable) b. Another up-front cash payment, in exchange for X% of XYZ Co’s equity c. Cash payments over time when/if the technology progresses through various stages of development. d. Royalties generated by the third-party’s eventual sale of propducts expoliting the technology. I’m approaching this as a risk-adjusted NPV model, with the following specifics for each payment stream (a to d above) a. The upfront (non-refundable) cash payment I’m treating as an inflow at time 0 with 100% likelilood (i.e., assuming the deal is done). b. The cash payment in exchange for equity I’m unsure of how to treat. c. I’m mapping out the timelines for the technology to progress through the various stages of development and applying a probability to each (using some industry specific data and management’s judgment). These probability factors are then multiplied by the milestones in the term sheet. d. I’m generating some high-level sales forecasts, probability-weighting them and applying the royalty rate(s) from the term sheet. The value of the licensing deal should be the PV of the payment streams above. My only issue is the cash payment in exchange for equity. As mentioned in my initial post, it doesn’t intuitively seem correct to simply include this as a cash flow, because XYZ Co. is giving up a value asset (a fixed percentage of the company) in exchange for it.
Interesting debate. Thanks for the input so far. I feared that I didn’t express the issue clearly in my initial post, so here’s a bit more detail. Fact pattern: 1. Company XYZ is privately held and is developing proprietary technology. It is currently burning money on research and has no revenue streams. 2. XYZ is considering licensing its technology to a third-party and is evaluating draft term sheets during the negotiation. End goal: To determine, on a DCF basis, the value of the licensing deal. Proposed deal structure (all are cash payments from the third-party to XYZ): a. Up-front cash payment (non-refundable) b. Another up-front cash payment, in exchange for X% of XYZ Co’s equity c. Cash payments over time when/if the technology progresses through various stages of development. d. Royalties generated by the third-party’s eventual sale of propducts expoliting the technology. I’m approaching this as a risk-adjusted NPV model, with the following specifics for each payment stream (a to d above) a. The upfront (non-refundable) cash payment I’m treating as an inflow at time 0 with 100% likelilood (i.e., assuming the deal is done). b. The cash payment in exchange for equity I’m unsure of how to treat. c. I’m mapping out the timelines for the technology to progress through the various stages of development and applying a probability to each (using some industry specific data and management’s judgment). These probability factors are then multiplied by the milestones in the term sheet. d. I’m generating some high-level sales forecasts, probability-weighting them and applying the royalty rate(s) from the term sheet. The value of the licensing deal should be the PV of the payment streams above. My only issue is the cash payment in exchange for equity. As mentioned in my initial post, it doesn’t intuitively seem correct to simply include this as a cash flow, because XYZ Co. is giving up a value asset (a fixed percentage of the company) in exchange for it.
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this is a nontrivial private business appraisal problem. you need to speak to an ASA about it. lots of CFAs think they can swing for the fences on these problems, but they are really trained for public company valuations, and have no idea how to even start breaking this down properly. there are all kinds of issues in here - intangible assets, marketability discounts, illiquidity discounts, pre-revenue business, forecasting nonexistent product sales based on nonexistent pre-commercialized technology, etc. the equity will need to be valued as of the transaction date, based on info known about company’s prospects as of that date. an ASA appraiser will know how best to do all that. without the equity being valued, you cannot solve this. you’ll need to determine whether the equity was sold at, below or above its fair value.
rohufish, I sort of get what you are saying…dont completely agree…but see what you are getting at. All the issues you have mentioned in the post above, I think Anonymous is probably comfortable dealing with… on the issue of the cash for the equity…question is…How much equity value is that cash adding to the company? While it could be assumed that the cash could be used for various great things which actually increase the value of the equity by more than the amount of cash infused… i doubt you could rationally argue that…or else the company could keep selling equity for cash till the marginal value added by the cash was equal to the cash invested. Which is why the approach specified by numi et al makes sense… i.e. Equity Value (post cash infusion & license agreement) = Equity Value (pre-cash infusion but post license agreement) + Cash investment Whether the equity infusion is accretive or dilutive to current equity holders is dependent on the pricing of the equity being issued. Value of license agreement = Value of current equity holders stake (post cash infusion & license agreement) - Value of current equity holders stake (pre cash infusion & license agreement)
Anonymous, thanks for clarifying. Your explanation appears to be in-line with what miker2800, Gecco, and I pointed out. Your “risk-adjusted NPV” is simply a probability-based DCF/NPV taking into account the likelihood of royalty payments – this is a very common valuation technique for biotechs and spec pharma companies. You would NOT model the initial equity investment as a cash flow – you simply take this into account as cash on the firm’s books today, to which you add the present value of your future CF’s to arrive at firm value today. I do not agree with rohufish’s assessment – in fact, this is a very easy situation to model as I described earlier, regardless of whether the company is private or public. We see companies like this all the time.
i can see where you guys are coming from - but i don’t see how you can do a DCF without knowing the appropriate operating cashflows to discount. i agree with the probability weighted ones (bullets 3 & 4), the upfront partial cash payment for license is also obvious (bullet 1), but without knowing whether there was additional consideration paid for the license (operating revenue) via the equity transaction, how would you prepare the operating CF stream to discount? yes, if you just blindly assume that the equity sale was at market value, so it has no distortive effects on the operating CF streams you’ve otherwise determined, i agree with your short cuts. but thats a pretty freakin strong assumption. you’d get killed in court if this were to get litigated. just because two interested parties get together and set a mutually beneficial value to the stock in a private transaction doesn’t mean it represents the market value. and if the cash that changed hands, supposedly for equity, partially represented payment for the license then that portion needs to be added to the DCF. and the future projections also need to account for the revised level of pricing for this technology, come to think of it. the treatment of the equity xtn absolutely affects firm value. debt, accretion etc is irrelevant. this firm doesn’t even have debt from the poster’s info. this is a 'lil pre-revenue private tech firm trying to be valued after its first revenue. also, marketability discounts / illiquidity discounts will apply (and possibly other discounts also). all you need to know is whether that equity transaction was at market or not. that is the crux of the issue. its the starting point for the rest of the answer. to take your own equation, Equity Value (post cash infusion & license agreement) = Equity Value (pre-cash infusion but post license agreement) + Cash investment how would you determine Equity Value (pre-cash infusion but post license agreement), without knowing the DCF stream?