Moving from Perception to Reality - Technology Valuation
By, Armand Lavoie, PAg, MBA
Vice-President, Western Canada
Foragen Technologies Management Inc.
The 20th century marked a transition from an industrial age to an information age. As we enter the 21st century, many believe we are witnessing the emergence of a new age based on the life science industry. Although the completion of the first draft of the human genome underscores the enormous potential of biotechnology for human medicine, the application of biotechnology to agriculture can have as much, or more, impact on human health and wellness. In response to this, a number of later-stage venture capital funds have been created to invest in agricultural technology companies. Unfortunatley, there has been little support for early stage companies who are in need of the financial, management and strategic resources to successfully commercialize their technologies. To meet these needs, Foragen was created as the first known seed investment fund that exclusively focuses on early stage advanced agricultural technology investments.
In Foragen’s first year of operation, we have seen a wide array of exciting technologies. As any investor would tell you, one of the key challenges we face is determining and negotiating the value of the technology. The two methods commonly used to value technologies are discounted cash flow models, and comparing or benchmarking to similar technologies. In this article, we will explain these two valuation methods, describe the differenct challenges we face in the agricultural technology sector, and identify how we manage these challenges.
A good discounted cash flow is a strong tool in determining the value. A discounted cash flow is a mathematical excercise that discounts the potential profitability of the business based on the risks and time associated with expected cash flows. The key components of these models are forecasts of future sales, estimates of expenditures and establishment of the discount rates. A financial model is then created utilizing a spreadsheet, such as Excel. The net output of the model is a projected cash flow stream over a number of years, usually five to ten. These cash flows are then “transformed” into a single number that represents the estimated current value of the technology using the Net Present Value function in Excel.
The key challenges with discounted cash flows are developing reasonable assumptions and selecting the appropriate discount rate. A change in any assumption in the model will result in a different valuation for the technology. Consequently, your assumptions should be substantiated with hard data so that you can support the value you have placed on your technology. Assumptions with little supporting evidence are one of the most common mistakes we see in business plans.
The other difficulty is selecting the appropriate discount rate. The discount rate not only reflects the desired return on investment but also incorporates risk factors. Risk factors attempt to estimate the chances of success. In the biomedical sector, we have access to a database of results from clinical trials for many disease conditions. For example, if one is evaluating a potential treatment for diabetis, one can determine the probability that the product will pass phases I, II and III of clinical trials by utilizing information from other diabetic drugs that have been in development. Unfortunately, that level of information does not exist for advanced agricultural technologies. Therefore, there is always an element of subjectively in determining the discount rate. Slight variations in the discount rate can have an important impact on the value calculated with a discount cash flow model, so it is crucial to justify the discount rate chosen
The second method of valuing technologies is to use comparables. This principle consists of determing the value of a technology by finding similar technologies that have a history of commercial success or failure. The difficulty we face is that there is limited information available on comparable deals for other agricultural technologies or agricultural companies. Even where such data exists, it is also difficult to know if the value of the deals was realistic compared to your information and assumptions.
The problem with scarce information is not limited to the fact that there are relatively few deals to compare with. When you do find comparables, much of the key information is often kept confidential because of the private nature of many early-stage deals. Since small variations in the price, market size or costs can result in significant variations in values between the comparable technology and the one you are assessing, the lack of any of these data can dramatically effect your valuation exercise.
Even when you do find a good comparable, it is of limited value if the initial deal was improperly valued. For example, we were considering a technology, but there seemed to be a substantial variation between our assessment of the technology and that of its the developer. Upon further negotiation, we learned that he was using a value from a deal he had completed in the past as a benchmark. We reviewed the deal in question and noticed that the company in question eventually did an IPO and lost over 70% of its value in the public market. Obviously, the company was initially overvalued. Another example is in the Internet world, you certainly cannot get the same value for an dot.com company as you would have two years ago.
At Foragen, we find that a combination of both models is the most effective method to determine the value of a technology. We utilize a discounted cash flow model as the tool to determine the value of technologies, but also use comparables to determine and test our assumptions. Many of the assumptions involve information that is not confidential and readily available in the public domain, or easily acquired from third party sources. For example, if we are looking at an animal health product, we will look at similar disease conditions and utilize that information to guide our assumptions. We start by finding information on the disease we are using as a comparable, such the frequency of the disease, the cost of the disease, the perceived seriousness of the disease, efficacy of the products, the steps and time required to develop the product, and the market penetration of treatments for the disease. Utilizing the same information for the technology being valued, we estimate the price, market penetration, and other important assumptions. We find that by calling a few experts in the field or even people active in the field (veterinarians in this case), we are able to get good feedback. Using this information, we are able to develop well substantiated assumptions that we have a higher level of comfort with.
To determine the discount rate, we first determine the level of technical risk, market risk and competitive risk. We then compare this to other technologies we have assessed in the past. If the technology is in the early stages of development, still requires key elements of proof-of-concept, and there are significant market barriers, we will use a higher discount rate. The range of discount rates varies with the stage of development. Traditional venture capital will look at established businesses with exisiting management, a level of sales and profitability, and use between 20 and 30% discount rates. An early stage technology with no sales and further development and regulatory approval required will require a much higher valuation, such as 50% or higher.
The key element to remember is that a strong understanding of your technology’s value proposition is as important, if not more important, than the value you believe the technology has. For an investor, the most exciting projects are those where the inventor has a solid technology and also demonstrates an understanding of the technology’s weaknesses and its strengths. On the other hand, the greatest frustration comes from looking at a potentially great technology, but the proponent does not have a good understanding of the technology’s value. If these projects do get financed, they often reach a state of limbo as future investors realize that the initial value was set too high. This is unfortunate, because value is only truly achieved for an investor when the investment can be cashed in, and maximum value can only be achieved if one reaches the market in a timely matter.
Another important point to remember is that investors are as concerned with a strong relationship with the technology proponent as they are with the value of the technology. If someone has a good understanding of the technology’s value proposition, and is willing to discuss it openly and accept input and suggestions, he/she demonstrates that he/she is someone who would be fun to work with. In our opinion, the relationship is equally as important as the value propostion, and provides the best foundation to maximizing commercial success.
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