How to evaluate a new business idea or investment proposal

May 17 ,2021 / Complinova Team /
Key points for evaluation of a new business (“Target” = a candidate/business available for acquisition / investment)
  • Assess total market size of the business – make it year on year (yoy) for the next 5 years
  • Here, assumption of growth percentage is very important. Need to be very conscious of the factors determining the growth e.g.
      1. What are the key drivers of the business
      2. Expected behaviour of these key drivers – in future
      3. Whether tech/product/solution is commercialized or still in “trying-to-create-a-space” stage
      4. Probability of market acceptability, whether customers would really be keen to buy. For this purpose, it is very important to undertake “technical due-diligence” of the product or the solution by an industry expert with significant domain knowledge
      5. Existing clients and their pocket size
      6. Target prospects and their pocket size
      1. India centric or Global play
      2. Difficulties in scaling – logistics, cost, creation of physical network of intermediaries / distributors
      3. Delivery model – whether in-person (low scalability) or over-the-platform (high scalability)
      4. Difficulties or ease of clients moving to alternate tech/product/solution providers (Client stickiness – why and how)
      5. Whether tech/product/solution is project type (mostly one-time with AMCs) or annuity / managed service type
      6. Evaluate risks
        • Regulatory & Compliance risks
        • Environmental risks
        • Competition risks –possibility of entry of an aggressive with deep pocket player which would disrupt the existing players – question on sustenance
 
 
  • First create a value for the total market rather than value of the Target
  • What is expected market share of the Target – yoy for the next 5 years
  • What makes us believe that the Target would achieve these yoy market shares – assign “probability factor” based on uncertainties
  • Calculate cost of delivery of the proposed tech/product/solution. Ensure all the cost line items are covered as any miss may create surprise in future. Cost to be calculated under following heads:
    1. Direct Cost (mainly and proportionately linked to delivery). This is mostly variable in nature e.g. delivery related manpower, travel cost, IT recurring cost, raw materials, input cost etc. More sales/delivery, more the direct cost. Manpower cost includes all related cost e.g. superannuation benefits, medical, staff welfare (tea/coffee/other facilities), leave cost etc.
    2. Direct Overheads – Occupancy cost (rent, electricity, maintenance, house-keeping, security, water, insurance, communication costs etc.) related to a given scale of business. Though these are also direct cost but these are not purely variable as we need to create a given scale of space / infra keeping in mind near future requirement
    3. Sales Cost – Manpower, travel, occupancy cost
    4. Support function cost (Common IT, HR, F&A, Legal, Admin etc.)
    5. Capital Expenditure (Capex) – This requires special attention. Sometime, there might be regular capex requirements (either to manage growth or as replacements) and hence, these (regular capex) needs to be considered as part of periodic operating cost
    6. Make proper assessment of “to-be” cost, post-acquisition (for buyer). In case of start-ups and small businesses, lot of compliance and support function (F&A, Legal & Compliance Dept, HR, Admin, IT, Marketing & Communication, Security etc.) cost is not incurred and hence, not included. As the business grows, compliances and support functions would be more and need to be considered appropriately.
  • Margin is derivative of revenue and cost
  • Valuation:
    1. Whether Target is expected to have dominance (70-80%) in the given market. If yes, the Target would command a “premium factor”
    2. Calculate “Life Time Value” (LTV) of customer base being created:
      • In case of some of tech based solutions, a customer is acquired upfront and value is generated over lifetime of the customer being retained
      • There might be initial loss which will eventually reduce over the lifetime of the customer remaining in the system
      • Potential of retention of customer is very important
      • The ratio of LTV of the customer & amount spend for acquiring the customer would ideally be 3-4 times e.g. For $4 per client TLV, Target should not be spending more than $1 in acquiring the customer
      • LTV should be determined for each category of the business segment / customer class and not on overall basis. The LTV business case may look good on overall basis but when it is analysed for each segment, it shows correct assessment. This will help in deciding valuation for each segment and also help in customer acquisition strategy for each segment
      • Evaluate past customer churn data and undertake cold calling to few key customers. This will help in understanding the real reason for attrition
    3. For Enterprise SaaS revenue generating company, the valuation may range from 5-10 times revenue (of market share) – as they would have mainly sales team cost – margin 30-40% margin, expected to have higher growth
    4. International business / clients would be advantage
    5. Traditional multiple for matured companies with steady state growth would be in the rage of 6 to 8x of margin or 1 to 1.5x of sales
    6. High growth and annuity / guaranteed / sticky revenue would command higher multiple - in the rage of 12 to 15x of margin or 2 to 3x of sales
    7. Business with compounded growth of 50-60% or 200-300% yoy growth etc. would have different kind of valuation
    8. Strategic Investors vs. Financial Investors
      • Strategic investors would be more mature thoughtful as they would be integrating the Target into their own business
      • Financial Investors would have “hot money” and would be having more risk appetite and would be able to take more forward calls
  • The assessment above does not consider post-integration / synergy benefits, in case acquisition is proposed by an existing business entity in similar lines. This needs to be evaluated separately as one of the most successful acquisition strategy by an existing business entity is based on the cost efficiencies & not based on revenue / growth assumptions
  • Apart from above objective evaluation, sometime, it is important to play on gut-feel (entrepreneurial instinct)

Categories


Archive