Appraising a 'New Economy' Company

By: Scot A. Torkelson

The year is 1990 and inflation is accelerating again to near 6.0%, GDP languishes at a little higher than 1% annually and there is a high probability of recession. Unemployment is 6% and rising, while economists debate whether an unemployment rate at 6% doesn't in fact represent 'full' employment in the modern economy. Mortgage rates remain stuck at 10% or higher with the U.S. Treasury 30-year bonds above 9.0% due primarily to the record high deficit which, if the S & L bailout is included, exceeds $500 billion.

Now fast forward to 1998 with inflation nearing 1.5%, GDP at 4.0% driven by surging productivity. Unemployment is approximately 4.5% and despite these fundamentals, mortgages are available at rates approaching 7.0%. Meanwhile, the government is going to post its first budget surplus in a quarter century which is driving treasury rates down to 5.8%. Can anybody name the economist who predicted this scenario? Welcome to the emergence of the 'new economy.'

Looking more closely at the long range trends one realizes that something has indeed changed. Of the 50 largest corporations in the United States in 1960, only 13 remain on that list today. Furthermore, if you look at the largest 50 corporations in 1998, there is scant evidence of the heavy industry which composed the list just 35 years ago. The steel mills, oil refineries, and heavy manufacturers are being replaced by insurance companies, bankers, publishers, entertainment conglomerates, software writers, and brokerage houses none of whom produce the kinds of products normally thought of as representative of our largest corporations.

The 'new economy' is variously termed post-industrial, the communication or computer age, the global economy, etc. All of these descriptions are seeking to come to terms with a period where more people work with their brains than with their backs, where new ideas are more important than mass production, and where future growth is predicated more upon the ability to maintain a steady flow of these new ideas than on maintaining a status quo. It's a world where global competition keeps prices low, not from a lack of demand, but because newer and better ideas for producing and distributing goods and services make the existing goods and services less valuable almost immediately. In fact, manufacturing and distribution have essentially been commoditized (much as agriculture had been through the 20th Century). This means that the real value of companies operating in this new economy relates more to their marketing ability, product branding, and continual innovation, than to their factories or offices full of equipment.

Appraising businesses in this new landscape, therefore, requires a new awareness and understanding of how these changes have impacted the economy, the various industries and, in the final analysis, the value of the companies themselves which are operating in this altered environment. In the most basic application of business valuation, one must ask: is this company on the right or wrong side of the changes, and could it be left behind as a result? And if you find yourself appraising a company that is at the leading edge of the 'new economy,' you may find yourself wondering where the employees are, or the equipment and inventory, the factories and warehouses; and not finding them anywhere. Even more difficult, you may be appraising a company which hasn't seen any earnings for the past ten years, but whose revenues have been tripling every yearöwhat's going on?

Here are a few possibilities:

• A 'new economy' company centers around its ideas rather than its production. Because of this difference, more than ever, the appraiser needs to thoroughly understand the economy, the industry and the market sector in which the subject company is operating. How big is the market into which the subject is growing? How new is the idea? How large could the market potentially become? As never before these issues need to be carefully examined, explored and understood.
  
• Related to the issue of a company's specific new ideas, is understanding whether the whole industry sector itself is new. Did the industry exist last year? Is it tripling every year? Some nascent industry segments are at under $20 million today and projected to be $5 billion in five years. An appraiser, without understanding the emergence of a fundamentally new industry, may simply lump the company with a more traditional sector and thereby completely miss on the value conclusion.
  
• In many 'new economy' companies, the issue of competition becomes less significant. Competition begins in earnest when a market becomes static (the pie stops expanding) and the companies in the market begin to take market share from one another. In fact competitors in such markets frequently recognize their expanding economic environment and frequently begin with significant areas of cooperation among themselves, developing standards and sharing their breakthroughs öterming it coopetition. This is a tacit recognition that the competition does not really begin until the market's growth slows and becomes saturated.
  
• Unlike mass production, some ideas don't require significant capital, the addition of factories nor employees. If these areas can be outsourced, the company may not have more than a simple office. Further, because the need to build a large corporate infrastructure is not necessary, the company may have the ability to grow much more rapidly by outsourcing advertising/marketing, manufacturing, ordering and distribution. Such growth potential cannot be ignored for many of the historic reasons of the time needed to physically grow. A well written piece of software, once designed, can be copied at low-cost reproduction facilities for less than two cents a copy, distributed by fulfillment houses at the cost of shipping and handling, and then sold to the end user for hundreds of dollars; or the idea itself can be licensed to a production house.
  
• Alternatively, a correct analysis needs to be made as to whether there is adequate available capital, or whether arrangements are in place to allow for the kind of growth envisioned. Without understanding how these 'new economy' companies operate, an appraiser can miss the very different kinds of capital flows which may be needed.
  
• The company also must be examined in relation to its ability to generate new ideas. If ideas are the lifeblood of 'new economy' companies, then the creative ability of the company must be examined more closely. Is it a one idea company? Maybe you don't apply a residual value, maybe the company exists for only three years. And don't forget ideas can be outsourced as well. Thus, in a 'new economy' company, the appraiser must spend more time evaluating the capabilities of management in order to arrive at a sound value.
  
• In some companies the ability to market or brand products can be much more important than the products themselves. The classic model of economics, where products are considered to be finite and demand infinite, is changing. For 'new economy' products, the demand is finite and the products are infinite. Thus, the command for attention becomes the all-important factor. Time makes people's attention finite from the standpoint of marketing. When there are only so many hours in a day, what is looked at in the time available is directly related to the quality of marketing and branding of products and services. If an appraiser spends time looking at the products and not at the marketing, the real value of the company can be missed entirely.
  
• The concept of what constitutes capital is changing in the new economy as well. Employees can be hired at lower cost and given stock options in exchange, distributors can make arrangements with vendors for free product which enables them to enter new markets quickly. Thus, in today's environment, capital can mean more than receivables, machinery and equipment; and the value of the new forms of capital's contribution to a company's growth can be greater than anything money could buy.
  
• The guideline companies selected to appraise a 'new economy' company, rather than being those which are most similar to the subject, may in fact represent the most likely acquirers of the company. In countless new economy start-ups the end-game plan is to develop their new idea to the point where a target company would then come in and acquire the start-up. In many instances this can be accomplished in less than three years. Therefore, the appraiser should identify potential acquiring companies to use as the guidelines: they frequently buy at their own P/E levels.
  
• While the risk for start-up companies can be quite high, in 'new economy' companies with very strong ideas, the long term relationships with manufacturers, distributors, retail outlets, etc., may actually ameliorate the applicable risk which start-ups typically encounter. In effect, the start-up is leveraging its new position with that of more established companies, with which it has established relationships, thereby reducing risk. If a startup has a reputable manufacturer with a long operating history, and high quality retailers for its product, the level of risk may be reduced. In fact, it may be the manufacturer or retailer who becomes the start-up companies' acquirer.
  
• New companies operating in a new industry by virtue of the fact that they are growing so quickly will frequently apply all available cash to increasing market share, and growing into the new industry. Thus, in many instances there will be no earnings, and maybe even substantial losses. Such a position may actually be a positive sign, and the valuation multiple of the industry may be multiples of revenue rather than of earnings (since there are none). In essence, the very methods of appraising a 'new economy' business may be challenged, and appraisers must be open to the adaptations which may be necessary.

Appraisers who fail to recognize the changing environment in which businesses operate today, can significantly miss the true value of a company they are appraising, particularly if that company is operating at the heart of the 'new economy.' If you are seeking an appraisal for your own company, and recognize it as participating in the 'new economy' make certain that you retain an appraiser with a thorough understanding of these issues.

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