QUESTION
From a prospective investor's (or buyer's) point of view, determine the price you are willing to pay, if you are to invest.
- Write a brief paper (two pages maximum) supporting your rationale for the valuation you have chosen, and provide appropriate financial appendices (in addition to the two pages of text) showing your analyses.
CASE
Abstract
After the excitement of spinning their business out of Initier Partners SA ('IPS'), Adrien Dubois and Pierre Martin were now facing the realities of the venture capital funding market. Launching a start up in the semiconductor field was always going to be a challenge. They were on track with their product development but the summer of 1998 had flown by and they now had only three months to raise the €6m they needed to take the product 'into silicon'.
Plenty of investors had wanted to see the plan and what was by September 1998 a very refined sales pitch! Dubois and Martin had been disappointed that only four had made the effort to visit but they were now confident they would get offers from at least two. Frustratingly, neither of the investors had been specific on valuations and the team had no idea if the offers would meet either their or their other shareholder's expectations.
Background
Ntellu was established in France in 1998 by two management consultants: Adrien Dubois, a 40-year-old with a background in sales and marketing, and Pierre Martin, a 38-year-old technology engineer with an impressive reputation in the chip design field. They had worked together for a number of years at IPS, a technology consulting firm based in the Nice high tech R&D cluster.
Martin was the driving force behind Ntellu. He was an internationally recognised expert in the field of wireless chip design and had progressed quickly through IPS' ranks to become head of technology solution design. By the end of the 1990s he was tired of the long hours demanded by a consulting career and felt he wasn't reaping the rewards of the many successful solutions he and his team developed for IPS' clients.
He had been working on a number of applications in the communications infrastructure field. It was an exploding sector with the Internet driving rapid growth in demand for communications systems and the market for network-enabled devices. New standards were evolving in this fast-paced world and with ever-shortening product cycles increasing the pressure towards commoditisation, opportunities were emerging for new players to compete. The race was now on to develop technologies to support wireless data and voice communication that could operate across disparate devices at the network edge.
Martin's recent focus had been the development of a new wireless embedded chip product that he believed provided the simple, low cost cross-platform solution the market was looking for. This chip enabled devices to communicate directly with each other as part of a Personal Area Network. In the past two decades, electronic devices such as mobile phones, PDAs and digital cameras were progressively becoming interconnected through wide-area networks (WAN) such as the Internet, as well as local-area networks (LAN) such as Ethernet. These devices also needed to communicate directly with each other. Peripherals and accessories (such as keyboards, printers, headsets) could at present only function with a direct 'wired' connection to data processing devices (such as PCs, PDAs). Martin's technology provided a 'wireless' communication solution for these and other data processing devices that required interconnections to exchange files or synchronise data with each other.
Martin felt that the time was right to step away from providing solutions in a consulting capacity and start a stand-alone business. He persuaded his good friend and colleague, Adrien Dubois, to join him and in February 1998 they approached IPS and proposed a 'spin out'. IPS had a history of supporting spin out businesses and after surprisingly smooth discussions, agreed to licence the intellectual property rights the team needed and invest €350,000 to seed the business. In April 1998 Ntellu was formed.
The seed capital funded initial development and the team were on track to take the product into silicon by Q2 1999. Martin reckoned they needed at least €6m to complete the development and testing. The company would then require a further €29m to move to volume production. Their aim was to raise the first round of €6m by the end of 1998, raise the further €29m in a second round in 2000 and then take the business to IPO in 2003. It was an ambitious strategy.
The Plan
The plan was to develop a product offering based on a combination of wireless chips, communications protocols and software applications. Target end-customers included companies such as Ericsson, Motorola, Nokia, Apple, Dell and Microsoft who assembled wireless chips directly onto end product motherboards. Even dishwasher manufacturers were building partnerships with technology suppliers to network their appliances into wireless home networks and the Internet in order to allow them to introduce new pricing models based on usage.
A number of competing wireless communications standards were emerging at this time such as Zigbee, Bluetooth, UWB, CDMA and WiFi. It was not clear at this stage which standard was going to take precedence but the trend towards mobile connectivity was clearly an accelerating market force, and the upside for developing products based on the right standard would be substantial.
Ntellu's approach was to adopt a fabless1 business model under which the manufacturing of its chips and their assembly, packaging, testing and shipping would be sub-contracted to third parties. Ntellu would then focus its efforts on the design, development, sales, marketing and support of its products. It would principally sell its products through stocking distributors who would purchase directly from Ntellu and hence take on the inventory risk.
Timing would be key; failure to develop and introduce the Ntellu chip in a timely manner would be management's biggest challenge. Long product design cycles and short product life cycles meant continual investment in R&D to develop new products would be critical to continue competing in these markets. There was also the inherent problem of protecting IP2 in this space with industrial espionage and the rapid emergence of 'copycat' products by low-cost Asian manufacturers another area of potential risk.
Adrien Dubois and Pierre Martin would jointly run the new company. Ntellu had a license in perpetuity from IPS for its propriety wireless chip software, and the top development engineers and technicians who had been working with Martin on development of this technology would become part of Ntellu's team.
The Market and Industry
Ntellu intended to capitalise on the trend for wireless mobile connectivity which was expected to ramp up in all areas of computing, networking and consumer electronics, as well as the growth in the number of digital devices commonly owned by consumers (from toasters to motor cars).
Key market drivers included:
- Proliferation of personal electronic devices over the past decade - both on desktops and in pockets, creating market demand for generic inter-connectivity, supported by high bandwidth/baud rates;
- Availability of unlicensed parts of the radio frequency spectrum in Europe and the US allowing potentially widespread take up of cheap wireless technology;
- Increasingly urgent search for new USPs in maturing mass markets such as networked PCs and handheld communication devices;
- Health scares associated with existing offerings, especially in the mobile device space.
The industry in which Ntellu was looking to operate was intensely competitive, characterised by rapid technological change, evolving industry standards and declining average selling prices. The company would be up against the giants in the industry including Intel, IBM and Hewlett-Packard. These and other competitors were established players with substantial resources, able to respond quickly to changing customer demands or devote greater resources to develop new products. But the high level of uncertainty surrounding the viability and/or adoption rate of this technology, as well as the availability of competing short-range wireless communications standards being developed, created the opportunity for new entrants such as Ntellu.
The semiconductor industry was growing at this time, but was highly cyclical. The industry had experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles (of both semiconductor companies and their customers' products) and declines in general economic conditions. Any future downturns would significantly harm Ntellu's prospects.
Financial Model
Ntellu expected to earn revenue from the following sources:
- Sales of its wireless chip products to stocking distributors who would then sell to OEM3s and ODM4s;
- Direct sales of wireless chip products to OEMs and ODMs;
- Sales of reference design kits, used by these customers to assist in the design-in phase;
- Royalty revenues from license of its chip designs to OEMs.
Key components of costs would include:
- Cost of sales: primarily purchased silicon wafers and associated costs of assembly, testing and shipping;
- Research and development expenses: primarily personnel, contractor and related costs, development equipment and pre-production costs associated with early stage product development;
- Sales, marketing and admin expenses: primarily personnel and related costs. Management believed that maintaining a widely available and high quality technical support group was key to expanding and maintaining its customer base.
Ntellu's ability to achieve sustainable profitability would depend on the rate of growth of its target markets, the commercial success of its wireless chip products (which would depend on the viability of the technology and rate of adoption of the technology by OEMs and ODMs), its ability to reduce production costs in line with average selling prices of its products, the competitive position of its products and its ability to develop new products.
Ntellu would incur substantial expenses before it earned associated turnover and it was assumed that all development costs would be expensed. Based on a detailed set of projections, the business plan's forecasts were as follows:
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Ntellu financial projections
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(€m)
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1999
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2000
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2001
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2002
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2003
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2004
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2005
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Turnover
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0.2
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4
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14
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23
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56
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212
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412
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Cost of sales
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-0.5
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-2
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-8
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-13
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-31
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-113
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-223
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Operating costs
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-1.7
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-7
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-15
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-23
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-28
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-50
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-102
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Profit before int. & tax
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-2
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-5
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-9
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-13
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-3
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49
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87
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Financing Issues
Currently, IPS owned 35 per cent of Ntellu and the two founders owned 65 per cent between them. IPS was not prepared (or able) to invest further in the business but expected to maintain a substantial stake in recognition of the IP transfer and seed funding. Both Dubois and Martin were willing to invest €50,000 each in the business, but wanted to continue drawing their salaries of €80,000 p.a.
The two entrepreneurs expected the initial round of €6m to be all equity finance. But they wondered what valuation the competing investors would place on their fledgling enterprise and hence what stake they would be able to retain in the company. They also wanted to understand what else the investors could bring to the opportunity and, importantly, what their position would be when Ntellu needed to raise the second round funding.
Dubois and Martin had found it difficult to find comparable investments in similar businesses that they could use as a guide to valuations, but they had collected some data that they thought would provide useful benchmarks:
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Market Ratios in 1999
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Comparable Public Company P/Es
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CAC 40 average P/E
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21.6
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ST Microelectronics
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70.4
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FTSE 100 average P/E
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28.9
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Texas Instruments
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62.6
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FTSE Infotech h/ware average P/E
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88.5
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Micron
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17.7
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FTSE Fledgling average P/E
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42.7
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Mean
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50.2
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Tax and Lending Rates
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Large Cap European Technology
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Corporate tax rate (France)
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35.33%
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Alcatel
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63.1
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Base lending rate (Europe)
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4.25%
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