An Alternative Model to Value Early Stage Technology Companies
A news service for the valuation profession recently profiled a discussion of the “H Model” among valuation professionals (BV Wire Issue 83-1 published August 5, 2009 by Business Valuation Resources, LLP). Since we sometimes include the H Model in valuations of early stage technology companies performed at The Brenner Group, I thought I would add a few comments.
Many people are familiar with the concept of a Discounted Cash Flow (DCF) analysis which calculates the value of a firm as the present value of its future cash flows discounted at the firm’s cost of capital. The H Model is a form of discounted cash flow analysis in which the firm’s cash flow is modeled in two stages. The first stage is a relatively short period time in which the firm is expected to experience a high rate of growth and the second stage is the long term sustainable growth rate of the firm. One of the features of the H Model is the high growth period is not modeled assuming a fixed high rate of growth, but the model reduces the growth rate linearly through the initial stage, until the long term growth rate is reached. The model also allows for the use of different cost of capital assumptions in the two stages, allowing one to model the high growth period according to a higher risk, higher capital cost profile, and then reducing the cost of capital in the second stage to reflect the expectation that the company reaches a stable level of operation and lower risk conditions.
H Model is appealing for early stage technology companies
Here’s a hypothetical example. Assume a company has commercially launched its first products or services, and develops financial projections covering a three to five year period. The projections portray the company achieving sufficient scale and profitability to proceed with an IPO at the end of the forecast period (assuming, of course, the equity markets cooperate).
The H Model allows us to model this situation according to three stages. The first stage represents the three to five years the company has projected its initial period of growth. The company may have negative cash flows for much of its first stage of development, and may be deemed high-risk, with a commensurate high cost of capital. In this first stage, we may simply rely on the cash flows contained in the company’s financial projections. The H Model is then used for stages two and three. In this hypothetical example, the H Model’s high growth stage is used to model the continued growth in cash flows following the IPO. While not within the scope of the company’s financial projections, there may be an expectation that growth will not drop off suddenly after the IPO. If cash flows grow 50% in the year before an IPO, it may be reasonable to assume that growth trends downwards for the several years following the IPO until the sustainable level is reached. The H Model’s sustainable growth stage is then used to model the value, assuming the company has achieved its full potential scale of operation and continues to grow at a long term, sustainable rate.
A key benefit of the H Model is that it appears to fit the financial history of many venture capital backed technology companies. One can exhume a company’s actual historical financial results and see a very common pattern of results. One can then see, in the first years of operation, the negative cash flows. One can observe the growth in revenues, the improvement in profitability and cash flow results through the IPO, and on into the years following the IPO.
Of course, one may also see the volatility of market value after the IPO (positive and negative), and periods of stronger and weaker financial results, rather than a halcyon existence of sustained growth.
A formal valuation would include multiple valuation models
As a final note, the applicability of the H Model is subject to the specific facts, circumstances, and expectations that are unique to each company. While the H Model is one form of discounted cash flow analysis, there are others which may also be used in any particular valuation. In general, the H Model analysis performed would also be accompanied by other valuation approaches (such as a Market Approach), as appropriate, within a formal valuation report.
The interested reader can find out more about the H Model in Chapter 4 of Financial Valuation, Application and Models, 2nd Edition by James R. Hitchner (Wiley, 2nd Ed., 2006). If the reader is in the CFA program, multi-stage cash flow valuation models are addressed in Chapter 3 of Equity Asset Valuation by John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA and Dennis W. McLeavey, CFA (CFA Institute, 2007). Some writers use the term H Model to refer to a specific dividend discount model. However, other authors apply the term more generally as a method of cash-flow based valuation, as I do here.
Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.
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