BPI Network Views & Commentary

Valuing AI, Cryptocurrency and Tech Companies That Are Literally Out Of This World

By Eric Sundheim

“Most people, even finance professionals, don’t understand that all methodologies are extrapolations or corollaries of the same essential methodology. Valuation can be simplified into two elements: Risk and Return. Value today is predicated on future returns and the risks of achieving them.”

How do you describe your “independent financial valuator” (IFV) role working with key stakeholders in the complex process of appraising and valuing business entities?

When it comes to value, most opinions are a dime a dozen. Very smart, financially savvy players in the tech space will freely tell you that they think some company is over-valued or under-valued. Those opinions may make for interesting conversation when it comes to a business panel or a cocktail discussion, but when issues of tax, accounting, legal liability, or M&A arise, an opinion that goes beyond mere speculation is called for. The exact value of a business or asset becomes of critical importance in these domains, as does the ability to defend and explain that conclusion of value. My firm provides professional opinions of value that will withstand scrutiny from tax authorities, auditors, counterparties, and triers of fact. And we do that primarily for tech companies.

What factors make tech company valuations more challenging, complex and often inflated?

Traditional valuation methodologies were established to value mom and pop businesses that had 30-plus years of history and low, steady growth. When you value these businesses, you’re valuing a relatively predictable profit stream, almost like an annuity. Tech companies are different from these businesses in almost every respect. They don’t have a history of profits: They don’t have profits, and they barely have history! Forget profits, many don’t even have revenue. Some don’t even have a product yet! While main street businesses may grow revenue at 3-5%, tech growth can be forecasted in triple digits. Given these fact patterns, so many of the inputs to traditional valuation models will either be nonexistent or irrelevant. Valuing these tech companies requires separate methodologies and a unique skillset that few appraisers have mastered.

As far as tech valuations being inflated, to understand that, you have to understand venture capital dynamics. When venture capitalists invest in tech companies, they are swinging for the fences. They want a 10x return on their investment. They also understand that it’s very hard to tell which company will provide that return; and the majority of startup investments will provide a negative return, if any. When you view early-stage technology companies through that lens, it makes sense that most companies will be overvalued, but a minority will be grossly undervalued.

Fascinating. How did you get into this business?

I grew up in the Bay Area and wrongly assumed that Silicon Valley was “average.” After exploring many cities across the country, I concluded that the Bay Area is the best place in America and wanted to settle down here. I had also seen my dad serve startups as an attorney growing up (he formerly chaired the Palo Alto Bar Association) and enjoyed seeing the products his clients were working on as a kid (especially video games). I was living and working in valuation in Washington, DC in 2012. I ultimately found a valuation job a few blocks from my old high school in Palo Alto and ended up serving the same types of clients my dad worked for 25 years prior.

You’ve worked with some wildly innovative clients. Are there any business models that still surprise you?

My most interesting client has been Varda Space Industries. I met the CEO in 2021, and he very confidently told me he wanted to build a manufacturing empire in outer space. Manufacturing in outer space?! That had never even crossed my mind – but their team and vision was so impressive, I became an instant believer. I even reached out to some of my VC contacts to market the business to them. Three years later, Varda has now successfully manufactured pharmaceuticals in space and parachuted them back to earth. Incredible!

How large is AI from a valuation perspective? Is it just hype?

We were into AI well before it was “cool.” It’s not that we had some incredible foresight: Given our location and network, we are subject to the whims of Silicon Valley, and Silicon Valley has been big into AI for a long time. I think the general public really became aware of AI with the release of ChatGPT in late 2022, but AI was the largest domain of M&A for many years before that.

In general, we engage with very large clients most people have never heard of: They’re typically B2B clients that only market to a very small subset of the global marketplace. Companies I have worked with since inception like CrowdStrike and Databricks became household names years after I started working with them. Now that most people can practically see and use AI tools, they are more aware of its potential and impact.

How are new AI-driven upstarts, innovators and disruptors challenging traditional valuation methodologies and will AI transform the valuation process?

Every serious valuation firm uses advanced software to produce their analyses. For hefty fees, third parties like Standard & Poor’s offer subscriptions to tools that can help automatically spread financial data, screen for relevant M&A transactions, and create unique charts using application programming interfaces (APIs). These data providers are constantly improving their software and adding in artificial intelligence features that increase our capabilities. Copilot also offers some tools that help increase the productivity of our junior staff. These tools are exciting and beneficial, and I expect they will continue to improve.

That’s the good. For the bad and ugly, there are now software firms that claim they can perform valuations. For $299, plug in some financial data, bip-boop-beep-boop: Here’s your value and 100-page report! It’s pretty easy to come up with values and calculations. The problem is, these outputs are rarely grounded in logic and fail to incorporate key fact patterns: For example, is that “revenue” number you entered in the model product revenue or non-recurring engineering (NRE) revenue? Is a transaction negotiated strictly for a direct financial return or is there another primary consideration such as a strategic partnership? There are thousands of potential issues like these that can wildly throw off conclusions of value. We’re not a licensed profession, so it’s not illegal for these firms to market themselves as appraisers (as it would be for them to claim to be doctors providing medical advice). However, it’s very misguided to think they offer a comparable service and work product. To-date, software has yet to replace appraisers, though it can certainly aid them.

What about cryptocurrency and Web3? How is value trending in these emerging sectors?

If you add up the value of all cryptocurrency tokens – Bitcoin, Ethereum, and all the public alt-coins – you get around $2 trillion dollars. To put that in perspective, that’s less than the market capitalization of NVIDIA, just one “AI company.” I think there are incredible applications and potential for blockchain technologies, and we have wonderfully innovative clients that have developed their own tokens. I also understand the appeal of having a medium of exchange that cannot be inflated by irresponsible national governments. But I think ideological interests and stories of insta-billionaires and multi-million-dollar NFTs have heightened the public’s perception of this industry beyond the scope of its relative value, at least as of today.

What’s the biggest misconception around the work you do?

Understandably, many lay people think: “a valuation is a valuation is a valuation.” But saying, “we have a valuation,” is akin to saying, “we have insurance.” What type of insurance? Product liability? Cybersecurity? Is the policy active?

There are many types of valuations performed for a variety of purposes. A valuation of a small block of common stock for tax compliance is very different from a valuation of equity for an investment purpose, for example. In the former, the appraiser must consider IRS regulations, case law, and the like. In the latter, the appraiser is not bound by the IRS. An investment valuation might also consider buyer-specific synergies and the level of control the investment provides.

Different valuation purposes necessitate different standards and definitions, and often result in different values. “We have a valuation,” is usually a launching point for a conversation, not an ending point.

What about valuation methodologies themselves? What do most people fail to understand about valuation techniques?

Most people, even finance professionals, don’t understand that all methodologies are extrapolations/corollaries of the same essential methodology. Valuation can be simplified into two elements: risk and return. Value today is predicated on future returns and the risks of achieving them.

When you run a discounted cash flow analysis, you are explicitly quantifying these elements of risk and return in your projected cash flow and discount rate. When you use an EBITDA multiple to value the company, that multiple implicitly considers these elements of risk and return. A company with higher growth and lower risk should have a higher EBITDA multiple. You are extrapolating from current profit to future profit.

The use of a revenue multiple requires an additional extrapolation as the appraiser must implicitly consider a profit margin. One extrapolates from revenue to profit. You can see even further corollaries when early stage companies are valued on non-financial metrics such as monthly active users or subscribers. When you value a company based on users, you are implicitly making assumptions about how much revenue and profit those users can generate, as well as the risks of that transpiring.

The third approach to valuing businesses is the asset approach. Not unlike a balance sheet, this approach adds up all the individual assets of the company and subtracts the liabilities. Historically, assets were largely tangible: land, buildings, machinery. Today, the primary assets are intangible. When you take the asset approach, you end up valuing the individual assets the same way you would value the entire business, i.e.  with respect to their impact on risk and return.

What are the key intangible assets being purchased today?

When companies make large acquisitions, they are required to identify what they purchased on their balance sheets. So, if a company spends $200 million to acquire another firm, the acquiror will then note on its financial statements: $80 million was for the developed technology, $45 million was for the customer relationships, etc. Houlihan Lokey authors a report that quantifies certain industry patterns for this. In their most recent study on the tech industry (2020), the primary intangible assets were developed technology, customer relationships, and in-process research and development (IPR&D).

How can you value IP that is very early in its development?

Like all assets, intellectual property (IP) is valuable because it either increases revenue or reduces costs. When IP is very early stage it can be difficult to predict whether it will do either of those things, even in a binary sense; it is of course even more difficult to predict the magnitude of revenue growth and cost reduction. I liken this kind of IP to Schrödinger’s cat. It is either “dead” (i.e. worthless) or “alive” (i.e. valuable); but we won’t know which until the “box is opened” (e.g. some milestone is achieved or missed). In the absence of evidence to the contrary, we have to assume that such IP is “average,” and its value is commensurate with that of IP that is of comparable risk and has had a comparable level of resources (both time and money) invested in it. To explain the quantification of that is a bit more complicated, but hopefully that explains the theoretical framework.

Why do owners, investors, buyers and sellers need professional, third-party “fairness opinions” when going through some form of liquidity event, divestiture, acquisition or sale?

Where you stand depends upon where you sit. Different stakeholders in a company may have opposing views on a transaction based on the type of security they hold (e.g. preferred vs. common). A company’s Board of Directors has a fiduciary duty of loyalty to act in the interests of all shareholders. Board members must avoid conflicts of interest and prioritize the company's well-being above personal gain. You might refer to the lead investor from a Series B round as the “Series B director” but that director must consider more than the interests of just Series B shareholders. If they fail to do so, they can be sued.

A fairness opinion from a third party like Mercovus helps insulate fiduciaries from claims of breach of duty. In Smith v. Van Gorkom, the court ruled against the board of directors of TransUnion Corporation, who voted for a leveraged buyout, based in part on the absence of a fairness opinion from an independent financial advisor.

Some people think to obtain such a fairness opinion from their investment banker, but that advisor is clearly not independent. If the bank is advising the target company or buyer for a fee that is contingent on the successful completion of the deal, that presents an obvious conflict of interest. If the bank offers the fairness opinion “for free”, that creates an even greater conflict of interest. Because of our true independence and deep valuation experience, Mercovus is often sought after to author fairness opinions.

You have an impressive list of nonprofit clients. I would think that a company that didn’t make profit would inherently have no value. What kinds of work are you doing for these companies?

Nonprofits are usually backed by corporations and wealthy individuals that are very much “for profit,” while also having charitable intentions. Sometimes the nonprofits develop a tool or technology that these backers see great monetary potential for. These backers want to move the technology out of the nonprofit and into their commercial entity. The IRS doesn’t want taxpayers to unfairly benefit from the use “tax free money” to develop their assets: The IRS won’t disallow a transfer of IP from a nonprofit to a for-profit, but they do require that the nonprofit receive compensation commensurate with the fair market value of what they’ve developed. We get hired to determine that value.

Download PDF: Mastering M+A: Dealing With Variations In Global Business Valuations

Eric Sundheim Bio