Valuation Methods for Small and Medium-Sized Enterprises in MENA
Valuation in the Middle East and North Africa for small and medium-sized enterprises (SMEs) is a mixture of art, science, negotiations, hand waving, and culture. Valuating a private enterprise is something that is practiced on a daily basis worldwide. Yet in the MENA region, various constraints interact to create very interesting discussions and lengthy negotiations.
Family businesses historically have been built with sweat equity from the original owner, financed mostly by cash, very much under-leveraged, and operating with no or little management structure. In this scenario, the founder’s valuation of the company can be subjective and emotionally-driven, as he seeks to compensate for past struggles or to secure the future lifestyle of the family. Many of the known and universally-accepted valuation methods, whether financial or strategic, often do not apply here or are outright rejected by the founders.
In our experience at Riyada Enterprise Development, we have found that this reality also extends to companies set up by individual entrepreneurs. There is a need to educate the local market on the basics of valuation and how private equity investors approach getting to a win-win situation with target companies.
There are various methods that can be used to value a company objectively. Which is preferred or optimal depends on the type of the business itself, and, depending on which method is employed, we may have a range of values that form the basis for further negotiations.
Discounted Cash Flow (DCF)
This method assesses the intrinsic value of the company based on future free cash flow of the company. It is a favorite for entrepreneurs in the MENA region for several reasons, mostly because the future cash flow depends on a management plan that in many instances doesn’t reflect historical performance and is optimistically and easily adjusted to serve varied needs. We have consistently seen SME financial plans that project a rocket take-off of revenue, estimating abundant cash generation with no substantive or sustainable strategic plan to back it up.
Most of the time, the assumptions and business drivers behind the cash flow growth are easily challenged and scaled down by the investors, to the detriment of the target management team. Consistently, the discount rate applied by the investors takes in consideration the risk of operating an SME in the MENA region, while the entrepreneurs and heads of businesses favor a much lower rate used by public multinationals. Intrinsic valuation using DCF method is therefore not optimal, varies wildly and should likely be used only as a data point.
Comparables Multiple
This method is market-driven, using multiples of public companies’ EBITDA (earnings before interest, taxes, depreciation, and amortization), or Price/Earnings ratios as the basis of the valuation. The financial performance of the target SME Company is benchmarked with public companies (or recent transactions) in the same sector, with applied discounts that take into consideration the size, market, maturity and intrinsic risks of the company itself. For example, a multiple of EBITDA is widely used to obtain a base value, and EBITDA is often a favorite because it allows the company to be measured independently of variable factors such interest rates and depreciation.
The approach requires conducting market research to collect data on companies within the same sector or adjacent sectors, and applying a reasonable and sensible discount rate that takes company risks into consideration. In the MENA region, these risks include the size of the market, regionally or internationally, the company’s ability to achieve aggressive growth potential in the target segment, its ability to scale and execute beyond its local boundaries, the uniqueness of its products and services, especially in remote markets and countries, and the ability of the company to reach a favorable liquidity event, something that is still heavily constrained in the MENA region for SMEs. Valuation of MENA SMEs will always be discounted relative to their peers in the developed world. This market-driven method is, as expected, strongly contested by the entrepreneurs and owners mostly because of the discount applied.
Web and mobile valuation
Valuation is also very difficult for web and mobile assets. The usual key indicators used in the developed world for valuing companies in hyper-growth and strategic markets apply in the MENA region, but at a highly discounted rate. For example, online and mobile businesses in software, ecommerce, social media, ad networks, digital media, will be discounted to take into consideration the realities of internet constraints in the MENA region. Price per digital user, revenue per user, CPM/CPC, subscriber value, and the value of a digital library are examples of methods we use as a starting base in this model. The discount rate applied takes into consideration aspects such as lack of economies of scale in the MENA region, slow movement in the online ad sector, the nascence of sophisticated platforms for selling inventories online and brand campaigns, and the facts that online consumer behavior is still developing, fully open markets haven’t been achieved, and e-commerce across MENA borders is still at an early stage, to name a few. While online businesses are promising more likely exits than their counterparts in other sectors, the fragile state of supply and demand between investors and online businesses keeps valuations in check. As these constraints are eliminated, we foresee the valuations of internet and mobile businesses climbing.
We therefore use these various methods jointly to create a range of values that will drive the negotiations and agreement with the target SME company. We take our time in the negotiations to be fully transparent by making the target team fully aware of the methods used, the intrinsic risks, and the value-add we expect to bring to the investment in order to mitigate risks and accelerate growth.
In conclusion, SME valuation in the MENA region is still more of an art than a developed science. In many instances, smart money is available and ready to be deployed, but the realistic valuation of a company becomes the stumbling block that, once surmounted, will facilitate more venture capital and private equity-funded enterprises. The MENA region is today crowded with unrealized opportunities and severely limited enterprises because of the valuation dilemma, among other things. Hopefully understanding the nuances of these approaches will help ease the process.
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Elie Habib is the Fund and Country Manager of RED (Riyada Enterprise Development, a division of Abraaj Capital) in Lebanon. He manages the Lebanon Growth Fund, which was established by Abraaj Capital, Cisco and the European Investment Bank (EIB) in December 2011 as a US$ 50 million fund for small and medium enterprises in Lebanon. The fund is industry agnostic and focuses on companies with significant growth potential, proven products and services, and those with the ability to expand regionally. Elie can be reached on Twitter at @ehabib and via email at elie.habib [AT] abraaj [DOT] com.
Family businesses historically have been built with sweat equity from the original owner, financed mostly by cash, very much under-leveraged, and operating with no or little management structure. In this scenario, the founder’s valuation of the company can be subjective and emotionally-driven, as he seeks to compensate for past struggles or to secure the future lifestyle of the family. Many of the known and universally-accepted valuation methods, whether financial or strategic, often do not apply here or are outright rejected by the founders.
In our experience at Riyada Enterprise Development, we have found that this reality also extends to companies set up by individual entrepreneurs. There is a need to educate the local market on the basics of valuation and how private equity investors approach getting to a win-win situation with target companies.
There are various methods that can be used to value a company objectively. Which is preferred or optimal depends on the type of the business itself, and, depending on which method is employed, we may have a range of values that form the basis for further negotiations.
Discounted Cash Flow (DCF)
This method assesses the intrinsic value of the company based on future free cash flow of the company. It is a favorite for entrepreneurs in the MENA region for several reasons, mostly because the future cash flow depends on a management plan that in many instances doesn’t reflect historical performance and is optimistically and easily adjusted to serve varied needs. We have consistently seen SME financial plans that project a rocket take-off of revenue, estimating abundant cash generation with no substantive or sustainable strategic plan to back it up.
Most of the time, the assumptions and business drivers behind the cash flow growth are easily challenged and scaled down by the investors, to the detriment of the target management team. Consistently, the discount rate applied by the investors takes in consideration the risk of operating an SME in the MENA region, while the entrepreneurs and heads of businesses favor a much lower rate used by public multinationals. Intrinsic valuation using DCF method is therefore not optimal, varies wildly and should likely be used only as a data point.
Comparables Multiple
This method is market-driven, using multiples of public companies’ EBITDA (earnings before interest, taxes, depreciation, and amortization), or Price/Earnings ratios as the basis of the valuation. The financial performance of the target SME Company is benchmarked with public companies (or recent transactions) in the same sector, with applied discounts that take into consideration the size, market, maturity and intrinsic risks of the company itself. For example, a multiple of EBITDA is widely used to obtain a base value, and EBITDA is often a favorite because it allows the company to be measured independently of variable factors such interest rates and depreciation.
The approach requires conducting market research to collect data on companies within the same sector or adjacent sectors, and applying a reasonable and sensible discount rate that takes company risks into consideration. In the MENA region, these risks include the size of the market, regionally or internationally, the company’s ability to achieve aggressive growth potential in the target segment, its ability to scale and execute beyond its local boundaries, the uniqueness of its products and services, especially in remote markets and countries, and the ability of the company to reach a favorable liquidity event, something that is still heavily constrained in the MENA region for SMEs. Valuation of MENA SMEs will always be discounted relative to their peers in the developed world. This market-driven method is, as expected, strongly contested by the entrepreneurs and owners mostly because of the discount applied.
Web and mobile valuation
Valuation is also very difficult for web and mobile assets. The usual key indicators used in the developed world for valuing companies in hyper-growth and strategic markets apply in the MENA region, but at a highly discounted rate. For example, online and mobile businesses in software, ecommerce, social media, ad networks, digital media, will be discounted to take into consideration the realities of internet constraints in the MENA region. Price per digital user, revenue per user, CPM/CPC, subscriber value, and the value of a digital library are examples of methods we use as a starting base in this model. The discount rate applied takes into consideration aspects such as lack of economies of scale in the MENA region, slow movement in the online ad sector, the nascence of sophisticated platforms for selling inventories online and brand campaigns, and the facts that online consumer behavior is still developing, fully open markets haven’t been achieved, and e-commerce across MENA borders is still at an early stage, to name a few. While online businesses are promising more likely exits than their counterparts in other sectors, the fragile state of supply and demand between investors and online businesses keeps valuations in check. As these constraints are eliminated, we foresee the valuations of internet and mobile businesses climbing.
We therefore use these various methods jointly to create a range of values that will drive the negotiations and agreement with the target SME company. We take our time in the negotiations to be fully transparent by making the target team fully aware of the methods used, the intrinsic risks, and the value-add we expect to bring to the investment in order to mitigate risks and accelerate growth.
In conclusion, SME valuation in the MENA region is still more of an art than a developed science. In many instances, smart money is available and ready to be deployed, but the realistic valuation of a company becomes the stumbling block that, once surmounted, will facilitate more venture capital and private equity-funded enterprises. The MENA region is today crowded with unrealized opportunities and severely limited enterprises because of the valuation dilemma, among other things. Hopefully understanding the nuances of these approaches will help ease the process.
--
Elie Habib is the Fund and Country Manager of RED (Riyada Enterprise Development, a division of Abraaj Capital) in Lebanon. He manages the Lebanon Growth Fund, which was established by Abraaj Capital, Cisco and the European Investment Bank (EIB) in December 2011 as a US$ 50 million fund for small and medium enterprises in Lebanon. The fund is industry agnostic and focuses on companies with significant growth potential, proven products and services, and those with the ability to expand regionally. Elie can be reached on Twitter at @ehabib and via email at elie.habib [AT] abraaj [DOT] com.