Follow the money: Interview with Matt Costello, Newport Capital on valuing digital agencies
What’s your day job?
I’m a Director at Newport Capital Group Pty Ltd. Newport is a TMT sector specialist corporate advisory and investment banking firm established in 1989. The company has completed hundreds of transactions over the years in capital raising, divestments, mergers and acquisitions in the Technology, Media and Telco space including Digital services and digital media. Transactions that the company have undertaken include;
My role here is to lead our clients through the transactions which include preparing the company for due diligence, valuation guidance which often includes an analysis of similar transactions and then researching and approaching potential acquirers or funders. We also lead the process of negotiating term sheets and final shareholder or share purchase agreements.
What type of projects do you work on?
Right now I am engaged in the sale of two local IT services businesses to multinationals. I am also working on a capital raising for a listed software company to assist with growth. Recently I worked on the valuation of a new e-commerce implementation business for a small capital raising from a partner business. I spend a huge amount of time talking to people about their companies, which I love; there are some really fantastic stories out there.
From time to time we are engaged by larger companies to do a market scan for potential acquisitions, we will then work on the acquisition. Our most recent project like this was for a Netherlands based mining company who asked us to act for them in the purchase of an Australian company that had some interesting IP around drill bits for the mining industry. That was a little left of field.
Its critical for us to understand our market and the various players and what the hot spots are for exit and entry into a particular sector. Developing these strategic insights (often also called “opinions”) is one of the more engaging parts of my job.
What type of people do you work with?
Mostly business owners. They are truly are awesome to work with. Folks that have started a company 3 or 5 or 10 years ago because they thought “this can be done better” or “I can solve this issue” or even “I hate my boss”. And then set out to prove themselves. It takes real guts and perseverance. These people believe in themselves, their teams and their ideas and are generally very principled (thought these principles can cop a bit of a battering in the face of commercial and market realities).
What’s really interesting is that whilst I engage a lot in the digital start-up space, where there really is some genuine excitement and commitment to building for a major exit, there are 10 times as many less ambitious businesses that have built a great company with solid fundamentals. When we help them exit, they walk away with cheques from $5m to $50m. This is not a trivial amount of money, and quite often these people go on to be business mentors or angel investors.
In these kinds of transaction it’s great to see the reward for effort and while building the next Google, Facebook, YouTube or even Atlassian should not be shied away from, we shouldn’t dismiss the opportunity to build and exit a good old straight ahead digital services, agency or technology business where by the end of the journey, you still own 100% and you’ve been the master of your journey from day one.
What are the obvious/not so obvious challenges you are seeing in these businesses?
Right now there seems to be several critical issues facing business:
- Economic uncertainty – there is no single issue you can point to and say “this is crippling my business” but overall, the current environment makes it had for small business to keep ahead of the game. Clients tighten their spend, competitors cut prices, projects get delayed or reduced in scope. They add up to difficult times.
- Structural Shift – Paul Wallbank has written some great stuff on this and it’s the opposite to the issue above. There is amazing opportunity for businesses as our economy makes the transition online, into the cloud, off the desktop and into the realm of the hyper-connected. Disintermediation is one of my favourite words here, so is capital efficiency…for another forum though. No-one really knows what all this means now let alone in 3 to 5 year’s time but it sure as hell is great fun working it out with and for your clients and being paid to do it. It’s the engine of growth for our sector and it’s just going to get bigger and faster.
- Capital constraint – you’re right to hate the banks, mostly because they hate small business. They make it almost impossible to grow and both offset the risks of Economic Uncertainty and capitalise on the opportunity of Structural Shift. For the most part by the time you are in a position to successfully raise bank debt, you don’t need it, and the banks will be falling all over you to get you to borrow money from them. Managing growth is a significant challenge for every business and many companies over extend themselves and end up in a mess. Understanding your capacity for growth, what resources are required for growth (financial, experience, back office systems and physical capacity) is critical.
You talk about the importance of a financial dashboard for agencies – what financial indicators should be included?
Every business is different, but essentially there are two kinds of metrics that a company needs to be tracking. Lead and Lag indicators. Pretty much all financial information is a Lag Indicator. P&L, Balance Sheet etc. are tools that tell you what happened last month. They are essential to good management, but you also need to dig into the indicators that will tell you what will happen next month or in 3 months.
Softer measures such as how many taxi and coffee receipts you process may indicate your sales team is working hard out in the market, and then you also need to understand their close rate and average opportunity values. A critical number is the Funding Gap, especially if you are on a step growth curve. This is the number of days gap between when you have to pay money (on average) and when you get to collect money. Both on a time and value basis because inevitably, this gap needs to be filled with cash…from somewhere, usually the owners pockets. Per Head metrics are often useful as well in terms of how efficient on a month to month basis the company is.
What are the current multiples for a digital agency looking to sell?
Every-one asks that question. My answer is usually short – 3 to 5 times. The trick is 3 to 5 times what. EBIT? EBITDA? NPAT? Sustainable Earnings? Adjusted Net Profit before tax? Multiples are short hand for comparing similar business valuations.
A quick example; STW Communications is currently trading at a Price to Earnings Ratio of 8.87 (average). Before things went pear shaped for Photon they traded at a PE ratio of up to 181 times. Why such a big difference? One thing drives valuation – Earnings. One thing drives earnings multiples – Growth. If your earnings are growing at great than 10% pa you may be able to justify a 5 x earnings multiple. The underlying valuation methodology is the discounted cash flow. Using this, the driver for valuations is growth in earnings and risks to that growth. All of this translates to a market rule of thumb of 3 – 5. Often more (you hear most about those), usually less (who was that company?).
There is defiantly this concept called “strategic asset value”. In this scenario, you have a client, some IP, some market share…something, that a company will value over and above your earnings. Obviously Instagram is a classic example, so is some of the early daily deals business were the beneficiaries of this concept. Shareholders of the companies that made these acquisition are currently asking about the long term value that these “strategic” acquisitions are contributing.
How did you get started in digital?
Started? I don’t understand the question. Is there something else other than digital that I could be doing? Digital touches everything. My kids don’t do anything that isn’t in some way digital. They don’t even notice it. My daughter thought the computer was broken the other week…it was working perfectly, it was the internet connection that was down.
What’s your current favourite book, website, blog or source of inspiration for your business?
Gotta love the Digital Pigeon (Mitchell Lake). Paul Wallbank’s Decoding the New Economy is a good local perspective. Tomi Ahonen Communities Dominate Brands (for mobile stuff and Microsoft bashing). Mobile Marketer Daily. Paul Graham from Y Combinator has some great essays. Chris Brogan. I’ve been a subscriber to Jakob Neilsen’s Alertbox since I wrote my first website in a text editor in 1995 (well almost).
I don’t read self-help motivational books. I read great fiction. It’s much more inspirational, for me anyway. Unfortunately though I also have books on my shelf like “The Valuation of Business, Shares and Other Equity” 4th Edition, Quantitative Analysis for Management and that ever popular Fair Value Impairment Testing Under IFRS.