Valuing and Structuring Hosting Company Acquisitions (Session #201)

Not to be used or reproduced without permission

Joe BardenheierHillary StiffCHEVAL CAPITAL, INC.

Background – Cheval Capital

• Who we are– Investment bankers active in hosting/ISPs since 1996– Completed over 120 Hosting/ISP acquisitions including

transactions such as the Endurance/iPowerWeb merger• Who we have worked for

– Endurance Int’l Group, Verio, Rackspace, Nextel, etc.• What we do

– Represent buyers & sellers of hosting, telecom and related companies

– Distribute a weekly deal listing with many sellers, creating a deal marketplace for small and mid sized companies

Background – Endurance International Group

• Founded in 1997• Backed by a $2 Billion private equity firm• A leading provider of Web Hosting services to small and medium

sized businesses • 3rd largest shared hosting provider in the US• Completed over 28 acquisitions in the last six years• 24 hour customer support via e-mail, phone and chat• Highly automated Operational Support System (OSS)• State of the art clustered Unix and Windows platform• Can easily private - brand for its multiple properties and resellers• Multiple brand strategy to reach certain market segments• Proprietary 350-step Migration Methodology

Background - Endurance International Group

Agenda

• Valuation Categories & Drivers

• Buyer Types

• “Let’s Make A Deal” Game Show

• How The Numbers Work– Seller’s Perspective– Buyer’s Perspective

• Valuations– Historic, Current & Future

• Prize Ceremony

• Q & A

Valuation Categories & Drivers

• What are examples of drivers that affect the valuation of a hosting business?

• Major Categories:– Financial– Technical/Engineering– Sales/Marketing– Product/Service offerings– Customer support– Legal– Qualitative

Financial Drivers

• ARPU – Average Revenue Per User• Profitability – EBIT, EBITDA, Pre-

Tax(PBT) PAT• Cash collected vs. Revenue

recognition• Debt• Equity/Ownership structure• Assets/Equipment owned vs. leased• Cash flow• Cash on hand vs. restricted• Deferred revenue• % Credit card billing• % Invoice/check billing• Customer credit card information• Billing system

• Billing cycle distribution• Taxes/NOL’s – Net Operating Loss• Refund/Chargeback history• Cost of goods sold• Audited financials• Owner related expenses ex. Cars,

cell phones, T&A• Forecast and projections• Trailing twelve month

financial/EBITDA• Recurring vs. non-recurring

expenses• Recurring vs. non-recurring billing• Pre-paid expenses• P&L• Balance Sheet

Technical/Engineering Drivers

• Control panel

• Platform – Unix vs. Windows

• Efficiency of infrastructure

• Capital expenditure projections

• Bandwidth usage

• Storage usage

• E-mail configuration

• Ability to migrate customers

• Software developed

Sales/Marketing Drivers

• Pricing strategy

• Age of customer base

• Cost to acquire a new customer

• Commissions/Sales incentives

• Sales/Marketing employees

• Resellers

• Affiliates

• Advertising methods

• Outbound sales

• Customer additions

• Customer cancelations

• Domain name renewal rate

• Churn rates

• Brand segmentation

• Sales/Marketing touch points

and volume

Product/Service Drivers

• Breadth of offerings

• Internal vs. 3rd party offerings

• New product development cycles

• Up-selling strategy

• Package configuration

• Type of Hosting offerings

• Customer product/service usage

Customer Support Drivers

• Metrics and volume

• Hours of operation

• Types of support ex. phone, chat, e-mail

• In house vs. outsourced

• Customer satisfaction

• In bound up-selling

• Customer support employees

Legal Drivers

• Long term contracts

• Legal/Corporate structure

• Employee benefits programs

• Trade marks/IP

• Pending litigation and environmental matters

• Potential liabilities

• Royalty/licensing agreements

• Pending severance agreements

• Asset vs. stock purchase

Qualitative Drivers

• Seller/Buyer personality

• Team complimentary fit

• Cleanliness of customer data

• Organization of records and reports

Valuation Categories & Drivers

• What are two common themes among almost all of these drivers?

• Most drivers relate to the amount of cash that the business will realize or the Risk of getting that cash in the future…and

…the relative importance of any of these drivers Depends on each individual situation…

“Let’s Make A Deal” – Game Show

• Win amazing gifts and prizes!

• Impress your friends and colleagues!

• Did we mention the great prizes?

Buyer Types

• Consolidators buy revenue/customers to add to existing infrastructure– They care about the cash the seller’s customers will generate

on the buyer’s/consolidator’s platform

• Strategic/Platform buyers seek to fulfill strategic goals when acquisition is quicker, more economic or efficient than building from scratch– They care about the seller’s current business as a platform for

the buyer’s future operations

Game Show Question # 1

• A shared web hosting company has what is considered in the industry as “high ARPU”. Do you find this:

Highly valuable?

Somewhat valuable?

Not valuable?

And Why?

Game Show Question # 2

• A web hosting company has outstanding loans with two banks and an investor. How important are these when valuing an acquisition?

A lot?

Somewhat?

Not at all?

And Why?

Game Show Question # 3

• A web hosting company has an infrastructure that is not very efficient and has many older servers without central storage. How important is this when valuing an acquisition?

A lot?

Somewhat?

Not at all?

And Why?

Game Show Question # 4

• A web hosting company has been adding new customers very rapidly but at the same time has a very high churn rate. How important is this when valuing an acquisition?

A lot? Somewhat? Not at all?

What questions might you ask to get a better understanding of this?

Game Show Question # 5

• A web hosting company has very good new product/engineering teams that are able to implement new offerings on a rapid basis. How important is this when valuing an acquisition?

Highly valuable?

Somewhat valuable?

Not really that valuable at all?

And Why?

Game Show Question # 6

• A web hosting company has multiple legal entities in several US states and has employees in California, Virginia and Utah. How much would you take this into consideration when valuing this company?

A lot?

Somewhat?

Not at all?

And Why?

Game Show Question # 7

• A web hosting company has three years remaining on its data center lease and two years remaining on the lease for it office/support center. How much would you take this into consideration when valuing this company?

A lot? Somewhat? Not at all?

And Why?

Game Show Question # 8

• A web hosting company has a practice of selling 24 and 36 month plans and recently ran a promotion to all of their customers that would give them 3 months of “free” hosting if they renewed their plan for 36 months. How important is this when valuing this company?

Highly valuable? Somewhat valuable? Not really that valuable at all?

And Why?

Game Show Question # 9

• A web hosting company has found a number of new products that they have been able to effectively sell to their customer base on a one time basis. How important is this when valuing this company?

Highly valuable?

Somewhat valuable?

Not really that valuable at all?

And Why?

Game Show Question # 10

• A web hosting company has a long term contract with a domain name company which is not Tucows, known for poor customer service and higher prices. How much would you take this into consideration when valuing this company?

A lot? Somewhat? Not at all?

And Why?

Game Show Question # 11

• A web hosting company has a very large base of long standing customers who are very satisfied with their service, however the company has not had the new product/engineering resources to create new offers to up-sell these customers. Would you consider this when valuing an acquisition?

Highly valuable?

Somewhat valuable?

Not really that valuable at all?

And Why?

Game Show Question # 12

• A web hosting company has a customer support group based in mid-town New York City. Would you consider this when valuing this acquisition?

Highly valuable?

Somewhat valuable?

Not really that valuable at all?

And Why?

Game Show Question # 13

• A web hosting company owns the building that they occupy for their office and support functions which sits on land that is known to have hazardous materials 50 feet under ground. How much would you take this into consideration when valuing this company?

A lot? Somewhat? Not at all?

And Why?

Game Show Question # 14

• A web hosting company is owned by two people who run a number of their personal expenses through the company including car leases for both of them and their two children, gas, cell phones, and a couple of trips each year. How much would you take this into consideration when valuing this company?

A lot? Somewhat? Not at all?

And Why?

Game Show Question # 15

• A web hosting company has had three years of net losses and are projected to do so for the next three years, thereby allowing them not to pay any corporate taxes. How much would you take this into consideration when valuing this company?

A lot? Somewhat? Not at all?

And Why?

Game Show Question # 16

• A web hosting company has $3 million of deferred revenue on their balance sheet. How much would you take this into consideration when valuing this company?

A lot?

Somewhat?

Not at all?

And Why?

Valuation Issues – Deferred Revenue I

• Deferred Revenue - Collecting payment for services to be delivered in the future creates a liability

• Buyer’s adjustment for Deferred Revenue can vary from;– No adjustment– An adjustment based on the cost of providing the service – A $ for $ reduction for the amount of the liability

• Double whammy for prepaids >1 year. Often an adjustment for the cost of providing service but typically little to no value for these customers

• Issue is risk and for some accounting. Cash flow is not necessarily an issue.

Valuation Issues – Deferred Revenue IICash Flow Comparison – Annual vs. Monthly Customers

Cash/Sub/Month $15

Total Customers 12

All Annual Cust Jan Feb Mar Apr May Jun

Number of Subs Renewing

1 1 1 1 1 1

CF with Annual Pay $180 $180 $180 $180 $180 $180

All Monthly Cust

Number of Subs Renewing

12 12 12 12 12 12

CF with Monthly Pay $180 $180 $180 $180 $180 $180

Valuation Issues – High Growth

• Very high growth companies are a unique valuation challenge

• Growth engine can be quite valuable if new customers are of good quality and their cost to add is reasonable

• The valuation challenge comes from;– It can be difficult to tell if customers are of good quality until

they have a renewal history– It can be difficult for buyers to be confident that growth will

continue• A smaller buyer pool during the high growth stage

How The Numbers Work – Seller

• A key to evaluating a purchase proposal is understanding the amount of cash you are getting from your business+ Add up what you get in cash;

• Salary, bonuses and other distributions of cash to its owners (incl taxes)• Cash value of benefits, incl. health care, car leases, etc.• Cash building up in the business that won’t be used

– Subtract how much your business is costing you• Salary, bonus, benefits you would earn if you didn’t work in the business• Cash you are putting in to the business• Other cash “Opportunity Costs” of the business• Loans made to the company

How The Numbers Work - Seller

A Low levels of customer service, poor reputation & overselling of equipment and resources. High marketing costs due to high customer attrition rates. Lower prices than B and thus more customers to support.

B A well run company with high levels of service, high renewal rates and lots of customer referrals.

A BRevenues $10.00 $10.00 COGS % 20.0% 25.0% G&A % 25.0% 30.0% Sales % 45.0% 15.0% Capex % 0.5% 5.0%OCF $0.95 $2.50 Purch Price $14.00 $14.00 Price/OCF 14.7x 5.6x

$ in millions; OCF = Owner Cash Flow; Does not include taxes

How The Numbers Work - Consolidator

– Focus is on revenues, revenue quality, customer quality, renewal rates and predictability of cash flow.

– Also of concern is ease of migration.

A BRevenues $10.00 $10.00 COGS % 20.0% 25.0% G&A % 25.0% 30.0% Sales % 45.0% 15.0% Capex % 0.5% 5.0%OCF $0.95 $2.50

How The Numbers Work - Strategic

– Focus on cash flow, quality of operations and infrastructure, profitability, brand quality and scalability.

A BRevenues $10.00 $10.00 COGS % 20.0% 25.0% G&A % 25.0% 30.0% Sales % 45.0% 15.0% Capex % 0.5% 5.0%OCF $0.95 $2.50

Valuations – Comparables

• Many buyers + many sellers = robust market– If a buyer offers too little, sellers have other options– If a seller asks for a price that is too high, buyers have other

options• Its a large industry, be careful about finding quality

comparables for your business

• Comparables are not the total story, each seller and buyer are unique and transaction terms can impact prices.

Valuations – Public Companies

Annualized EnterpriseCompany Revs ($ mil) Value/RevsUnited Internet $ 2,547 2.3 xSavvis $ 813 1.4 xRackspace - Pending $ 478 3.9 xDada $ 257 1.3 xNavisite $ 157 1.7 xWeb.Com $ 123 1.6 xPeer 1 $ 91 2.2 xHostopia $ 30 * xGroup iWeb $ 14 2.9 x

Data as of July 21, 2008

Valuations - Hostopia

• Purchase price – C$ 124 million.

• L3MA Revenues – US$ 29.7 million (March 2008)

• Multiple calculations– Without adjustment – 4.15x– Adj for Cash of US$ 26.2 million – 3.26x– Adj for revenues at time of deal – 2.8x *– Adj for allocation of price to IP/platform value – 1.8x *

* - Figures provided by Hostopia

Valuations – Historic

• Another comparable are the prices hosting companies are being bought and sold for

• Industry prices peaked at the end of the 1990’s and have generally drifted downward since then

• Prices in North America were well defined during the 2005-2007 period thanks to a large number of transactions (Generally 1.0x to 2.0x)– Hostway/Affinity; Terremark/Data Return; Navisite/Alabanza;

Navisite/Jupiter; Endurance/IPower; Endurance/PowWeb; WebSitePros/Web.Com

• European transactions seemed get a significant premium

Valuations - Current

• Greater variation in prices

• Some larger, apparently strategic transactions at higher multiples in both hosting & adjacent industry segments for the first time in some time– Intuit/Homestead; Abry/HostedSolutions

• Recent transactions showing new entrants/capital coming into hosting– Deluxe/Hostopia; Wachovia/HostMySite; Spire/Carpathia

• European transactions at a premium

• Very active, vibrant market

Valuation Deal Price vs. Terms

1

2

3

4

5

-60% -40% -20% 0% 20% 40%

Difference in price from mean of group

Ris

k of

Ter

ms

to B

uyer

• A highly subjective chart.

• 12 hosting transactions.• Chart based on risk of

terms to buyer (5=high) • Seller risk chart would

generally be a mirror image.

• Note fluctuation at constant risk levels and at decreasing risk.

Valuations - Future

• The Future – Good News– Signs of higher transaction prices– New money coming into hosting– A very active market

• The Future – Bad News– Jury is still out on higher prices– Prices are dependent on the underlying economics of the

business and there are risks from a deteriorating economy or other changes in the industry’s revenues/costs

• The one rule is – There is no one rule.

Valuing and Structuring Hosting Company Acquisitions (Session #201)

Not to be used or reproduced without permission

Joe BardenheierHillary StiffCHEVAL CAPITAL, INC.

Thanks for coming!

Valuation Issues - Leases

• Leases & equipment rentals generally reduce valuation to the seller

• The physical plant of a company generates its revenues and cash flow and is included in any purchase price

• How valuation is affected;– Purchase price less debt and leases assumed by the purchaser– Purchase price less cost of equipment the purchaser must

replace– Purchaser only takes customers and owner must repay

debt/leases