Business Valuation and Close-ology

Brent Holliday

| November 3, 2010

When a tech company cashes in, everyone makes comparisons – but the science of "close-ology" doesn't compute in this market.

One of the more interesting terms I have heard from my friends in the local junior mining community is “close-ology.” Here’s the definition: if the junior company immediately adjacent to your property is purchased, your value goes up. If the purchase is by a large gold producer, your value goes way up. It was explained to me that this is how these things are valued prior to actually having discovered a sizable trough of a valuable mineral. The simple theory is that if there is gold right beside you, there’s a good chance gold is underneath you too. It is convenient and simple, although of course it doesn’t necessarily mean there are viable resources under your property. 

I’ve seen this optimistic and simplistic value assessment applied to technology companies in a slightly different way. As soon as a big technology acquisition is announced, a few dozen similar startups around the world immediately associate the “closeness” of their company’s strategy to that of the acquired company. And voila, the early technology companies are all valued by the same metrics. They all assume that the same multiple of sales or some other metric (because cash flow is usually not positive) applies to them. 

Close-ology in mining is at best a hopeful guide to what could be possible, and it should be viewed the same way in technology. Interestingly, the announcement of a technology transaction without a disclosed price or a low valuation is conveniently ignored. The same goes for mining: if the property next to yours is nothing but a dry hole, close-ology doesn’t seem to apply either. 

We played this game a lot when I was a venture capitalist. It kept us optimistic in a dark time. Whenever there was a great M&A transaction or an IPO, we correlated back to our own portfolio of companies. Then we slept more soundly for a little while. 

A proper business valuation?

Here is the issue with generalizing based on close-ology: using close, comparable transactions in valuing a private company is only one arrow in a quiver of proper valuation techniques. And any valuation in the absence of a buyer is still little more than navel gazing. But close-ology has a dark side: if an entrepreneur or their board feels that an early-stage company deserves a valuation based on another transaction, they may make poor strategic decisions. An inflated sense of value might result in a rebuffed buyer or investor when the reality is that the offered price is fair. Sophisticated technology buyers and investors probably know a lot more about the market pricing than the entrepreneur does. In other words, they know the stinky values paid, not just the well- publicized high transaction values. 

The key difference between mining and high technology is that the process of taking ore out of the ground is pretty much the same now as it was 20 years ago, while technology markets go through an upheaval every five years (ask RIM, Microsoft, Nokia, etc.). With technology’s rapid change comes extreme volatility in pricing and value. Growth is often spectacular in technology, and valuations can seem out of whack with reality. Also, unlike a vein of gold underground that does not move until it’s mined, the technology market that is hot today can fall out of favour tomorrow. Typically, the largest multiples paid for private technology companies go to those that are acquired first or second. After that, values can drop dramatically as the bigger and more obvious buyers are removed from the game. 

If Google or Cisco buys a company next week in your technology market, don’t rely on close-ology to figure out your net worth based on those multiples paid. Instead, try to figure out how you can be noticed by someone else and be the next one in line. As the old saying goes, close only counts in horseshoes and hand grenades.

Brent Holliday heads the technology practice for Capital West Partners, a Vancouver-based investment bank.