How to Value an AI Company
Artificial intelligence (AI) has been a hot topic over the last few years. With tech titans such as Google, Facebook, IBM, Microsoft, Amazon and Apple, to name a few, collaborating their research in their “Partnership in AI”, it is exciting to see the development of AI in the next few years and the changes this new technology will bring to the world.
While Skynet may be the first thing that comes to mind when thinking about AI, thanks largely to the popularity of the Terminator series, AI has been around for well over half a century. In a nutshell, AI is the science of developing computer programs and/or machines capable of learning and solving problems in a manner similar to that of a human brain.
During World War II, Alan Turing and his team created the Bombe machine used to decipher coded messages (i.e. Enigma code). This machine laid the framework for AI theory where if a machine was able to communicate with a person without the person knowing it was a machine, the machine would have won the “imitation game” and could be said to be intelligent.
The next few decades saw a considerable amount of research and development in the field of AI given the advancement (and proliferation) of computers. The technology took a turning point in 1997 when IBM’s Deep Blue computer was able to win a game of chess against the reigning world champion. In recent times, some notable AI programs and machines include Apple’s SIRI, Google’s Assistant and Amazon’s Alexa.
While current AI programs and machines have far more capability and reach than those in the past, AI is still at its infancy stage in the goal of having programs replicate human thinking. For example, Amazon’s Alexa still uses a database of “correct answers” to respond to a user’s inquiry, rather than deriving an answer based on analysis of existing data.
With the continued development of AI, it is not surprising to see more and more tech companies being acquired by larger firms to advance their position in this growth market. From a valuation perspective, AI companies are technology companies where a substantial portion of their value is from its intellectual property (IP). Key personnel who play a substantial role in the development of the IP are also invaluable.
When starting a valuation for an AI company, business valuators consider three valuation approaches:
While the Market Approach involves applying multiples with those observed in comparable public companies or precedent transactions, a common shortfall when valuing AI companies in the Market Approach is that comparable companies may not exist or may not be truly comparable to the subject company. For example, while Microsoft and Apple operate in a very similar space, their market capitalizations (i.e. their value) are very different. As a result, the Market Approach will very rarely be used in valuing an AI company.
The Income Approach, on the other hand, focuses on the future cash flows available to the subject AI company. As such, key performance indicators such as revenues, earnings before interest, tax, depreciation and amortization (EBITDA) and net cash flows are the focus of analysis in the valuation (by a valuator and by a purchaser). Of importance are the recurrence of revenues and customer subscriptions as these would drive the future cash flows of the business.
And last but not least, we have the Asset Approach. This approach is applied to AI companies that are pre-revenue, have minimal or negative cash flows and will not be able to generate any returns on investment in the foreseeable future (e.g. financial forecasts are not available or cannot be reasonably relied upon). In this case, the fair market value of the identifiable assets, net of any liabilities, will form the basis of the valuation.
Regardless of which approach a valuator takes, the valuation will focus on the value drivers specific to the subject AI company. Some consideration factors include:
- Stage/lifecycle of the IP
- Whether any patents exist for the IP
- Nature of the IP (e.g. subscription-based vs purchase-based)
- Key management and team
- Customer quality and retention/attrition rates
- Target industries that AI is developed to assist
- Sales pipeline and customer concentration
While there are many factors that come into play during an actual transaction, and notwithstanding the fact that a valuation is a notional amount determined without exposing the subject company in an open market transaction, it should be noted that acquisitions in recent years have cemented some AI companies as true unicorns in the tech sector, with their valuations jumping up significantly in a short period of time. A prime example is Mobileye – its IPO market capitalization was approximately $5.3B in August 2014; when it got acquired by Intel in 2017, the purchase price was $15.3B.
However, not all companies are the same, and depending on what the AI company can bring to the table, the subject company can either be valued as a unicorn or simply through its net assets.
Should you have any questions about this article, or are interested in determining how much your tech company is worth, we encourage you to contact Paul Woodhouse, CPA, CA, CBV.