Defence Tech – Valuation & Financial Advisory Services For Success | IR Global

[author: Thomas Pastore]

The defense technology sector (“defense tech”) has experienced remarkable growth in recent years, with projections indicating continued expansion in the near future. This surge is largely driven by increased global defense spending, particularly in the United States. According to the U.S. Department of Defense’s Fiscal Year 2025 Budget Request Overview, the proposed defense budget for FY2025 is $849.8 billion. Of this, $17.2 billion has been requested specifically for science and technology.^[1] Additionally, roughly 25% of the Defense Innovation Unit’s (DIU)^[2] budget of $983 million will support new projects in strategic technology areas including counter-unmanned aerial systems, space transport, advanced manufacturing, and critically, cross-cutting software and other complementary capabilities.^[3]

This upward trend in defense spending is not limited to the United States. Deloitte’s 2024 aerospace and defense industry outlook reports that global defense spending is expected to surpass $2.5 trillion by 2027, as nations worldwide seek to replenish depleted inventories and invest in next-generation technological innovations.^[4] This surge in investment is creating unprecedented opportunities for both traditional defense contractors and a new wave of tech-focused startups entering the defense sector.

The influx of innovative companies into the defense industry is reshaping the landscape of military technology. The number of seed funding rounds for Defense Tech start-ups increased from 2010 to 2023 at an annualized rate of 32.4% from 22 seed rounds to 849 seed rounds, respectively.^[5] These new entrants are bringing cutting-edge technologies such as artificial intelligence, autonomous systems, and advanced materials to the forefront of defense applications, complementing the capabilities of the traditional industrial base.

FINANCIAL ADVISORY SERVICES FOR DEFENSE TECH COMPANIES

Financial advisory firms can provide the following services to defense technology companies.

1. Preparation of projected income statements, cash flows and balance sheets

2. Scenario and stress testing liquidity and solvency analyses

3. Quality of Earnings (“QOE”) studies for companies courting buyers

4. Fairness opinions for mergers and acquisitions

5. Valuations of intellectual property (“IP”) and employee stock options

Projected Financial Statements

A financial advisory firm can develop due diligence based projections significantly enhancing credibility for investors by creating a concise presentation with supporting metrics, graphs, and visuals, including:

· C–level executives’ backgrounds and experience

· Strong and protected company IP

· Product/services’ competitive strengths

· Relevant supports for revenue growth and margins

· Demographic trends

· Economic factors

· The company’s projected market share capture

Quality of Earnings (“QOE”) – Historical Accounting Profits v. Going Forward Cash Flows

In the M&A space, the QOE report helps the buyer and seller understand key company operating metrics, such as QOE ratios, revenues, gross margins, cash flow, adjusted EBITDA, and working capital. It bridges the knowledge gap making both buyer and seller comfortable completing the transaction.

QOE analyses dive deeper than financial statements and include:

· QE Ratio: Net Cash Flow from Operations ÷ Net Income

Quantify quality income and compare to non-cash accounting profits arising from policy changes, foreign exchange fluctuations, allowance and reserve estimate changes, and depreciation estimates

Ratio > 1: higher quality earnings; ratio < 1: lower quality earnings

· Additional Key Ratios: quick ratio; accounts payable days outstanding; sustainable profit margin; employee turnover

· Revenue patterns and growth, such as anomalies, seasonality, customer concentration, and product concentration

· Expense Adjustments: 1) additional recurring costs post-transaction; and 2) expenses not required post-transaction, such as duplicate overhead for consolidated operations or above-market salaries

· Future working capital requirements, reserves, and liability recognition

· Identify and analyze potential indebtedness not on the balance sheet which may reduce purchase price, e.g., fixed asset purchase commitments, litigation matters, and income and sales audits

Fairness Opinions – Testing Deal Terms

A company’s board of directors are subject to the business judgment rule. In M&A, this means the board must either: (1) possess the knowledge and experience to ascertain whether the proposed transaction is financially fair, or (2) lacking such knowledge and experience (most always the case), rely on an outside independent financial advisor to make this determination in the form of a fairness opinion letter and supporting pitch deck. These advisors conduct due diligence, including:

· Extensive interviews with target company’s executives

· Independent research on target company’s operations

· Detailed financial analyses of target’s historical and projected financial statements

· Scenario and stress tests on target’s projected financial statements

· Reviewing all drafts of the purchase agreement

· Industry, economic, and competition analyses

· Valuation analyses of target usually employing accepted methods

If deemed fair, the advisor issues a fairness opinion letter and pitch deck to the board, presenting findings and answering questions about the process and transaction.

Valuations of IP and Stock Options – Key Assets and Employee Incentives

If a company possesses key know-how, technology and/or patents, it may consider additional monetization through a valuation of IP which can be presented to existing and potential investors as support in raising further investment.

Another monetization consideration is licensing IP to other companies. Valuation professionals can determine the royalty rates the IP would fetch in open markets.

For start-up and emerging growth companies which need to carefully conserve cash balances, granting employees stock options is a non-monetary method of building a strong culture and incentivizing the team. For financial and tax reporting purposes, these options must be valued by an independent valuation firm.

^[1] Office of the Under Secretary of Defense (Comptroller)/Chief Financial Officer. Defense Budget Overview. United States Department of Defense Fiscal Year 2025 Budget Request. April 4, 2024.

^[2] The Defense Innovation Unit (DIU) is a U.S. Department of Defense (DoD) affiliated organization and acts as a defense tech start up accelerator. Founded by a former U.S. Secretary of Defense, the DIU provides initial funding and guidance to vetted defense tech companies in preparation for transition to DoD contracts.

^[3] Defense Innovation Unit. DIU Announces Strategic Allocation of 2024 Budget and Plan To Scale Commercial Tech Adoption. June 19, 2024.

^[4] McKinsey & Company. A rising wave of tech disruptors: The future of defense innovation? February 22, 2024.

^[5] Ibid.