Defence Tech – Valuation & Financial Advisory Services For Success

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

• 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.

Footnotes

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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.