Valuation Multiples….Helpful Mental Short Cuts or Biased Anchors?
Spring is almost upon us for those readers living in the Northern Hemisphere. Like many of you, I am ready for spring — — given an atypical COVID-induced winter hibernation, a recent reduction in coronavirus reported cases and a promising vaccine rollout…spring is in the air.
In March 2020, many of us were saying here comes 1929. Now in March 2021, some are saying it’s 1999 all over again. So it only seems fair to address the topic of valuations for technology companies.
Price vs Value
Before we jump into technology valuations, let’s start with a simple illustration we can universally relate to: home values.
How many times have you seen a house sold in your neighborhood or a similar house sold nearby — then you quickly calculated the $/SqFt of the transaction and then multiplied that $/SqFt by your own home square footage to arrive at a “value” for your own home?
The resulting “value” is quickly dismissed if too low and never forgotten if higher than anticipated!
There are many fallacies of this logic that ultimately create mental roadblocks, or valuation anchors, for home owners who get tied to a “price” someone may be willing to pay versus the “value” of their property.
Revenue multiple shortcuts
Small technology and software business owners face a similar dilemma when trying to determine the price or the value of their company.
Common practice in the technology and software markets is to use Revenue Multiples as a valuation shortcut given it’s an easy common metric across multiple businesses.
However, just like a home there are many factors that can drive appropriate valuation of a company but also unknown circumstances that can drive aggressive prices such as buyer mood, motivation, scarcity or speculation.
For technology and software businesses, the historical and future revenue size and growth rate is the primary driver of value and price. Bigger revenue, larger growth, means higher valuations. But just like home prices that can be driven by curbside appeal, staging of a house, or prime residential location — revenue is not the only driver.
Fundamentals drive value
Founders cannot easily see the underlying fundamental value drivers of peer companies in private markets. There is often a very small sample set of similar companies where fundamental metrics are known.
Given lack of transparent comps, owners guess as to what may be the fundamental factors driving valuation and often rely on oversimplification to speculate on comparable value.
For software companies, these fundamental factors include a laundry list of business model elements beyond revenue scale and revenue growth. More specific SaaS measures such as recurring revenue, gross margins, sales & marketing efficiency, unit economics like LTV:CAC, customer diversification and customer retention trends should all be considered when trying to decipher true value.
These fundamental factors can significantly impact the value of a business but cannot be compared across companies easily due to insufficient data.
Externalities can steer pricing away from value
External factors like private company deals or public company multiples provide a daily parade of headline news that often focus on the outliers that have achieved both significant valuations and outsized pricing.
For most small technology companies, these external market headlines create noise and bias in the form of high implied valuation multiples that are most likely not applicable to their businesses.
Check size often drives price but is not a determinant of value. Investors required to write bigger checks can lead to the check size driving the price, not the fundamentals. You can read more here about the negative influences of large equity check sizes influencing private company prices (not values).
Deal structure also drives price. Give a buyer a price to meet and anyone can create a structure to achieve that objective. You can read more here about how private investment structures inadvertently create misperceptions of value.
Finally, the basics of supply and demand imbalances (or sometimes even the perception of imbalance) can create scarcity that can drive price higher in order to access a deal which often means value was not a consideration.
For some, spring brings welcomed warmer weather, March Madness bracket challenges, the start of spring training for baseball fans or the blossoming azaleas of Augusta National.
It may also bring a desire to sell a home, or business owners reflecting on the next steps for capital to support growth for their company.
In either case, you need to do some spring cleaning to analyze the fundamentals that could drive value as well as explore the externalities that may impact your pricing.