VALUATIONS METRICS AT DIFFERENT STAGES OF GROWTH
Companies at different stages in their growth have different assets, quality of staff, technology maturity, and financial profiles. Therefore, it stands to reason that different valuation metrics apply to companies at different stages. Earnings multiples are irrelevant to the “garage band” startup, whereas a replacement value analysis will not fully capture the value of a profitable, going concern.
Let’s look at the appropriate methodologies at each stage of growth.
At the concept stage, the company is an idea championed by an individual or a small group of individuals. They may convince friends, fools, and family to invest in the development of the concept. They may convince partners to join them in trying to get the company off the ground in exchange for equity. The value is largely unrealized; a founder is chasing a vision, but the pieces aren’t yet in place. How would an investor or buyer measure the value of the company at this stage?
The value would lie in the potential return on the money that they invest in the company to develop the idea. If they believe that the company can capture 10% of $100 million market over a three-year period on a $5 million investment, then there is an opportunity for venture level return, and the company will be given a pre-money valuation based largely on the quality of the entrepreneur and team, the scale of the opportunity, and the odds of succeeding. This valuation for a venture capitalist is largely determined by context. Most venture capitalist are thesis driven. They decide to invest in a market opportunity, and then they look at the five or ten startups that are addressing that market problem, and they make a decision based on which team is most likely to succeed. If that team is asking for too high a valuation, they move on to the next team and try to negotiate something reasonable.
For mergers and acquisitions
The math is very different for a buyer. There is no unicorn flying across rainbows on the investment horizon, because in M&A, what you buy is when you get, and what you make of it depends largely on the resources that you, as the buyer, bring to the table. In this case, what you get is a team that wants to work on the problem. They may say that they’re willing to work on the problem as part of your company after you acquire them, but they’ve already proven this to be a questionable premise because in fact they took the risk of starting a business around the idea, and entrepreneurs tend to be repeat offenders. So the real value that a buyer will gain by acquiring a company at the concept stage is the services of a small team for a short period of time. Therefore the transaction would typically be structured as an acquihire, with most of the consideration going to employees, management, in exchange for retention.
But going back to our valuation question. How do we value the acquihire? The value is in the cost savings of paying recruiting fees to bring the team in, and the advantage of having a team that is already figured out how to work well together.
In the next phase of growth, an early-stage company will have completed a product or least a prototype and ideally will have deployed it at least on customer site. The company now has more assets than simply the services of a small team. They have a product, they may have developed some patentable IEP, and they’ve ideally gotten some feedback from a customer or customers that can then inform the further development of the product. Now that the value includes the value of the product, and early customer relationships, we can add to our acquihire math additional benefit from those assets. We still don’t have earnings to drive valuation, but we do have some assets that have been developed.
The value of these assets is often expressed as replacement value, reflecting either the actual cost to build the assets, or the buyer’s own buy vs build analysis. The entrepreneur will argue that they have better skills, and high quality, underpaid resources, such that the actual dollars spent on developing the product represent only a fraction of the cost for a larger company to develop the same technology. I tend to take these claims with a grain of salt; often the startup develops technology cheaper because they take a lot of shortcuts that will result in more development work later. Nonetheless, the startup will have their own estimate of replacement value, and this total should include the cost of technology that was acquired and included in the product.
At that point, we have a dollar figure representing the cost of building the attack, but that doesn’t tell the whole story; just as hiring an existing team can save on recruiting fees, buying an existing technology can create a time advantage in that the acquirer will have the new technology immediately when the deal closes, rather than having to wait for their own engineers to build it.
What is the value of that time-to-market multiplier? Nobody knows.
There was a moment in time when I was convinced that I was only seconds away finally gaining access to that arcane secret formula that prestigious buyers use to establish a time-to-market multiplier for the companies they are buying. I was sitting in a conference room in Building Nine on the Microsoft campus only a couple doors down from Bill Gates office. I was representing a Canadian company that had developed an Outlook client on a platform that was important to Microsoft. Post-acquisition, Microsoft wasn’t going to continue selling the platform so there was really no point in arguing over a discounted cash flow analysis, and the revenues did not represent the time and effort that had gone into building this recently released product. My negotiations with the VP of M&A had finally gotten down to the level replacement value.
We had built a spreadsheet showing a total investment of $9 million in the technology platform. We frankly didn’t know whether Microsoft was going to value it $15 or $50 million, and were reluctant to put any number on the table. After half an hour of verbal jousting. I finally got an opening offer from the Microsoft. “We accept your $9 million estimate on the replacement cost, and we would apply a time-to-market multiple of 3x to that number.”
After a long pause, I asked the VP, “How did you get to a time to market multiplier of 3x?”
There was another long pause. I was waiting for the next part of the analysis, which was the detailed explanation as to how the Microsoft analysts had come to a time to market multiplier of 3x – how they looked at the growth rate of the total addressable market and the white space that they would be able to occupy if they got there first, or the e increased customer acquisition cost that would result from coming late to market, and having to wrestle accounts away from competitors that had gotten there first.
I waited for words of wisdom, but I waited in vain. The VP said, “Um. . . we are willing to pay about $27 million.”
That’s as close as I ever got to unlocking the secret. But as far as I am concerned, if anyone asks, the number is “3x”.
For a company that survives the early years and reaches the growth stage, the valuation metrics change once again. During the growth stage, the company will have a team, a product, customers, and a repeatable sales process that is now driving revenue growth. Therefore, to our acquihire math and our replacement value math we can add financial multiples. The focus is typically on EBITDA multiples for most companies, but on price to sales multiples for recurring revenue companies. In this analysis, quality of earnings starts to matter a lot. A dollar of perpetual license sale has a very different value than a dollar of recurring SaaS revenue. A review of public comparables and precedent transactions typically reveals a range of possibilities. The target company will move up or down in that range depending on their growth rate (EBITDA and revenue), gross margin, and quality of earnings.