Valutation of tech companies
Appraising the total economic value of a business is a complicated task. As corporate finance professionals like to point out “valuation is full of judgment”.
This probably explains why many listed companies have shown staggering market caps and meteoric growth, while losing money and burning through cash. Notable examples are Amazon and Tesla. But how come investors are willing to pour their money into what seems to be nothing but a black hole?
The reason for these valuations lies on future performance expectations. The ability of these companies to provide their investors with a positive return on their investment finds its foundation in the business’s long-term strategy.
In the case of tech companies, what made investors so confident that sooner rather than later said companies would start generating outstanding profits? And what made their stocks outperform the market in the meantime? Their business model. Terms such as Annual Run Rate (ARR), Churn Rate, Net Retention, Bounce Rate are frequently used, but not as frequently understood. Of these, ARR is key for most. Take Spotify, for example. You pay a fixed monthly fee to access their content without taking ownership of it. That means no more subscription, no more music. Suddenly, stock markets and valuation professionals had to consider a whole new financial performance indicator. The EBITDA multipliers, as an indicator of value, were now obsolete, since EBITDA was almost universally negative in the industry, investors now turned their focus to ARR applying double digit multiples (ARR based revenue model is the typical business model of the SaaS industry). As such, tech companies defied all corporate finance logic applied thus far.
As financial advisors, we, at Maveria, have experience in the SaaS industry, either through sell-side mandates or equity valuation mandates. During the first quarter of 2022, we conducted a very interesting business valuation of a Swiss SaaS company. The Company itself was small (at the time of our report) but it was able to grow and develop its operations without the enormous capital injections usually seen in its sector. Furthermore, the Company had just recently turned profitable. Our team started off as usual by gathering insight into the flow of capital of private markets (Venture Capital, Private Equity and Mergers & Acquisitions), as well as public markets related to the industry. We then analysed the Company by taking a deeper dive into the business model. As expected, they had applied an ARR revenue model, so our goal was to compute the average contract value and the average contract life. Interestingly, the Company was yet to face its first customer loss (churn) after 3 years since inception, so we were immediately faced with the challenge of building a forecast model of average client lifecycle. Moreover, the typical yearly contract turned out to be above CHF 100,000, while the annual standard spend on advertising per client onboarded was about CHF 10,000. That immediately tells you that the ratio between the lifetime value of a customer and the investment faced by the Company to onboard said customer was extremely favourable to the Company, regardless of the actual lifetime of each contract in year terms – which was still virtually infinite at the time of our valuation. This ratio ensured our clients of outstanding long-term gross margins. Our analysts drafted a monthly growth plan by forecasting i) the average amount of leads managed by a single salesperson, ii) the expected marketing costs and iii) the most likely conversion rate going forward. In broad terms, this procedure leads to an accurate simulation of client onboarding and client loss dynamic for the analysed period. The simulation applied to the individual contract, provides an accurate forecast of ARR evolution.
As the manager of a tech company, odds are you will be frequently approached by potential investors. Many of them will just be curious people kicking the tires and testing the market, but others will have a genuine interest in investing in your business. The question you must ask yourself is: how much of my company am I willing to give up to this person and for how much money? That is where we come in.
