For the last 10+ years I have been working in the startup world. It moves fast, breaks rules and changes the world – it’s awesome.
While some rules do get broken, there are more fundamental rules that do not. Just like with the laws of physics, we can break the sound barrier, but every action still has an equal and opposite reaction.
I studied engineering in college, but I had the opportunity to take one class that informed my approach to business in a very meaningful way: Finance 335 – Corporate Valuation, Governance and Behavior. This class illustrated how the theory of valuation works in real business situations. We looked at case studies ranging from oil & gas to retail to technology in a variety of operating scenarios from growth to turnarounds to carve outs.
My key takeaway from the class was not the myriad ways to value a company, but the development of instincts around when and how to use them. Being able to creatively apply a set of tools while respecting the laws of physics is what any great scientist or artist does effectively. Company valuation is no different.
The increasing prevalence of the revenue multiple as a valuation metric for technology companies has me thinking about this constantly.
The single thing that makes a business valuable is its ability to generate cash flow – ideally a lot of it, with a high degree of certainty, and for a long time – it is an axiom of business.
Accelerating revenue growth, a new industry, and the potential for macro change are all extremely important to understanding the ability of a company to generate meaningful cash, but they also make the exercise of understanding cash flow projections very difficult for innovative technology companies.
As new markets arise and new business models flourish, the cash projection exercise becomes increasingly difficult. The result is the development of shortcuts, proxies, and rules of thumb.
An example: the software subscription model. If we look at it from the bottom up, we can tie each operating characteristic of the business to its ability to generate meaningful cash flow long term and therefore drive value.
- Scalable Product Delivery: multi-tenant software has the unique ability to scale nearly infinitely and do so almost instantly. There is no limitation of supply, no issues with inventory or suppliers. You can build something once and sell it a million+ times with minimal marginal cost.
- Recurring Revenue Model: Revenue is earned ratably as the product is used over time, historically the same way that a service works. This ties together value and price.
- Compounding Growth: The margin dynamics of the business are very favorable at scale because growth is a one-time cost, but customers will keep paying, leaving only marginal recurring costs over time. As a result, spending $100 to acquire $75 of revenue might seem less than ideal, but after 4 years of that, you will have $300 of revenue and only $100 of acquisition cost for that year.
- Favorable Cash Dynamics: Cash is collected upfront on annual contracts, which meaningfully increases the value of that cash flow stream and funds the rest of the business in advance of other ongoing costs like service, but also uniquely funds additional growth investment.
All these characteristics together result in very strong long term cash flow dynamics: high growth, high margin, predictable cash flow. This pushes all the variables in the DCF analysis in the right direction, namely discount rate and long term growth rate.
The challenge is that actually doing this DCF analysis with any level of precision for any early-stage, non-cash generating business is nearly impossible. (As a senior banker once told us: DCFs for growing technology companies are just fun with excel).
As a result, we use proxies: if we can assume these characteristics are consistent, we can roll back what we see in scaled, cash generating businesses and apply it to what we do know about their earlier stage counterparts. Enter: revenue multiples.
It turns out that a company at $100M of ARR with certain specific customer, margin, growth and market dynamics is worth $1Bn when you do the fully DCF analysis. What is our output conclusion? 10x ARR is how the company is valued, and therefore we can apply that same simpler method elsewhere. This is a nice hack, but is just that - a hack, and without a more fundamental understanding of the components of the formula, it can result in some very problematic conclusions.
It is important to understand that historically revenue multiples were used only to compare the relative value of $1 of revenue of Company A to the value of $1 of revenue of Company B.
For example: a dollar of Microsoft revenue is worth more than a dollar of Walmart revenue. Why? If we go back to the core drivers of value, we can see that Microsoft is growing faster (12% vs 4%) and has much better margins (49% vs 6% EBITDA margin). The margins and growth are driven by certain key characteristics of Microsoft’s product offering and target customers.
This is why it is so important to understand the characteristics that fundamentally drive the valuation output.
Let’s look at two companies at a smaller scale that are both subscription software businesses: Crowdstrike and Toast.
Crowdstrike sells cyber security solutions to enterprise and medium-sized companies.
Toast sells software to restaurants that allows them to operate and process payments. Historically restaurants have been bad software customers and the payments revenue is volatile. In addition, the amount of implementation required to get value from the software is non-negligible.
The characteristics of the products and end markets mandate the margin, retention and growth dynamics which ultimately drive valuation. The result is that a dollar of Crowdstrike revenue is worth 6 times more than a dollar of Toast revenue. Revenue is the top line, cash is the bottom line, and then we must project it into the future - there are a lot of steps and decisions to make along the way. Revenue tells us the least information about the business, but is the easiest to measure and project because it has fewer input variables.
Companies with larger customers tend to have more predictable and scalable growth and can grow efficiently and produce more cash as a result – their revenue is worth more. Companies with smaller customers or limited addressable markets risk slowing and inefficient growth, resulting in more cash consumption to maintain that growth. This is why revenue multiples vary so greatly.
When understanding valuation of complicated, new business models it is critical to look at these fundamental characteristics and root them all the way back to the fundamental idea of valuation: value is the ability to generate meaningful cash flow predictably for a long time. This means high growth, but it requires a low discount rate and high margins to complete the equation.