The following post is from Innovacorp investment manager DAWN UMLAH. The post also appears on Dawn's personal blog, DAWN UNFILTERED, which you should check out regularly for her insights and tales about the VC and technology worlds she lives in.
Multiples can influence the perceived value for an investor and the actual valuation of your company in significant ways, and you should know why.
There are numerous ways to value an early stage tech company. I won’t get into the various methods in this post, but you can check out an OVERVIEW PREPARED BY A COLLEAGUE OF MINE, GREG PHIPPS.
One such method is using multiples – either as a multiplier of a company’s EBITDA or revenue (typically more prevalent in earlier stage companies because they don’t have a long operating history and more important, their EBITDA is negative). You want the highest multiplier possible.
What drives a higher multiple?
Short answer: Everything.
- Large market
- High customer growth
- High revenue growth
- Sustainable competitive advantage with high barriers to entry
- High switching costs or some other lock-in provision (aka stickiness) – You want to keep your customer with you in a way they are comfortable with. It could be through a closed system, with nothing coming in or out without your involvement and approval (think Apple), but this is falling out of favour with customers, so ensure your approach is something your customers are ok with. Your churn rate is a good indicator of your stickiness. Simply put: high churn rate = low switching cost = lower multiple.
- Network effects – The more customers or users you have, the more valuable your company is to each incremental customer and as a whole (think Facebook & Snapchat). It’s not very fun or valuable talking to yourself or being limited in your reach.
- Predictability and reliability – The more predictable and reliable your revenue and expenses are, the higher your multiple. For example, SaaS models get a higher multiple than those businesses where you have to continually win your business for each sale (think traditional software sales).
- Being the centre in a connected system – Bring together various elements of a tech stack or disparate ecosystem, make them work collectively and be the central go-to interface. Think centralized access point and APIs. Being the go-to-gal or -guy = power.
- High gross margin – You sell your product for a lot more than it costs you to make it.
- Ability to scale profitability – I’m going to explain this a few ways, as this is a principle I find people aren’t very comfortable with. Scaling profitably means your revenue increases at a higher rate than your costs as you grow. As you grow your revenues, your profit margin increases; more hits the bottom line. (See below for a quantitative example.)
One typical driver of scalability in tech companies is the cost to acquire a customer. Do you have a large enterprise sales team or do you spend massive amounts of money on marketing to reach your customers? If so, your ability to scale profitably is reduced.
- Lower capital expenditure costs – Everything else being equal, the company with lower capital intensity will have a higher multiple.
- Fewer dependencies on others – Dependencies can take many forms. If you have a low revenue/customer concentration, you have numerous customers and are not dependent on one or two customers for a significant part of your revenue. This is good. Dependencies can also be in the form of reliance on partnerships. What’s really yours in the partnership and how much power do you have in the relationship?
- Oh, and being in a sexy, hot space helps!
In simple terms, your multiplier boils down to power, scalability and opportunity.
Early stage tech note: These multiple drivers won’t all translate 1:1 for you and you likely don’t have all of these elements planned out tactically, but you should think about them as you design and build your company. Interpret and extrapolate them for where you are today and more important, what you will build your company to be.
Thinking of these elements also helps you determine your funding path. Typically, VCs invest in high multiple companies, family offices invest in mid-range and lower multiples, and angels invest across all multiples. VCs can straddle the line depending on their investment thesis, the return requirements of their LPs and/or the stage of their fund. Another general rule: the more capital you require and/or the longer your exit or growth path, the higher your multiple needs to be for VCs to be interested.
For extra credit, you can read FRED WILSON’S DETERMINING VALUATION MULTIPLES.