How to assess your company valuation
2021 was another strong year for software companies seeking investment, with $195bn raised through private markets.
But what was fuelling this demand in H1 2022? Despite the worsening economic outlook, the valuations of technology and software businesses were soaring up until now. Why?
There are two main drivers.
The first is the eternal principle of buying low and selling high. Challenging times create opportunities for institutional investors. When fundamentally sound businesses seek investment, investors can capitalise on economic events to negotiate favourable commercial terms — giving greater returns to their shareholders.
The second driver is related to the pandemic. In 2020, the world switched to remote working and many businesses accelerated their digital transformation in order to survive. Technology not only enabled this switch, but it also benefitted from the revenue and recognition that came with it. And that wasn’t all. The pandemic also demonstrated the fundamental resilience and flexibility of software subscription businesses.
In this piece, I’m going to describe some of these tools and how CEOs and founders might do their own calculations. This kind of due diligence is useful for those seeking investment, but should not be seen as a one-time exercise. Leading indicators like these are a useful way to track the ongoing health of a business.
Early-stage or pre-revenue businesses are hard to value for the simple reason that there is little or no historical data to go on. Instead, investors must assess the value of unproven capabilities, business models, executive teams, technology roadmaps and financial projections.
Here are two approaches that investors might use to assess early-stage businesses:
Revenue multiple method
In this approach, value is estimated by comparing a company’s current (and potential future) state to other companies within its industry, ideally with similar commercials, products and services. By assessing the valuation of peer companies, you can apply a similar revenue multiple to estimate the value of your business.
You may still need to apply caveats to account for risks because your revenue, product and hypothesis will be based on forecasts.
The Berkus method provides a framework for assessing pre-revenue businesses. Rather than focusing on unproven projections, Berkus assigns a base value to the core business idea and compares that to the ‘cost’ of a standard set of risks faced by technology start-ups. These include technology risks, execution risks, market risks and production risks.
The more of these risks that are mitigated, for example by a working prototype (technology) or an experienced management team (execution), the higher the valuation.
More mature valuations
Although proven businesses can be measured by the methods above, investors are more likely to rely on historic data to support their forecasts.
The typical assessment will look at recurring revenue, total contract value, accounts receivable billings, margin and profitability, assets, liabilities, competition, market, intellectual property, industry, leadership, pipeline and so on. Some of these will have a greater weighting, but to help CEOs and founders filter out the noise, the following options can be employed:
Rule of 40
The most common approach for software companies is using the ‘rule of 40’. The rule of 40 was embraced by VCs to do a high-level and relatively simple health check, which assesses the combined growth rate and profitability.
Rule of 40 = Y/Y revenue growth (%) + EBITDA margin
There are caveats here. Achieving 40%+ each year is challenging. Businesses are constantly balancing profit and growth, often focusing on one at the expense of another. Investing in growth inevitably reduces short-term profit, whereas a focus on profit (doing more with less) limits the funds available for long-term investment.
Consequently, mature businesses often find that their overall Y/Y rule of 40 score tapers off. In these cases, we assess the business against its competitors, the performance of the overall market, and the historical trend. Is the business maintaining the status quo, growing or declining over time? In the current climate, it is particularly important to keep an eye on your EBITDA margins, working capital and cash preservation to weather any sudden economic downturns.
Customer lifetime value: customer acquisition cost ratio (LTV:CAC)
As a business moves beyond product development and early stage growth, the focus shifts to acquiring and retaining customers. The LTV:CAC ratio is one of the most critical indicators used by investors to determine valuation.
Step-by-step instructions for calculating the LTV:CAC ratio for your business.
Example LTV:CAC calculation.
How to interpret the LTV:CAC ratio.
- An ideal LTV:CAC ratio will be 3:1 or better, which indicates that the value of your customer(s) is three times more than the cost of acquiring them.
- A ratio of 1:1 or worse indicates high risk. This can happen if, for example, you are entering a new market, but it’s a signal to start looking at the customer acquisition cost, churn rate etc.
- A ratio of or 5:1 suggests that you may want to re-invest back to fuel further growth.
Whilst the LTV:CAC ratio can be applied across the entire business, it can also be drilled down to assess individual regions, countries, industries or even sale reps.
We came across a business that was established in 2003, which was averaging a 3:1 LTV:CAC ratio. In a nutshell, this meant that it was costing the company $60,000 to win a customer that would earn them $20,000. You donʼt need to be an accountant to figure out that this was an inefficient, misguided business. Costs were out of control.
Not surprisingly, it is these businesses that struggle when investors start to pull the plug. It is far better to track LTV:CAC and other key ratios early, know where you are, and take the appropriate steps.
At Citius Partners, we can assist to calculate the health and status of your business, providing a personalised market report.
To discuss this, or the specific challenges you face, contact us.
About Mitul Ruparelia
Mitul Ruparelia is a Managing Partner of Fortius Partners, a growth transformation partner for private equity and venture capital backed businesses. He has over 20 years of growing profitable, sustainable business units, defining strategy and leading sales, marketing, product, innovation, finance, raising investment and people management for established, underperforming, and scale-up businesses. He has helped companies scale to valuations of over $1 billion.
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