Recently I was asked by a CEO how they could value their early-stage technology business. The company was looking to close its first round of institutional investment and needed to settle on a price of the deal.
The simplest way is to compare one company with another. Unfortunately, although companies may be similar, it is rare for two to be so alike that a direct comparison is possible. So, we use metrics from one company and apply them to the other.
Corum tracks all software and IT service M&A transactions and has maintained a monthly average of the sales multiple (value of the deal divided by the trailing 12 months revenue). Over the last 20 years, this has rolled between a high of 3x and a low of 1.5x, with the long-term average being 2x to 2.5x. Currently valuations are heading back up from a low point reached in Q109. So, the implication is that if your business has revenues of $10m, the current average would give it a value in the range of $15m to $20m, the long term average is $20m to $25m, and at peak of the cycle it reaches $25m to $30m.
This fluctuation of valuations over time is not the most significant factor in estimating a valuation. Individual sectors and sub-sectors within software and IT services vary by much more. Sub-sectors that are in demand will be sought by many companies and this will drive up the price paid (both in absolute terms and as a multiple). Similarly, sub-sectors that are no longer in demand will be valued at much lower multiples. Being in a hot sub-sector has a greater impact on valuation than the rolling trend of the general market over time. Of course what is hot this year may be not hot next year, so timing is still important, but it is timing within your sub-sector. Some sub-sectors are intrinsically rated on lower multiples, for example IT services, and some on higher ones, such as SaaS-related revenues, but this is most probably too much detail at this time!
Corum segregates the Software and IT Services market into 6 sectors and 22 sub-sectors. It is unlikely for there to be a sufficient number of deals each month in each of the 22 sub-sectors for a meaningful statistical analysis of multiples. So Corum tracks the multiple for publically quoted companies in each sub-sector, as a proxy for private sector transactions. The Enterprise Value divided by the trailing 12 months revenue is used.
Long term analysis shows that private transaction multiples follow the ups and downs of public multiples, often with a lag of a couple of quarters and often in a more accentuated way (higher highs and lower lows). However, the upward and downward trend and the relative hotness of sub-sector compared to other sub-sectors are reliably indicated by these public market proxies. Work out which sub-sectors best match your business and use the multiples for these sub-sectors to get a feel for your likely valuation.
Sector and Sub-sector valuations and transaction multiples across all Software and IT Services deals are available from Corums research just ask us!
Other factors that impact on valuations are growth, profitability and stability (a strong balance sheet). This will vary company by company. Indeed, ultimately the only way to obtain a real valuation is to get a number of interested buyers to bid competitively for the company, but clearly that cannot be done until a company is put up for sale!
Estimating a valuation is an art, not a science. I have given guidance on some of the techniques that we use here at Corum. Comparison against comparable transactions and against public peer groups using a revenue multiple or an EBITDA multiple, coupled with a discounted cash flow, are our preferred methods. However, for early-stage companies this can still not be satisfactory the company may be too small for any sales or EBITDA to be meaningful and for any cash flow forecast to be reliable.
So, finally, here is my guidance as to how we approached the problem when I was a Partner working within an early-stage technology VC where I valued companies when making investments. This is not a method of valuing a company, but it is a method of producing a valuation that allows the deal to work from the VCs perspective. We worked backwards from what we knew we had to achieve for our fund to return the multiples expected of it. We knew that we had to have the potential of returning say 10x out of any investment. We could estimate what the company might be worth at some future exit event (say in 5 years time you might expect your revenues to be $15m, which on a 2x sales multiple would give you a value on exit at that time of $30m). So if we were investing $1m today, we would need that to be worth $10m on exit, and $10m out of $30m meant that we would need to take 33% of the company. This would then give a current valuation of $2m, to allow our $1m investment to provide the 33% equity holding.
Again, this is only a simple example for example, if you are going to need to take further investment before your exit event, then this will dilute the shareholding taken by the original investor, and many VCs work on needing to achieve an IRR% rather than an absolute return%. However, I hope it gives some food for thought.