Wednesday, 9 November 2011
Why is a Tech Company Worth Three Times Revenue?
First off, let me clarify that the number, three times revenue, is the actual average revenue multiple of over 85 private company digital media M&A transactions that we have tracked in the years 2009 and 2010. If you would like a copy of this report please email me at firstname.lastname@example.org.
Now, of course you can’t generalize when it comes to assessing the value of a business, but there are two items of note in the title: (i) the valuation metric; a multiple of revenues and (ii), the notion that technology companies as a group are different from other companies.
So why do people speak of a multiple of revenues when they are referring to the value of a technology company? First of all, if there is no EBITDA to speak of (i.e. the company is in a loss position/operating with a burn rate), then a multiple of EBITDA is meaningless; and, second, what if the EBITDA margin is at a very low level, much lower than the long term expected average? What we are really describing here are two early stage phases that many technology companies go through. The first stage is the start-up phase where companies incur a burn rate and the second stage is the initial growth phase, where it enjoys rapid growth but has not yet achieved the economies of scale to cover its relatively large product development (R&D) and marketing (product/service launch) costs. In cases like this, while it doesn’t account for many possible differences in business models, the multiple applied to revenues is used as a proxy of future normalized EBITDA.
Many established software companies generate very healthy EBITDA margins. Margins of 40% - 50% are not unusual (both Microsoft and Google EBITDA margins exceeded 40% during the last two fiscal years). Equally revenue growth can be very strong, particularly in the early stages. So what does a growth multiple combined with strong margins translate to, in terms of a revenue multiple? It could be 3, 4, 5 times, and we have seen strategic acquisitions as high as 10 times revenue. Three times revenues with 50% EBITDA margins equates to six times EBITDA, not that different from traditional metrics.
At this point manufacturing, service, retail and distribution income statement ratios are all in well established ranges but technology companies can typically achieve stronger margins, quicker growth and, in some cases, generate sticky recurring revenues which reduce the risk associated with these revenues. There are consumer product innovations from time to time that are low-tech and achieve tremendous growth (think of infomercial products like Sham-wow or Spanks) but in general the growth sectors in the North American economy are technology sectors like Software as a Service (SaaS) and Platform as a Service (PaaS) as well as search/comparison engines, e-commerce, social media and mobile applications (also clean tech and bio tech which I personally don’t see that much of). Companies in these sectors can leverage digital distribution (where the cost of manufacturing and delivering an incremental copy is negligible) and the reach of 80% broadband and 90% mobile penetration to generate very robust growth.
So are technology companies different from other companies? In a word, yes. Many are venture funded and achieve substantial market penetration, creating tremendous value while still unprofitable and therefore, while nowhere near perfect, a multiple of revenues can be used as a common metric for technology companies in various stages of growth.
Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.