(co-authored by Mo Lam)
Meyer, the CEO/Founder of a SaaS business, was ready to sell the company.
But the offers on the table made no sense to him.
“The comps say that technology businesses like ours trade at 6-8x annual recurring revenue (ARR). I got an offer for 3x. Another for 4.5x. My business broker tells me it’s worth 6x. How can they be this far off?”
A little context: the company was an email marketing service. $2.1M ARR, growing at 25% annually, generating a profit of nearly $700,000. Team of 9, mostly engineers. All in Seattle.
“What am I missing here?” asked Meyer.
If beauty is in the eye of the beholder, then valuation is in the eye the acquirer.
Or something like that.
The point is that the same business can be valued differently depending on an acquirer’s strategy and her investment objectives. Which is why it’s important to put yourself in the mindset of the person doing the valuation. Because knowing what a buyer is willing to pay will help you to competitively price your business. So how do you know what a buyer is willing to pay?
Start with the answer and work backward.
Smart acquirers think about valuation as a function of the return.
In other words, they start with defining the potential yield of the investment and then work backward to price. It’s not a novel methodology. In fact, this is how income-producing assets (like commercial property or bonds) are valued by investors.
Acme Capital, a private equity group, has raised capital from its investors (pension funds) who expect 100% annual return. Acme has identified a business that it believes will be worth $100 at the end of year two. Therefore, the most Acme could pay for the business today is $25. Take it another way, the return and future valuation are given to Acme by its investors - the pension funds - and the market. Acme is trying to solve for the price. The price is the one variable Acme can control for.
This is called return-based valuation.
This approach applies if your business is being evaluated by a group like Acme, which needs to deliver a return to its investors. Acme doesn’t care about the comparables. Acme doesn’t care what a business was valued at its last funding round. Acme is an asset manager singularly focused on delivering a good return to its investors.
Different investors take different strategies. For example, a venture capital firm will value a business differently than a private equity firm, which will value a business differently than a strategic buyer. Knowing how each of these buyers operates is tricky.
Meyer - like most entrepreneurs - isn’t wired to think about his business this way.
So he does what any smart, scrappy startup CEO does. He asks around and looks to comparables as a shorthand for valuation.
Comparables tend to come from three sources:
- public market data (e.g. what Tableau is trading at);
- valuations for deals that VCs are seeing (e.g. Sand Hill Road propaganda);
- valuations for businesses that got “strategic exits.” A “strategic exit” is when a buyer pays a ridiculous amount for a business for their own special reasons (e.g. Salesforce buys Buddy Media for $745M).
None of these are useful comparables to evaluate a business like Meyer’s.
- His $2M business is lot riskier and illiquid than a publicly traded SaaS business like Tableau;
- VC valuations aren’t a true reflection of what a potential acquirer would pay (sometimes it’s a lot more, sometimes it’s a lot less);
- If someone is offering you a “strategic exit,” quit reading this and go find a pen.
Even if the comparables were 100% accurate, they are like a Kelley Blue Book: they provide historical context but they do not determine the value to the buyer sitting at the negotiating table.
How can Meyer value his business? To help him answer this question, we developed a simple model to let Meyer:
- Estimate valuation without undertaking a complex financial modeling exercise;
- Understand the factors that would impact valuation to help Meyer decide if he should sell at the current offer.
The model provides a broad estimate of his business’s value using two simple sets of inputs.
Set one is a proxy for current business performance using 4 KPIs: revenue, growth rate, expenses, and how expenses will decline or scale with more sales volume. By adjusting these inputs, Meyer can consider how valuation changes if he were to sell today vs. grow for another period of time and cut some costs. More importantly, it allows him to consider the risk or effort in growing sales or cash flow versus the potential reward.
Set two is around the investor or acquirer of his business.
- What type of investor is he/she?
- Is growth more valuable (VC) or is it cash flow (PE)?
- Is the investor conservative or aggressive? Aggressive investors are usually willing to pay more because they believe in the business’s growth potential. Conservative investors want to control for risk by paying less.
So what did he decide to do? Well, as of last week he hasn’t made a decision. But he now has the tools to evaluate the offers on the tale.
With Meyer’s permission, we’ve removed any confidential information and made the model available for the community. The model will let you independently value your business using the same methodology as a private equity analyst.
To help you get the most out of the model, we’ve put together a quick webinar. Mo (the finance guy) talks Jordan (not a finance guy) through the model.