Seven important quantitative factors that will influence the value of your business
Thinking of selling your business? Perhaps you’ve been running it for ten or even twenty years and itching to do something new? You’re certainly not alone. Exit planning is one of the big reasons our clients hire us.
Our Scaling Up methodology fits so well with optimising businesses for sale. We’ve helped Mudano sell to Accenture, New Signature to Cognizant, Wirehive to Pax 8, and many more success stories. Even if you’re not looking at selling in the immediate future, there’s value in having a ‘sale-ready business’.
It’s always been an area of personal interest to me. I’ve been there. In January 2013, I was Managing Director of Peer 1, which sold for C$635 million. At the time, it realised the highest multiple for a hosting company ever achieved. My experience scaling this business showed me the factors that drive valuation in tech businesses.
These factors are many and complex. So much so that I’m splitting them into two blogs. Read on for part one – the quantitative factors that will influence the value of your business. Part two – the qualitative factors will be the subject of next week’s blog.
1. Organic Revenue Growth
To be defined as a scale-up, you need an organic growth rate of 20% or more for at least three years. So work out your current rate. But you don’t need this alone. Potential buyers will be interested in how your growth rate compares to others in your industry.
Do some research. How is your organic growth rate relative to that of your competitors? You’ll likely attract a premium if you’re in an industry with low organic growth but growing at 15%. If your marketplace is expanding rapidly and you’re only growing at 20%, this may not be as attractive. With inflation as high as now, anything less than 10% goes backwards in growth terms.
Most clients we work with are either in a software business with high margins or a services business with aspirations for the same high margins. They are all working towards gross margins of 40% or more.
Regarding your EBITDA margin (meaning Earnings Before Interest, Taxes, Depreciation and Amortisation), you’re not profitable if it’s less than 10%. If it’s greater than 25%, you’re in great shape.
Worth listening to on this subject is a podcast conversation I recorded with Greg Crabtree, author of ‘Simple Numbers 2.0’. He talks about two of his concepts, ‘Launch Capital’ and ‘Labour Efficiency Ratio’. When looking at net profit before tax, Greg says you’ve got a stable business if you’re at 10%. At 20%, you’re going to attract competition.
This is all about being exit ready. Prospective buyers will look at EBITDA, and they’re going to want to see a number greater than 25%. But this depends on the quality of your earnings and what’s happening in your sector.
3. Rule of 40 value
A useful quantitative measure to judge the prospective value of your business is the ‘Rule of 40’. If you’re a SaaS company, you may have heard of this simple financial framework that balances revenue growth against profit margins.
The rule states that your EBITDA and growth rate should exceed 40. So you simply add your growth in percentage terms plus your profit margin. For example, if your revenue growth is 15% and your profit margin is 20%, your rule of 40 number is 35% (15 + 20), i.e. below the 40% target. To be attractive, you must increase either growth or profit to 40% or greater.
Interestingly, you can have a business with no profit and 40% growth or even -10 EBITDA and +50% growth, and it still ends up at a score of 40. This is why businesses might sell when they’re not making money as long as they’re growing fast enough. And they’ll still sell for a decent multiple.
4. Revenue Composition.
At Peer 1, the percentage of our recurring revenue was around 80% – pretty high. Long-term contracts were the norm, and our customers bought into our vision of the future and our five-star service. This also meant churn rates were low, further stabilising our revenue. As a result, even if things didn’t change, any downside risk was mitigated by contracted customers whose revenues were growing.
Building recurring revenue is a critical focus in our coaching. We work with our clients to move their business from project-based to service-based revenue. This might involve bundling or packaging products for the best return.
So what proportion of your business is made up of recurring revenue? The higher it is, the higher the premium you’ll attract. We’ve got some clients with % recurring revenue in the high 90s. The other useful calculations are CAC (Customer Acquisition Cost) and CLTV (Customer Lifetime Value). I’ve devoted whole blogs to them in the past. If you can track these effectively, they will affect your final valuation.
5. Cash Conversion
Is your business asset-light or asset-heavy? Often, we’re helping clients to make the transition. One of our current clients is moving from asset-heavy to light, so they need less CapEx working capital in the future to scale the revenue. Private Equity houses love that. It’s all about understanding how your business model works. And knowing how any invested money converts. So what return on capital are you getting? It needs to be a decent rate to attract a higher valuation.
Back to Greg Crabtree’s work. In his book ‘Simple Numbers 2.0’, he says if you’re a public limited company, you might be getting a 5% return on capital. But if you’re an entrepreneurial business, you should be getting between 50-100%. In our podcast chat, we talk about a familiar paradox.
Often, entrepreneurs that are getting 100% return on their capital go on to sell their businesses. They then invest the proceeds and only get 10%. Why do they do it? Why didn’t they run their thriving business as a cash cow and maybe work less? So think carefully if you are contemplating selling. Where will you invest, and will it give you enough for the rest of your life? Or will you have to start another business?
Over the years, I’ve seen several people sell and start again. They’d have been better served by not selling in the first place and carrying on. The amount they sold for wasn’t life-changing, so they needed to return to work.
6. Customer concentration
This is interesting and slightly debatable. Ideally, you want your top ten customers to be less than 10% of your total revenue. Any potential buyer will want the security of knowing that losing two or three customers won’t result in their investment going down the pan.
But often, the fastest-growing businesses have a high customer concentration. Of all our clients, Modarno was probably the most extreme example of this. At one point, 95% of their revenue sat with one customer, and then that customer paused their spend. They had to replace £5 million in a quarter, which they managed to do after a Herculean effort. Accenture then acquired them.
Our advice? Don’t be fearful. Would you rather have a business growing at 100% with some customer concentration or manage this and grow slower? In Modarno’s case, they went from nothing to £15 million in three years. They took a risk, and it paid off.
I don’t think you manage customer concentration as a way of running your business well. You need to play to your strengths. At Peer 1, 6% of our customers gave us 60% of our revenue. These were our core customers who were growing at 4% year over year. We ignored the tail and focused on this small, fast-growing segment, which eventually paid off with our high multiple.
7. Customer retention
On the other hand, customer retention is something to obsess about. In our view, it’s important to track customer numbers. People often talk about revenue retention when they’re thinking about customer retention. But I think you might be being disrupted if your customer numbers start to fall.
This happened to us at Peer 1 with Amazon. There was a shift over time as our smaller customers moved to use them. Seeing the writing on the wall, we sold Peer 1 before Cloud took over.
So when providing customer retention data, track revenue retention and customer numbers. Prospective buyers will want to see evidence that you’re keeping most of your customers and that they’re spending more over time.