Navigating Preliminary Valuation Gates and Discussions

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Most conversations with clients and prospects nowadays revert to exit or acquisition multiples and drivers. This Strategy Lab reviewed important value considerations and their impact on the likelihood or timing of completing a deal and value considerations.


We like the process of considering exit value and timing (see our previous discussion of planning frameworks) as a way to affirm strategic priorities. The discussion can be a good capstone to a planning effort.


And, sometimes the conversation is more pressing, as companies and management teams consider outside investments or more generalized inbound interest (which is a constant in this environment).

Ultimately a company is worth what another organization will pay for it. Process matters: Creating multiple options leads to higher values. Alternatives create value just by being present. Targeting matters: Strategic investors can almost always pay more than financially-motivated investors.

Still, a starting point for any discussion — internal to set possible expectations, or external to address possible ranges and show stoppers can and should be facilitated through some comparisons and stereotyping or classifying (see our discussion of the surprising benefits of stereotyping).

The Rule of 40

We find an increasing number of references to the “Rule of 40” when assessing the health and potential of software / SaaS companies.

The Rule of 40 states that the combination of a firm’s revenue growth rate and its current (albeit adjusted) EBITDA margin should approach 40.

Theoretically, this would imply that a firm growing at 40%+ per year would be valued solely on that growth profile. Whereas a SaaS business with 0 growth should be returning 40%+ EBITDA to its investors.

In practice, the rule reinforces some excellent guidance: As growth declines, investors will become laser-focused on profit potential. Staying on that curve creates a proper hurdle rate for possible growth investments, and for trade offs between growth and longer-term profit potential.

The Basics.

An in-depth discussion of 5 topics will typically allow a company to assess its attractiveness to investors and, more broadly, capital markets:

  • Growth Rate
  • Market Potential
  • Customer Retention (Churn)
  • Margin Potential
  • Customer Acquisition Cost

Put more simply, a compelling investment thesis should address these points very quickly and definitively.

A. Growth Rate
Investors want a crisp answer on growth of annual recurring revenue (ARR). Many smaller companies include professional services or non-recurring implementation revenue. Please don’t: Professional services revenue is a fine adjunct, but a good rule of thumb is that it should be broken out explicitly as it approaches or exceeds 20% of period revenue.

B. Market Potential
Investors classify market sizes underneath $1 billion as niche. There is, obviously, plenty of potential within niche markets.

C. Customer Retention
We have watched a lot of investment deals fall apart late in the process as due diligence uncovers higher-than-expected customer churn.


The general belief is that SaaS businesses should benefit from very high – > 96% – customer retention.


Current results — regardless of the story – below 90% is typically a reason to defer consideration of a transaction.


And, there is good reason: Growth becomes nearly impossible to sustain with high churn, and growth is what investors value first and foremost.

D. Margin Potential
Margin potential ends up being a more theoretical exercise in most discussions today.


We like to work with companies to break costs into ‘keep the business running’ and ‘growth investment’ categories. The process won’t be perfect, but the effort can provide insight into potential and returns / timing / scale to growth initiatives.

E. Customer Acquisition Cost (CAC)
See our in-depth discussion of CAC here.


In summary, we struggle with this discussion with investors, seeing it instead as an excellent internal framework for assessing trade-offs that are both known and perhaps less transparent.


Since this will be an investor discussion topic, we would encourage a) a fairly definitive statement and b) humility in presentation and ranging outcomes.


Summary


There are really two benefits to considering exit valuation as a strategic dialogue.


First, the discussion creates a fact-based assessment of a company’s storyline. Do the results today support the vision and positioning? Does the story become too complicated or overwhelming to hold together?

Second, the dialogue can confirm timing expectation. If the answers today play a transaction out of bounds (particularly the customer churn issue or the current growth profile), the discussion becomes more about the future wind opening, and the steps and metrics to track between here and there.

That is, indeed, a valuable discussion to have with a leadership team and the board.

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