Expectation Management: Is My Company a 1x or a 3x Revenue Business?
One of the most common questions I get asked when speaking with the many entrepreneurs of cloud and managed IT service companies, is “what are companies in my industry selling for, and how are they valued?”. My response varies depending on a culmination of factors, yet after a high-level assessment, it’s somewhere between 1-3x revenue. So, what drives this range, as there is quite a bit of variability between 1-3x? What time frame is this multiple tied to? While there’s no perfect science to get to an exact figure, as the market bears what the market bears, below, please find 6 key drivers of value, with their reasons, which will provide a sense of where you may fall within the range:
Amount of Revenue: there’s always a premium for larger companies as the adage goes, its more work to do a smaller deal than a larger one, as naturally a smaller company has less sophisticated and organized accounting and reporting. Not to mention, smaller companies do not move the needle compared to that of a larger company, as well as it’s generally harder to reach “scale” i.e. a larger size, thus larger companies are rewarded value-wise. In the lower middle market, the key revenue threshold which divides the small vs. large is $10mm, then step functions up from there to $25mm, $50mm, 100mm, etc. The exception here may be if a company is growing fast and projecting $10mm in the current year, and they’re run-rating (mid-year performance extrapolated out) an amount on pace to comfortably hit the projection of $10mm.
Margin of the Revenue: While revenue size is very important as noted above, equally if not more important are margins attached to this revenue at the Gross level, as well as at the EBITDA levels. There are two noteworthy examples here, one being VARs, which have become highly undesirable businesses due to low margins and disintermediation. Typically, Gross margins here are 10-20% and do not have a recurring nature to them, which is a double whammy. As a result, these companies are being valued somewhere between .25-.75x of revenue, or even a multiple of Gross profit. Another example is resellers of public cloud services, AWS and Azure for instance. It’s fascinating, as these resellers are in a hot, high growth space (public cloud), and have recurring revenue, where there is strong demand from acquirers and investors who are seeking acquire a “platform”. However, folks are reluctant to pay a strong multiple for these companies as their gross margins on such revenue is still in the “VAR range”, of ~10-20%. Also, it remains to be seen the long-term viability to grow such margins, as where is the true value proposition to demand a higher vs. lower margin on revenue? Companies have combatted this issue by wrapping other services around the resale business, which is helpful to the cause margin-wise, yet be mindful that sophisticated investors/acquirers will segment out the revenue by type and apply a lower multiple to the resale vs. the services (project vs. managed), despite there being robust growth and a recurring nature to it.
Recurring vs. Non-Recurring Revenue: It’s no surprise that recurring revenue is highly sought after, and the reasons are quite self-explanatory. Thus, recurring revenue will generally receive a higher value than one-time or project-based revenue, however, the Achilles heel of recurring revenue or subscription-based businesses is their churn. So, if you look at two businesses, both with $15mm of ARR (annual recurring revenue) and one may be receiving a 3x multiple and the other 1.5x. The key difference may be the churn of one being 5%/mo, vs the other being .5%/mo. High churn negates the stable nature and value of recurring, in terms of being able to predict future cash flows, so this is certainly something to be mindful of. While project-based businesses are inherently less desirable, some IT services silos who are experiencing rapid growth, such as ERP cloud consulting (CRM, SAP, Oracle), and the public cloud partners, are seeing strong multiples, due to the robust performance and large go-forward market opportunities. Another example where project-based revenue receives strong value is if they have sticky, repeat revenue who can be substantiated year over year, as well as those with multi-year contracts. These types of companies have been valued of late in the 2-3x range.
Composition of Revenue: This is an interesting one, as you can compare two recurring revenue businesses with $10mm of ARR (annual recurring revenue), yet one may be worth double the other. A good example here would be a horizontal player, vs. a vertical player. Naturally, the horizontal player will be less specialized than that of the vertical player, therefore require less specialized solutions, personnel, and thus pricing will be less. The horizontal player has a larger market opportunity yet faces greater competition. The verticalized player requires more specialization and thus will charge more for their solutions. Further, this provider will have naturally created a stronger barrier to entry, and in turn have less competition. While the vertical player may have a smaller market opportunity, they will have a better likelihood to monopolize that smaller opportunity, than the horizontal player, in a stable profitable fashion. This is attractive to private equity and strategic acquirers who are seeking to grow their investment 3-5x over 3-5 years, rather than acquire the next Uber. Further, with larger consolidators exploring buy vs. builds for offering more solutions or use cases, the acquisition of smaller specialized players makes a lot of sense, vs. another competitive yet smaller horizontal player. Vertical centric examples include healthcare, legal, financial, security/compliance, and or application-centric specialization such as ERP, CRM, etc…, or perhaps a combination of both.
Growth of Revenue: This one when combined with the positive elements above, is arguably the most critical factor to sway the revenue multiple to the top end of the range. Companies seeing 30-50% growth, where it’s sustainable and predictable within a large market, is the most attractive and will likely generate the highest multiple. Realistically, to receive a strong multiple, IT/cloud service companies who are generally bootstrapped, are expected to see growth in the ~25% range, while maintaining healthy gross and EBITDA margins, ~50% and ~20% respectively. What is key here is to be mindful of which buckets of revenue will generate the most value long-term, to strategically position your company as such, for instance only offering resale revenue if they will take services along with it, which may reduce overall revenue and growth, yet increases margin, as well as customer penetration/stickiness, which drives overall value.
IP: those who have developed and own IP, which is used in delivering their service, should see an increase in value, possibly incremental to the 3x figure. Whether it’s around management of the environment, for optimization purposes, or generally to enhance the solution for the customer, as well as to automate the process/workflow for the vendor, this should lead to scalability and increased margins over time, and thus creating a higher near-term value. It’s important to note, that this solution should be unique or differentiated to what’s available in the market from a 3rd party tools perspective, as why would you re-invent the wheel, and spend considerable resources doing so. Also, to receive value for this component, the vendor should be actively using this IP within their business as an integral component of delivering their solutions, vs. a customized solution built for one customer, to which there are grand visions of what’s possible for the product, yet it has limited traction.
Cyrus Maghami is Founder and Managing Director of Harbor Ridge Capital, which advises lower middle-market technology services and software companies on M&A and institutional capital raising. Prior to Harbor Ridge Capital, Cyrus was a private equity investor for both Kayne Anderson Private Equity and Shackleton Equity which he made considerable investments in the IT services and software verticals. Cyrus Maghami is a Registered Representative of and Securities Products are offered through Fallbrook Capital Securities. cmaghami@harborridgecap.com.