Looking back at 2013, it is clear that one of the big stories in the tech sector was the value premium now being paid for high-growth companies. This was the year of the growth premium — with high multiples being paid in the public and private markets for high-growth companies. While this is good news for entrepreneurs, only a lucky few are able to benefit from this. Not only do companies need to deliver high growth to command such a premium, but they also need to be in the right markets with a proven combination of team and business model that can sustain the growth. The valuations have been out of sight for founders who have been able to bring these three elements together as they seek funding.
How high are values?
First let’s consider these questions: What revenue multiple would you guess that a 100 percent revenue growth software company that recently went public trades for in today’s market? Think of a number before proceeding. Ok now, what multiple would you guess for the same business with 20 percent revenue growth? When you think you have the answer, continue reading.
Most software executives that do not closely track today’s values might say 10x revenue for the 100 percent growth company and 2x revenue for the low-growth company. Today’s reality is closer to 30x for high-growth companies and 3x for the 20 percent growth companies (adjusted for 75 percent software gross margins). These represent significantly higher multiples, particularly for the fastest growing companies.
The most visible rise in valuation for high-growth companies has been in the public markets. IPOs for companies growing at 50 to 100 percent are trading as much as 20x to 50x revenues.
Take a look at FireEye, which is trading at $4.7 billion or 30x, enterprise value/revenue multiple (based on trailing 12 month). The company grew by almost 147 percent in 2012, slowing to 107 percent in the first half 2013. Moreover the company is spending massively, with sizable losses to achieve this growth. It incurred a $67 million loss, of which $40 million was in Q2 2013 alone. Clearly the market is valuing growth at virtually all costs (costs at 2x revenue).
Lest you think this is just one deal, consider Veeva, which just went public. The company is led by great entrepreneurs, backed by one of the best SaaS software investors and it has built an amazing business in a short time by leveraging the Salesforce platform. Veeva went public with trailing subscription revenues of $106 million ($168 million with professional services) and has a current market capitalization of $4.2 billion, or over 30x subscription revenues. Driving this is a rapid 54 percent year-over-year growth and a 20 percent profit margin.
If we look at the top 30 tech IPOs of 2013 to date, we see a similar pattern: Trailing revenue multiples of 10x to 50x+ for revenue growth of 70+ percent (adjusted for growth margin variations). Meanwhile companies with less than 20 percent growth command revenue multiples of 0.9x to 4.8x (higher still after adjusting for the low gross margins of several of these companies, including Chegg and Covisint). That’s a broad distribution and higher values in general than we have historically seen for most of the last decade, and it’s driven in part by today’s low-yield environment.
As the Fed has driven long-term rates to all time low levels — 10-year U.S. Treasuries yield 2.90 percent — investors discount future earnings from investment by a lower amount. The faster the growth rate of the investment, the bigger the impact the low yield has on the revenue multiple. The investment environment also matters since investors will discount future expectations more if they are more pessimistic. Today’s values do not reflect much pessimism.
This results in a big increase in valuations in both the public markets as well as the private market for growth equity capital, where high-growth private companies are raising money at values rarely seen before. Furthermore, the closer to a potential IPO that a private company raises money in the private market, the closer the multiple to the public market.
As an example, companies 12 months from an IPO typically raise money at a 50 – 65 percent discount to the anticipated value at IPO pricing. The IPO pricing is often expected to land between 60 and 50 percent of the post-IPO value if everything goes on plan. So an IPO expected to trade at $2 billion might price at $1 to $1.3 billion and investors might be willing to invest one year prior or less at $300 – $500 million valuations. The further the company is from an IPO and the more additional investment is required to build a scalable business, the lower the expected multiple/value. Nevertheless, given the return potential for a successful exit, private high-growth company valuations are at an all-time, post-2000 high.
Growth alone is not sufficient. Companies also need three other essential ingredients to command high values:
- Large markets: Large-market opportunities command large multiples. Small markets indicate that the growth will stop or, best case, slow as the company reinvents itself.
- Predictability: A track record of consistent growth is necessary to inspire investors to pay up for future performance.
- Scalability: Founders need to make the necessary investments to ensure the company scales as the revenue grow. This means seasoned management, IP or other entry barriers to defend margins and operational investments to grow predictably. While these items can be expensive, cheap capital is available for such investments.
Four actions founders need to take
What does this trend mean for entrepreneurs? Good news potentially. Here are four actions founders should consider taking to be better positioned in today’s high-growth market.
- Capital is cheaper now if you qualify. At today’s values many companies can raise money with little dilution, invest in growth and get a bigger reward for doing so than ever before. Founder action: Identify investments in your business that can accelerate revenue growth.
- Competitors also will have access to cheaper capital, which can put you at a disadvantage if they access capital and use it well and you don’t. Founder action: Be vigilant for competitors using capital to increase market share at your expense.
- Acquisitions can be an attractive growth vehicle for private companies. Small, low-growth companies/products with less experienced teams often can be acquired at low multiples. There is little liquidity for these companies since public companies and private investors are all chasing large, high-growth businesses. As a result, high-growth private companies can pick up low-growth products/companies for relatively little dilution. With a strong sales channel, the buyer can accelerate sales growth, leading to higher value and possibly a broader market opportunity. Founder action: Look for synergistic product additions to expand your market potential and accelerate growth.
- IPO exit values are primarily available for companies with current or near-term expected revenue approaching $100 million or more. If your market opportunity is large enough — $1 billion or more — raising capital to help achieve this scale commands high rewards today. Founder action: Develop your team, operations and business model to capture a significant (10+ percent) share of your available market.
The net result is that the rewards have never been better for developing a scalable, high-growth business — that’s the growth premium. If your company has high-growth potential, this might be the perfect time to raise capital or realize liquidity.
Javier Rojas is a managing director at Kennet Partners, a growth equity fund, and leads its U.S. investment activities. He is currently on the boards of Prolexic, Revolution Prep, AcademixDirect and Intelepeer. Prior to becoming an investor, he advised founders on high value M&A exits at Broadview and Morgan Stanley. Previously, Javier founded a software company that developed products for capital markets interest rate and currency swap traders.