The turbulent markets of 2022-2023 and volatility in the M&A environment has brought the topic of valuation to the forefront in many of our discussions with founders and investors.
Regardless of market ups and downs, the factors that are most impactful to valuation remain relatively constant, with some standards changing with market cycles as witnessed over the past decade. Safe to say, valuation continues to be both art and science.
Allied Advisers put together this article as a refresher on some of the most important valuation factors in the current market for technology companies; we hope our report also services as broad guidance to founders, executives and investors in achieving an optimal valuation outcome for their business.
It is often said that valuing a business is more an art than a science. Another assertion is that
valuation is in the eye of the beholder, akin to beauty. There is truth in both these statements since
enterprise valuation is impacted by several variables, not all of which can be quantified, and
perception of future prospects of a business can be quite different depending on the biases of the
evaluator.
Regardless of this sense of mystery and fuzziness about valuation, there are several fundamental
factors that influence the value of a technology business.
In this article, we cover five important elements that have a distinct bearing on the valuation of technology companies, noting that many of these factors apply to businesses in other sectors as well.
1) Scarcity in a Large Market
A business that is the only player, or one of just a few players, in a large end market is likely going
to be seen as being valuable since there are limited substitutes for the scarce solution offered by
that company. It is simple supply-demand dynamics – when there is clear demand for a product in
short supply, the price of that product goes up.
2) Significant Differentiation from Competitors
Often referred to as “USP” or unique selling proposition, differentiation of a technology business is
important to valuation since it creates scarcity and sets the business apart from its competition.
Differentiation may come from unique product features, ability to address challenging use cases,
performance metrics, superior UI design, ease of deployment and use, economic value to the
customer (time to value, ROI), etc.
3) Growth vs. Profit Margin and Rule of 40; Capital Efficient Growth
In the frothy market prior to COVID that eventually peaked in 2021, hypergrowth was the mantra
for technology companies. Businesses that grew at breakneck pace with no heed to bottom line
profitability attracted nosebleed valuations in private funding rounds. A popular performance
measure of software companies called Rule of 40 (revenue growth rate + profit margin > 40%) was
highly biased towards revenue growth; companies that grew at 100% with -50% operating margin
(R40 metric = 50%) were highly valued due to their growth, albeit with poor profit margins, easily
attracted capital.
4) Revenue Model and Gross and Net Revenue Retention Metrics
Business models typical to technology product/platform companies are subscription, licensing or
transactional. Subscription models provide recurring revenue (monthly or annually), licensing is
usually a one-time fee, and the transactional model provides revenue per transaction.
5) Customer Profile and Concentration
Companies that have large enterprises as customers are more likely to be able to expand revenues
from such clients given the numerous groups within large organizations and bigger budgets for
vendors. In contrast, having small/medium (SMB) customers limits the opportunities for large
contracts and wallet share expansion given limited budgets. For these reasons, companies with an
enterprise customer base have traditionally been viewed more favorably by investors compared to
businesses serving SMB clients.
To read the full report, click here.
Ravi Bhagavan is a Managing Director at Allied Advisers