Michael Szalontay is a Co-founder and General Partner at Flashpoint, an international tech investment firm.
“A firm can have value only if it ultimately delivers earnings.”—Aswath Damodaran
The problem with tech companies is the lack of clarity on future earnings. As these companies mature, their cap table expands with every financing as founders are joined by employee option holders, friends, family, angels and VCs. Every round provides a useful yardstick of value.
How do you determine the value between rounds, especially in the current environment where companies are forced to go breakeven to survive without raising new money for a long time?
Foundation Of Value
The value of a business revolves around its ability to generate sustainable earnings on its invested capital and the associated risk. Mathematically valuation is derived as a fraction, where future cash flows are divided by a discount factor representing risk.
A precise intrinsic valuation of a company requires an accurate prediction of future cash flows. Unfortunately, this is an impossible task for most tech companies while the business model is still forming. Even in the regular financial markets in a recent survey, 93% of equity analysts confirmed their preference for pricing using “a market multiples approach.”
Comparables Method
If you lack the data or time for a proper valuation, the alternative is pricing, which is more reflective of relative market value. A rudimentary way to estimate price is the comparables method utilizing a multiple of a comparable public or private company. For tech companies, the most relevant are price-to-net revenue or gross profit multiples, since often there are no profits yet, and the more customary EV/EBITDA and price-to-earnings multiples used in finance are not applicable.
The math behind comparables is also based on future cash flows. The problem with trying to compress everything into a multiple is that tiny input variances can create huge differences in the outcome. It shouldn’t surprise us then that tech companies can trade anywhere from 1.5x revenues to over 20x revenues.
Valuation Factors
As a manager of a direct secondaries fund specializing in tech, I have to get the pricing right. Here are some key factors to evaluate:
Revenue Quality
Recurring revenues usually in the form of subscriptions (like Netflix) come at a premium. Retention cohorts are key with net dollar retention being the leading indicator of quality. Transactional revenues coming from a marketplace model (like Uber) are worse, even though they are partially recurring.
Another dimension is whether the company is business-to-business versus business-to-consumer. Business customers tend to produce more stable revenues than consumers, and it’s also easier to grow the average check. The flip side is the long sales cycle and a smaller target addressable market size. In public markets, B2C companies usually IPO at slightly better multiples, but often perform worse post IPO.
Growth
Growth leads to higher value only if the returns generated by a company’s assets exceed its cost of capital. I cannot stress this point enough. While it’s important to understand the growth profile of a business, knowing the accompanying costs is paramount.
Profitability
In tech, the key measure is unit economics, which takes into account the discounted lifetime value of all gross profit from one customer and contrasts it with all sales and marketing costs incurred to acquire this customer. For B2B, 5x to 10x lifetime value/customer acquisition cost is excellent, whereas for B2C 2x to 3x is considered best in class.
Unit economics is the money-making engine of the business. This is where the quality of earnings and the risks really collide. For LTV, one needs to evaluate recurrence (frequency or orders, average order size, ability to upsell), churn, reactivation rates and useful life. On the cost side, understanding acquisition channels and the conversion funnel is critical, and don’t forget customer service costs.
A modern view of the problem combines the growth and profitability of software-as-a-service businesses into a single metric called “Rule of 40,” which is simply the sum of the annual growth rate and the free cash flow margin. Get into the top quartile of public companies on this metric, and your multiple will nearly double versus the average.
Business Risk
This is the hardest factor to properly assess. The key objective is to evaluate the impact of the competitive environment and the market dynamics on the sustainability of earnings and the long-term margin in the industry. Personally, I prefer to look at the value chain in the sector through the lens of Porter’s five forces.
Funding Risk
Many tech ventures continue to be loss-making for a long time even with good unit economics since research and development and general management costs are below the line of unit costs. This risk is measured in burn and runway. The relationship of total capital raised to valuation is also important. Fundraising can become tricky if you need to force investors to accept a loss in the process.
Capital Structure
Traditionally tech businesses are financed via equity, so debt rarely plays into the calculation. However, the cap table showing the equity structure for VC-backed businesses can be quite complicated with different share classes and a liquidation preference stack from the funding rounds. The overall size of the stack and your position therein may have a significant impact on your price. The only way to avoid a subordination discount is to be capital-efficient.
Discounts
Pricing smaller stakes in private companies requires taking into account other discounts as well, such as the illiquidity discount, which can be up to 30%, in my experience. Another type of discount is a minority discount, reflecting the price difference between buying a controlling stake in the business versus a position without any influence. The good news is that public valuations already take it into effect.
Recommendation
Even if you just want a quick pricing of your stake and not a full valuation, it is a complicated exercise requiring specialist knowledge. And yet, understanding the value can be crucial in managing your personal finances.
Nowadays you can use online tools to do the job for you, as long as you possess the necessary data about your company to arrive at an accurate outcome. Remember: Your stock will only have value if your company ultimately delivers earnings!
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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