March 13, 2022 revised January 15, 2023
This article discusses the popular business valuation methodologies for valuing tech companies:
- Discounted Cash Flow
- EBITDA times Multiple
- Revenue times Multiple
Discounted Cash Flow (DCF) approach
DCF is the time-honoured approach which you can find in every textbook on valuation. It is the most credible for mature companies because it uses the historical actual cashflows as a predictor for the future.
But few tech companies are predictably profitable, so the methods based on multiples described below are more appropriate.
Definition and Use of EBITDA
EBITDA is the Earnings before Interest, Taxes, Depreciation, Amortization, Stock-based compensation and other non-cash charges to the income statement. EBITDA is normalized to remove one-off expenses or income that won’t recur after the buyer purchases the business. Normalized EBITDA is essentially the cashflow of the company without all the non-cash adjustments required by accounting principles.
To use this method, the company calculates its normalized historical EBITDA for the trailing twelve months (TTM). It then multiplies TTM EBITDA by a multiple appropriate for that business.
This method works well for companies with a history of growing or predictable earnings because it uses numbers that are more reliable than attempting to forecast future performance in a volatile industry like tech.
EBITDA Distorts Performance of Early-Stage Tech Companies
There is a more fundamental problem for tech companies using EBITDA as the valuation factor. The EBITDA method penalizes companies which are investing today to grow over the long term at the expense of lower current earnings. The TTM results are likely to be lower than if the company was managed to conserve cash and boost earnings. The EBITDA multiple approach only works for later stage companies where the company is managed for steady-state performance
Lastly, there are no rules set in stone in the technology industry for the using an EBITDA multiple to value the company. Multiples can oscillate widely reflecting the buoyancy or misery of the M&A market at that time. For example, multiples for software companies can soar to 30x when markets are confident but settle into a range around 15x when markets are calmer.
Revenue Multiples for Enterprise Software
Revenue Multiples Most Applicable
Of the three valuation methods, the revenue multiple method is applicable to a larger number of companies. In this section, we will examine the use of the revenue multiple method for enterprise, or on-premise software. The revenue multiple method for Software as a Service (SaaS) companies is discussed below.
To use the revenue multiple model the company first calculates its trailing 12-month (TTM) revenue. The TTM is multiplied by a revenue multiple reflecting the overall performance of the company.
Using revenues as a base of valuation solves many problems. Revenues are the most reliable number because they are at the top of the income statement and are therefore less subject to adjustment based on the company’s accounting policies. So, buyers can better trust the numbers. The revenue multiple record measures the performance factor that early-stage technology companies are most focused on: revenue growth.
Using revenue multiples, companies are not penalized for investing in product development or rapid revenue growth which reduce current enrings for long term growth. As a result, revenue multiples can be applied to virtually any technology company which has sales revenue.
Many Factors Affect the Revenue Multiple
The revenue multiple is adjusted for a myriad of valuation metrics. The most important variable, as noted, is the growth rate. A high growth rate generates more value for a tech company than any other factor as it has the greatest impact on the revenue multiple. However, the revenue multiple is affected by many factors other than the growth rate, including:
- Gross Margin: for a software company, a gross margin of 75% or better is expected. Lower than that will penalize the multiple.
- Predictability of revenue and earnings: If customers are dependent on your software for critical operations, then valuators are reassured that the customers will renew and the revenue stream will continue. Lower risk earns a larger multiple.
Software as a Service (SaaS) companies are discussed in a separate section below.
- Sustainable competitive advantages: As is the case with any company, if your business model has an advantage which you can protect from your competitors through:
- unique well-developed technology that cannot be easily replicated,
- products that are deeply imbedded and difficult to switch away from,
- regulations that require your services to be in compliance,
- or other “moats” which discourage competitors
then, your company can better fend off competition, leading to a higher multiple.
- Customer concentration: If your revenue is dependent on a few large customers, then you are vulnerable if they leave or extract concessions to remain. Usually, you don’t want any one customer to represent more than 10% of your revenue stream.
- Partner reliance: On the supply side, if your business is dependent on partners continuing to provide critical technology or access to channels, then you are highly vulnerable.
- Market size and structure: The larger the total available market (TAM) the more opportunity for growth and the higher the revenue multiple. But if your software targets a niche or vertical market then the market may be limited. Similarly, if the market is well-served already, your growth depends on stealing share. Multiples are lower for companies in smaller markets or competing for market share.
- Capital intensity: if growth requires heavy investment in sales, marketing, infrastructure, etc., then your software business generates less return on investment which reflects in a lower multiple. Alternatively, a new breed of fully remote companies is agile, easily scaled, with minimal facilities and overhead costs. As described in our Fully Remote Company posting, fully remote companies earn much higher multiples for these and other reasons.
- Strength of the team: A motivated, experienced team is better able to react to unforeseen events and opportunities. This increases the predictability of results which would be reflected in a higher multiple.
Different Types of Revenues
Another simple business valuation method for enterprise software companies is to segment the revenues by type, as each type has its own characteristics and revenue multiple:
Revenue Type Typical Multiple
- Recurring revenues (revenue automatically continues) 5x
- Annual Maintenance and support (typically 15% of a perpetual licence) 3x
- Perpetual software licenses (licence sold once for perpetual use) 3x
- Professional services revenue (e.g. installation, training, etc., non-recurring) 1x
- Ancillary hardware and other low-margin products (non-recurring) 0.5x
These multiples can be adjusted based on the company’s specific position, as described above.
Revenue Multiples for SaaS Companies
Software as a Service (SaaS) companies charge a monthly or annual fee to rent the software to customers on a continuous basis. Instead of receiving a large up-front licence fee, SaaS companies receive a smaller recurring fee each month, which over time, generates greater revenue.
Young SaaS companies must invest heavily in development and marketing prior to earning revenues. A new practice has evolved to evaluate SaaS companies in the early stages when they are losing money. Their performance across several parameters determines their long-run profitability which is then reflected in the SaaS revenue multiple.
Considerations specific to SaaS
- Customer Acquisition Costs (CAC) – total sales and marketing expenditures divided by the number of new customers
- Payback (CAC / (MRR * GM%)) – the number of months required to recoup the cost of acquiring the customer
- Churn rate – the percentage of customers or revenue lost per month or year
- Long Term Value (LTV) (Revenue * GM% / Churn rate) – gross margin expected to be generated by a customer over its lifetime of purchases
Performance Metrics and Thresholds for SaaS Companies
The tech industry has evolved these rules of thumb for SaaS companies:
- LTV / CAC > 3 – If a company earns a lifetime gross margin at least 3 times the cost of acquisition, it is well positioned
- Payback < 12 months – similarly, if a company can recoup the cost of acquisition in less than a year, it is performing well.
Churn Rate is an important performance indicator but difficult to benchmark. Churn rates are highly volatile depending on the industry, varying from 5% per year to 5-10% per month. Smaller companies have larger churn rates.
In summation, there are 3 main methods to value technology companies:
- Discounted Cash Flow – almost never used
- EBITDA Multiple – good for companies with a track record of positive earnings
- Revenue Multiple – good for all technology companies which have begun sales, with specific parameters for SaaS companies.
Please link to the companion article: How to Value a SaaS Company.
Detailed Review of the Discounted Cash Flow valuation technique:
The Discounted Cash Flow valuation technique is the standard method for valuing profitable companies with an operating history and somewhat predictable financial results. It is rarely used in the tech industry as many tech companies are not profitable, and have volatile results. For completeness, here is the DCF process:
- Forecast the cash flow or Adjusted EBITDA for as many years as it can be reasonably estimated into the future; i.e. CF1, CF2, CF3, … CFn;
- Discount each annual cashflow by the cumulative discount rate, i.e. CF1/(1+r), CF2/(1+r)2, CF3/(1+r)3, … CFn/(1+r)n
- Calculate a terminal value (TV) of the company in year n based on the formula:
TV = CFn * (1+g) / (r-g) where:
- CFn is the cash flow in year n
- r is the discount rate
- g is the company growth rate in cash flow
- Calculate the Net Present Value (NPV) of the forecast discounted earnings stream and Terminal Value using r as the discount rate;
i.e. NPV = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + … + CFn/(1+r)n + TV/(1+r)n
- The Net Present Value is the value of the company.
While DCF delivers reasonable valuations for mature companies with predictable earnings and comparables to benchmark the variables, it does not provide good valuation metrics for high growth technology companies. Here’s why: DCF requires the estimation of three variables:
- future cashflows: CF1, CF2, CF3, … CFn
- growth rate (g)
- discount rate (r)
The uncertainty of DCF calculation is the compounded risk of all three of these estimates, each with a range of uncertainty. For a high growth tech company, compounding the three uncertainties leads to a range of possible NPV calculations so wide as to be meaningless. For this reason, DCF is not used often as a business model for valuing high growth tech companies.