As the Pandemic Subsides, the Financial Markets Continue Their Exuberance
At the time of writing in June, 2021, the industrialized world was well on its way to recovering from the COVID-19 pandemic. Aided by record fiscal and monetary stimulus, economies were roaring back from the pandemic-induced recession. At its harrowing worst in early 2020, the pandemic had carved 30% from the GDP of many countries; among the worst downturns in history. But by late 2020 and early 2021, with containment probable, the economy was rebounding, particularly in the financial sector.
Venture capital investments were setting new records, public technology company valuations were soaring, and even startup valuations were accelerating with too many new unicorns to count. Software companies were achieving tech valuations at historic highs, despite a slight pull-back in early 2021. SaaS companies had posted the best revenue growth in the software sector and were trading at the highest revenue multiples.
Amid this euphoria the capital markets, it was hard to appreciate the devastation cause by the COVID-19 pandemic. The virus has changed lifestyles, work styles, socializing, the economy and upset the way we live. It has accelerated the trend to remote work. When the pandemic hit in March 2020, literally overnight everyone was forced to work from home.
In large companies, managers had to throw out their manuals and learn to manage by delegation and empowerment. It was a difficult transition. Most workers relished their new-found freedom to set their own schedules and recover the time wasted in commuting.
Currently, as bricks-and-mortar offices come back online, many employees want to continue to work from home, at least most of the time. The balance between in-office and at-home work, with its secondary impact on housing and traffic, will take some time to achieve a new normal.
Virtual Companies Perform Better but No One has Noticed
Less noticed in the pandemic disruption has been the acceleration towards virtual, or fully-remote, companies. These are organizations where there is no physical head office and everyone works from home or anywhere they please. The savings on facilities costs, fixed assets, and related overhead are significant. Virtual companies are lean and agile and can scale quite quickly with much less capital infusion.
Lower costs, faster growth rates, and agile operations create a virtual business model very attractive to acquirers. As a result, virtual companies sell for money in an exit transaction. And the entrepreneurs who start virtual companies create more wealth for themselves because they are diluted less from external financing.
Strategic Exits is a boutique investment bank that acts solely to assist entrepreneurs in achieving the optimal exit transaction. In our practice, we noticed over the past several years that we were selling more virtual companies and they were going for higher prices. Our virtual clients also weren’t dividing the pie into small pieces; they were keeping more of the proceeds for themselves and their families.
Curiously, there was no research that we could find on the impact of virtual companies on valuation methods or the M&A process. Despite the wall-to-wall coverage in the media on remote work, and the detailed statistical analysis of tech company valuations, the game-changing impact of virtual companies had gone unnoticed.
A New Valuation Method for Virtual Companies
Prompted by our success in selling virtual companies for higher prices, and prior to the onset of the pandemic, we began to research the impact on tech company exit transactions from the trend to virtual companies.
We considered many factors which we had observed in our practice that impacted valuations of virtual companies and the distribution of the wealth created in a tech exit transaction. We developed the Founders’ Wealth Creation Formula which quantifies the financial advantages that virtual companies hold over their bricks-and-mortar competitors.
Founders’ Wealth Creation (FWC) = (EBITDA * Multiple – LP) * F * (1-T) – EC where:
FWC – Founders’ Wealth Creation is the amount of money the Founders take home when they sell their company,
EBITDA – normalized Earnings Before Interest, Taxes, Depreciation, Amortization and other non-cash charges to the Income Statement,
Multiple – the buyer determines the EBITDA multiple based primarily on the growth rate and also includes other quantitative and qualitative considerations,
Note that EBITDA * Multiple calculates the price that the buyer pays to acquire the company, or the Gross Proceeds,
LP – Liquidation Preference is the amount that a Venture Capital investor takes off the top before the proceeds are shared with the other shareholders,
F – the percentage of the equity held by the Founders,
T – the tax rate in percent paid to the taxation authorities on sale of the company,
EC – the exit costs to close the transaction paid by the Founders.
Presentation to Creative Destruction Labs course at UBC
We introduced the Formula in a presentation to the Creative Destruction Labs course on Entrepreneurship at the University of British Columbia Sauder School of Business January 23, 2021.
The presentation covers:
- the financial advantages of virtual companies over bricks-and-mortar companies,
- the derivation of the Founder’s Wealth Creation Formula,
- a financial comparison using the FWC to explain why:
- why virtual companies sell for more in an exit transaction,
- why Virtual company founders generate more wealth.
We also review the acquisition of a virtual company which recently sold for over $100 million in under 60 days which demonstrates these points.
More articles on advantages of virtual companies can be found on the Strategic Exits Partners blog. See also; our article on Fully Remote Companies: https://www.exits.partners/fully-remote-companies/