Tech stocks have been on a wild ride during 2022. Compared to 18 months ago, valuation premiums have taken a beating. The tech-heavy Nasdaq Composite Index is down nearly 30% from its peak during November 21.
Technology stocks have performed well post-COVID. High valuations in part have been fuelled by investors, such as hedge funds and corporations, ploughing more cash into the sector.
An excellent example of this is SoftBank's Vision fund which invested vast sums of cash into tech businesses such as WeWork, Uber, and Zume. SoftBank's model was to invest sufficient capital, allowing companies to grow market share (even at a considerable loss) to gain market dominance. Then, once it becomes the market leader, the business can switch focus to unit economics (increased prices) and overall operational efficiencies.
SoftBank's strategy and buying power has the effect of distorting the whole VC market, which followed SoftBanks lead by raising larger funds and offering start-ups inflated valuations.
CB Insights reported that start-up raises grew to $628bn in 2021, more than double that of 2020.
However, in the current economic climate, all that has changed, and the key value drivers underpinning a firm's value have fundamentally changed.
Can you still get a premium valuation for your business?
Yes, but the market has shifted from growth-at-all-costs to focusing on traditional value drivers such as profitability and cash flows. Therefore high growth businesses with no clear path to profitability have lost their prestige.
What are the drivers of valuation?
During this next phase - cash is king, and businesses with a healthy margin are back in vogue. Profitable, cash-generative software businesses are fundamentally better positioned to weather the macro backdrop. SaaS valuation multiples still apply. However, they are evaluated alongside traditional EBITDA valuation metrics.
However, it's not that simple. Software companies with solid growth but also higher margins and cash conversion will trade at premiums.
In the run-up to the current macro environment, interest rates were low, and there was a lot of cash. As a result, technology buyers and investors had the flexibility to take risks with their investment strategies.
What are the drivers of valuation?
During this next phase - cash is king, and businesses with a healthy margin are back in vogue. Profitable, cash-generative software businesses are fundamentally better positioned to weather the macro backdrop. SaaS valuation multiples still apply. However, they are evaluated alongside traditional EBITDA valuation metrics.
However, it's not that simple. Software companies with solid growth but also higher margins and cash conversion will trade at premiums.
In the run-up to the current macro environment, interest rates were low, and there was a lot of cash. As a result, technology buyers and investors had the flexibility to take risks with their investment strategies.
In the current climate, this has reversed, and there is a far greater scrutiny on tech businesses to justify valuations.
What are buyers and investors focussing on?
Here are a few things that are important to buyers in the current climate.
Organic Growth
Many factors contribute to business valuation, but organic growth is often one of the most important. Simply put, organic growth is a company's sustainable growth through its own initiatives rather than through acquisitions or other external factors. While achieving organic growth can be challenging, it is generally seen as more valuable than other forms of growth because it signifies a healthy and resilient company.
Furthermore, organic growth is often a key driver of profitability and shareholder value. In other words, companies that can sustain organic growth are typically more valuable than those that cannot. As such, any business owner looking to maximise valuation should focus on driving organic growth.
In the current climate, growth, future growth and how sustainable this is, are critical. In other words, companies that can sustain organic growth are typically more valuable than those that cannot. As such, any business owner looking to maximise valuation should focus on driving organic growth.
In addition, the market size, competitive landscape (sector competitiveness) and market share are important.
Quality of Earnings
Profits are undoubtedly important, but they aren't the only metric you should focus on. Quality of earnings (QoE) is just as important, if not more so. Quality of earnings measures how much of your profits are coming from sustainable, recurring sources. In other words, it's a way of assessing your business's strength in the long run.
In the current climate, acquirers and investors have greater scrutiny of a company's earnings quality. Therefore as a business owner, this is a key value driver. After all, sustainable profitability is the key to lasting success. There are several ways to assess your quality of earnings.
One is to look at your recurring revenue streams. If a large proportion of your profits come from one-time sales or one-off events, that's not necessarily bad. But it does make your business less stable and more vulnerable to external shocks.
Another way to assess the quality of earnings is to look at the costs associated with earning those profits. For example, suppose you're relying heavily on paid advertising to bring in customers. In that case, that will eat into your profits and make it harder to sustain your business in the long run. So, when looking at your bottom line, don't just focus on raw profit numbers. Make sure you're also considering the quality of those earnings. It could make all the difference for your business in the long run.
Value generating M&A
One of the most common ways for companies to grow is through mergers and acquisitions (M&A). This strategy can help forms quickly expand into new markets, consolidating a company's position and increasing market share. Additionally, M&A can be an effective way to acquire new technology or talent, boosting a company's competitiveness.
When executed correctly, it can help companies to achieve their long-term objectives. Historically business could often be credited with additional business value through the investment case. However, investors are looking harder at how acquisitions impact overall growth and profitability. In addition, well-integrated M&A and synergies are now essential value drivers. As a result, leaving acquired businesses standalone (un-integrated) is generally not seen as best practice and can lower a business's valuation.
International growth
Investors want a business that can be grown internationally. This makes the market bigger and proves that products or services are more resilient as they apply to a greater diversity of needs.
Exit Readiness
In the current macroeconomic backdrop, the phrase being increasingly used by acquirers and investors is "be prepared". In other words, be prepared for an exit. Specifically for executives and business owners, this means:
a) Having a growth plan. Companies with a plan and those demonstrating they are and have historically delivered against it are well positioned to realise a premium valuation.
b) Have key metrics to hand: Acquirers will expect businesses to be able to report accurately:
Revenue by customer type
Annual Recurring Revenue (ARR)
The sales pipeline and probability of closing prospects.
The revenue cycle
Focus on these metrics at the time of a deal is too late to impact value.
Additional considerations
Any business executive knows the key to a successful company is its employees. After all, it is the employees who are responsible for carrying out the day-to-day tasks that keep the business running. For this reason, executives must create an environment that encourages employees to do their best work. This means providing opportunities for growth and development and fostering a culture of collaboration and innovation. When executives take the time to invest in their employees, they are ultimately laying the foundation for a strong and successful company.
Following COVID and "the great resignation", where there is a trend of voluntary mass resignations. Possible causes include wage stagnation amid rising cost of living, long-lasting job dissatisfaction, the desire to work for companies with better remote-working policies."
Compounded by a knock-on shortage of skilled labour, investors are starting to scrutinise a target's "People Proposition". A people proposition is an employer's way of saying what they can offer employees to attract and retain the best talent. This includes competitive salaries, flexible working arrangements, good benefits, and a great work-life balance. A people proposition is fast becoming a mission-critical part of any employer's strategy.
The Green Agenda
In today's business climate, more and more companies are recognising the importance of demonstrating their commitment to environmental responsibility. Consumers are increasingly concerned about the impact of their purchases on the planet, and they're looking for brands that share their values. What's more, studies have shown that millennial consumers are particularly passionate about supporting sustainable businesses. As a result, investors are looking to acquire companies that can demonstrate they're taking steps to reduce their environmental impact.
Conclusion
In summary, market conditions have made investors more risk-averse. Post-COVID, we've seen tech company valuations rocket. Still, as the macroeconomic conditions have changed, valuations have cooled, and valuation priorities have changed. So while premium valuations are still viable, businesses must work harder to demonstrate they are worthy.
Therefore business owners and executives must now focus on:
1. Sustainable organic growth and profitability.
2. Demonstrate the profits are coming from sustainable, recurring sources.
3. Well executed M&A, tighter integration and synergies.
4. Demonstrating their international growth potential.
5. Key KPIs and business planning.
In addition, there is now greater scrutiny by acquirers on:
a. The business's people proposition.
b. The firm's green credentials
Lighthouse Advisory Partners: Strategy Consultants for the Tech World.
As a premier strategy consulting firm, Lighthouse specialises in empowering tech companies to chart clear paths toward growth and enhanced value. Our expertise in growth strategy consulting, mergers, and acquisitions advisory makes us the ideal partner for businesses aiming to navigate the complexities of the tech industry. Let us guide you to your next horizon of success.