I recently helped a friend broker the sale of his small, bootstrapped company.
This is a smart guy with experience and a logical approach to such things, but the way he was initially trying to value his company was not only wrong, but the wrong way to think about the entire sale.
So, once and for all, I’d like to share my own perspective on how this works.
Many people start by looking at “the Multiples.” They’ve heard rules of thumb like “A growing software company is worth 5 times their trailing 12-months revenue.” I’ve also heard “10x profit.”
Trouble is, there’s such wide variation in these multiples that they’re effectively useless. When selling Smart Bear I had an M&A guy pull data about other companies which (a) sold development tools, (b) were sold recently, (c) were profitable, and (d) were growing. Even narrowing the field as much as feasible, revenue multiples varied between 1.2x and 9x. Profit multiples varied even more.
(The “Multiples” argument does work well in industries where company’s growth and revenue is highly predictable. For example, a laundramat has a well-known set of expenses and assets and can grow only so large. Or a company like Zappos (who was famous, growing, and profitable) still got only a 1x sales valuation when bought by Amazon because of thin margins. As another example, there are standards for valuing professional services firms (e.g. accounting, law, design) where the mechanisms for revenue and profit are well-known. This article assumes we’re talking about a volatile industry like software or emerging markets where almost nothing is “well-known” and company trajectories are all over the map.)
Most discussions on valuing companies try to find a “single truth” about what the company is worth, trying to combine things like growth, profitability, multiples, market penetration, etc., but this is flat wrong, as the failure of the Rules of Multiples demonstrates.
Instead, the first thing to realize is that there are two completely unrelated pieces to the sale: the buyer and seller. Each have particular goals, rationale, risk-factors, and yes, emotions. When there’s an intersection between what each is willing to accept, there’s the chance of a sale.
By considering both sides separately, it will become clear how each will “value” the sale, and therefore whether there’s overlap, and therefore what the sale could look like, if anything.
Let’s start with the buyer. What does the buyer want with your company? There’s many possibilities, each of which will cause a different valuation of your company.
To stoke an existing sales channel.
We entrepreneurs love ridiculing big companies for their inability to innovate, and we’re right. But one thing they do have is a “channel,” meaning an established pipeline wherein a product can be pushed (often by salesmen) into customer’s hands. Maybe it’s because the customers trust the company, maybe it’s because they’re obliged by contract, maybe it’s because there’s a powerful marketing machine behind it… whatever the reason, it’s there.
But exactly because big companies cannot innovate, they can’t create new things to cram into the channel, which means it’s hard to generate new revenue. That’s where acquisition comes in — if you can’t make it, buy it!
They value your company based on how much money they believe they can get from their channel. Notice what I didn’t say: They don’t value your company based on your existing revenues or growth. That sounds silly — after all, you’d reason, won’t they get both their channel value and the customers you’ll get “on your own?” Actually, no.
Channels are often measured in the billions of dollars. Even if you’ve managed to scrape together ten million dollars of revenue over the past five years, that’s still just a drop in the bucket, irrelevant, not worth their time. They need to know that they can turn it into $100m through their channel, and do so quickly, like in the next 4-8 quarters, so they get a nice bump on their bottom line and, ultimately, their share price.
In fact, it’s rare that just putting your software into channel alone will be enough! They need to know that they can sell more of their existing product line because your product is in the channel. Often a salesman hasn’t been able to land “the big deal” with a particular customer, but with the introduction of your product — very likely thrown in for free — the customer is now ready to buy. Complex and indirect I know, but a common case.
So the value of your company in this scenario is: How much of their existing software — because of yours – can they sell through their channel? And that’s a quantity that’s almost impossible for the seller to compute! (Yet another reason why the two interests must be considered separately.)
To control a market.
Why did eBay (an online auction house) purchase Skype (an online telephone company) for two billion dollars before Skype had one cent of revenue? The answer sure doesn’t have anything to do with revenue multiples!
They wanted to control Internet telephony, and Skype was the clear winner. Control equals money.
For small companies, “controlling a market” won’t be as grandiose as “telephony,” but it’s still control of something. Salesforce.com recently bought Heroku for $250m because the latter controlled fully-managed Ruby on Rails deployments. Taking a smaller example (I can’t reveal numbers), Smart Bear bought a little company because it controlled the market of small- to mid-sized development shops who wanted “just enough” product lifecycle management.
Buyers know how to estimate the value of controlling a marketing they can’t otherwise attack and how badly they want to be the only ones playing in that space, but sellers rarely know.
To remove competition.
What’s your first thought when you hear that Whole Foods (the largest organic-centric grocery chain) bought out NaturalEats, a local organic food store? Mine is: To eliminate competition.
It happens all the time, in software as much as anywhere else. Sometimes it ends up improving the big company — Whole Foods in particular is known for incorporating good ideas from the stores they purchase, and in fact sometimes don’t change the names and branding of the existing stores.
Which makes sense. It’s not necessarily about destruction, it’s about ownership. It’s about not having competition, whether by conversion or just putting everyone’s revenue in the same pot. The main thing is: a competing franchise didn’t win.
To hire key employees.
Google is famous for snapping up teeny two-person pre-revenue startups for a million dollars. Why would they part with so much money for what is often a completely dead-end so-called “company?” Because Google values talent and is able to spend as much as they want to get it. If those founders are sharp, if the technology they built is impressive, if their entrepreneurial spirit is part of a culture Google wants to cultivate, then it’s rational! In fact, it might be one of the only ways to get people like that to join a big company.
In this case, all the typically-valuable things like “multiples” or intellectual property or the customer base or the product-market fit or the market size are irrelevant.
To “build” a product.
If you have a product that seems to work, and if a big company wants a similar product, the big company has two obvious choices: Build it themselves, or acquire it from you.
Fortunately for you, everything’s more expensive at a big company. A new product needs a product manager, a project manager (I still can’t remember the difference), a team of developers, QA folks, tech writing, sales training, support training, and legal review. Something that took you and your co-founder a year to build — even with those 80-hour work weeks — would take them ten man-years to replicate.
On top of that is lost time. If they buy the product they can start selling it almost immediately. Otherwise they have a lot of planning and hiring to do before the project has a decent velocity, which could take 6-18 months.
On the flip side, entrepreneurs are an unknown quantity which typically doesn’t fit well into corporate culture, so that will inevitably come to a head. Also the product probably won’t match existing company standards, neither in the user interface, the design patterns underneath, the technology it’s based on, etc..
So it’s not a cut-and-dry decision, but it’s clear how your company will be valued primarily: The cost of acquisition + re-culturing versus the cost of build-from-scratch.
It’s boring so it’s not covered in TechCrunch, but there are monolithic entities chartered to acquire companies with defined characteristics: Industry, size, growth, revenue, etc..
Sometimes the goal is to find “turn-arounds” which can be had at a discount, then fixed and flipped. Sometimes the goal is to find cash-generating companies that look like they can continue to generate for a decade. Sometimes it’s akin to a mutual fund or hedge fund or even VC fund in that they’re rolling the dice for a chance at a big return.
Sometimes this is literally a VC or private equity firm who, rather than investing in brand new companies hoping for the rare, massive multiple, invest in well-established companies where the upside multiple is lower but so is the risk.
Here the financials and circumstances of the company are indeed more important than in the other scenarios, but there’s still other forces at work. For example, depending on whether they’re just starting a new fund or running out of time on an existing fund they might be under more or less time pressure to get deals done.
Applying this to selling your company
The take-away point is that buyers have lots of reasons for acquisition, and few of them relate to basic company financials or your existing customer base. Of course the scenarios above are just examples; there are others, and often it’s a combination of factors.
So when you’re faced with selling your company, step away from the numbers and ask: Why is this particular buyer interested in me?
Answer that question, understand their motives, and you’ll get your arms around how they’re valuing your company. It’s key for negotiation because it sets a price range and defines what the buyer won’t compromise on. Or it might just point out that the deal isn’t going to work.
The other half: The seller’s angst
There’s two equal but separate concerns, and we’ve only addressed the buyer. Next week in Part 2 I’ll delve into the seller’s perspective, in which we’ll still find financials, while important, are trumped by simple human needs.