Leaders of larger companies are under intense pressure to grow their valuation by hitting aggressive revenue, margin, and EBITDA targets. Acquirers pay a valuation premium on recurring, high-margin, and high-growth product revenue. However, the metrics most companies use (ROI) fail to capture the impact on valuation, causing leaders to make choices that slow their valuation growth. That’s where the Valuation Index can help.
A Quick Primer On Valuation
Valuation in this context is the dollar value an acquirer would pay to purchase a company. A simple approximation of valuation is a Multiple (M) of either Revenue (R) or EBITDA (E). M is a market-driven number determined by the “flavor” of the company’s income. Run-of-the-mill consultancies in stagnant sectors tend to get low multiples. Rapidly growing Software-as-a-Service (SaaS) startups have high multiples.
Valuation = R*M OR R*E
A better approximation of Valuation appreciates that a larger companies have many different Revenue (R) streams. For instance, a modern consultancy might have: SaaS (S), one-time fees for use of a software Tool (T), and Consulting (C). Each of these has their own Multiple (M).
Valuation = (RS*MS) + (RT*MT) + (RC*MC)
The Limitations of Standard ROI
Most Return On Investment (ROI) metrics are excellent for measuring an initiative’s impact on a company’s operations. Example: if a salesperson is expected to generate $1 million/year in sales and cost $100k in salary & benefits, the ROI would look to be about $1 million/$100k or 10x.
The challenge is this doesn’t take into account the desirability of that particular flavor of revenue to acquirers. If they sold $1 million of…
- Widgets with a 10% profit margin, that would mean the salesperson was basically just paying for themselves. An acquirer would likely not value this at all.
- Widgets with a high profit margin, but low revenue growth would have some value.
- Widgets with high margin and rapid growth in sales would be of medium interest.
- Subscriptions to a rapidly-growing software platform would be valued very highly indeed because they are high-margin and relatively predictable.
The Valuation Index
The Valuation Index measures the impact on a company’s valuation for every dollar of investment. The formula applies market-driven Multiples (M) by the different types of Revenue (R).
- SaaS (S): Recurring subscriptions for access to an application that are high-margin, require minimal labor, and generate predictable future income. Multiples tend to be high.
- Tool Use (T): One-time payments for access to software during a project. This is also high-margin and requires low-labor. Multiples tend to be moderate.
- Consulting (C): This is a catch-all for labor-intensive service revenue. Such revenue is low-margin and can only scale with increased headcount. This is hard, expensive, and offers diminishing returns. Multiples tend to be low.
Once you start applying this metric to competing initiatives, it can make decisions clearer.
- Growing consulting/services, while often the thing a consultancy is most comfortable doing, generates the lowest score because it requires scaling up expensive, hard-to-recruit & retain talent.
- Adding one-time payments for use of software during projects scores moderately well because the software requires little labor.
- Creating subscription offerings that clients use before, during, and after a consulting engagement scores by far the highest because the company keeps on making money 24/7/365, usually for years with relatively little cost of sales or support.
The concepts outlined here were co-developed with Jeremie Spitzer.