Assessing a tech company

As I promised, let’s get back to writing ☺. I was talking the other day with the owners of a software company in Romania about “how to assess a software company”. So let’s write a little bit on this topic, without claiming to go into details.

1. Multiple of EBITDA. We look at similar companies that have a public valuation (given by that company’s listing or by a recent transaction) and we find out that their value is set at “10 times the annual profit”. In other words, a sort of “I give you 10 times what you earn this year”. There are some specific multiples for each industry, with 10 being a number that is pretty close to reality. This method is mostly used by financial investment funds that look only at profitability tables. It is used for companies that reached maturity and for which “the future growth” element is not very important.
2. Multiple of Revenue. Very similar to the previous method, only that what we compare is Revenue and not EBITDA. It is useful if the company has not yet reached maturity, but it has paying clients. A fair number is somewhere around “3”, assessing somehow that the average profitability of a software company is 30%.
3. The company’s previous valuation. In other words, if there was a previous investment round in which someone not involved (preferably a VC or Angel unrelated to the entrepreneur) placed money based on a valuation, this valuation is taken as such and it remains to quantify what has been built since. This can be a good argument if you managed to receive a great investment in the past and now you want to force a larger sum. The essential counter-argument here is “but why doesn’t the previous investor give his money now?” You are in a very good situation if the previous investor also places some money in the valuation that you wish, saying that he cannot give more and that you are looking to complete the sum. For an exit, of course, the discussion is a bit simpler.
4. The amount of money already invested. You can come and say “I have invested 1 million, so the value of the company is 1 million”. It depends here on how efficient you were – this method can sometimes be useful to you and other times it can be useful to the buyer.
5. A very interesting method, used especially in Silicon Valley, is based on the number of developers. If you have no other arguments, if you only have a product, no money and no clients, you can try to roughly assess the company based on the number of devs. An American valuation (I’ve never seen this in Europe, let alone in Romania) is between 500,000 and 1,500,000 USD per developer. If you take an even wilder guess, you can say that each dev is a million dollars. Don’t jump to say “it’s like selling people”, because it is just a way to assess a company; people are not actually bought :-). And don’t fool yourselves into thinking this works elsewhere than in SV. And even there, don’t try to cheat the system by hiring meaninglessly; it doesn’t work :-).
6. Number of subscribers. Used mostly for telecom companies and recently for SaaS – generally useful to assess any company that has recurring revenue from a large number of subscribers. The number can be used either with a multiplier that is specific to the industry, or with ARPU (Average Revenue Per User).
7. Replacement Value. How much would it cost the person who buys you to create what you give him? This helps a lot if you are selling a company from Romania, created in your own home with low costs, to a big company in the States, with very high costs for development and for operation. You can add here costs related to “time-to-market” and other opportunities.
8. Net Present Value (NPV).This method can probably give you the best value for the company. It means you have to be able to present a believable plan for the next 5 years that can show how much you can earn next year, two years from now etc…, then to discount future profits according to a formula (that you can also find in Excel – NPV) and find out what the net present value of future profits is. The problem with this method is that it will always be contradicted by a potential investor or by a buyer who will always come to tell you why you won’t be able to do all the things you talk about in the plan. Generally, they have more experience that you do in this type of contradictions. What’s more, the negotiation process might extend up to a year and it might become visible with the naked eye that you are not within the plan’s parameters 🙂
9. To any of these methods you can add the value of potential patents that the company developed. Relevant patents can be quantified around the area of 1,000,000 USD, while “by the pound” patents can be valued at about half of what it costs to apply. So pay attention when you decide to apply for a patent.

Other ideas I’d like to discuss in this context are the following:

It’s good to know exactly what happened and what is happening with the values of companies from the same industry as you, to know their multiples and the arguments used for their valuations. And, in the end, it’s good to know in what valuation area each of the methods above applied with the index in the industry places you. It’s also good to get an idea about the “fair” value of your company, built from a mixture of these methods. Of course you’ll try to get the highest value possible, but it’s good to build your expectations as closer as possible to reality.

To each of the methods above (and there might be more that I missed now), “fine tuning” values that you should be aware of and use if necessary are added or subtracted. Patents represent one such element; Corporate Governance is another one; then intellectual property protection; the quality of key-people and their wish to remain in the company; the proximity to open source (it’s good or bad, depending on the context); licenses; partnerships and so on. All of them must be taken into consideration and built brick by brick in the overall construction of the story you want to sell.

The interesting thing is that the methods above will provide very different values for your company. Probably between 1 and 10; in other words, there is a difference of at least an order of magnitude between them. The one who is buying will try to convince you to accept valuation methods closer to option 1 (multiple of EBITDA), which generally gives the lowest value, being also the most conservative method, not taking into consideration any potential bright future. At the same time, you will want to go to a 7 or 8, which give the highest values. And you will have to prove that you know a lot about this kind of negotiation. Anyway, in case of a real deal, all these assessment methods are just a pretext for discussions. The final value will be given by the negotiation power of the two parties, and the deal is closed only if there is a number that is acceptable to both contenders. We’ll talk some other time about the theory of the first acceptable compromise.

It’s useful (especially if we are talking about larger sums) to hire a company to handle the investment or sale. The Investment Banker (IB) is the one who can master much better than you can all these techniques and methods, and he also has access to market information. It’s not shameful to say you are not good at this and let others do the work. Usually you will come out on the winning side. However, pay attention and gather references about the IB 🙂

It’s phenomenal if you manage an auction – here the IB can help a lot. The auction may increase the price very much if you really have a value that can be speculated.

Last but not least, the price in money is not the only element that is up for discussion. Other elements can make the difference: guarantees, non-compete, payment method, money vs. shares, earn-outs etc.

And, after all, the right value is the one for which the buyer is willing to pay and the seller is willing to sell.

(English version by Teodora Popescu)