Financial Fluency: Understanding Valuation

Giff Constable finance, private equity, product management

If you want a strategic seat at the table as a product leader, you need to have an intimate understanding of how product metrics turn into financial metrics and business value. This post is an attempt to help more product managers understand the connection their work has to finance and, in particular, business valuation. I’ve got a few cautionary tales thrown in, and I’m going to start with one right now:

Company X had a successful Internet marketplace but their growth had slowed. The CEO tasked a product/innovation team to come up with a new revenue stream. They came up with an idea and early experiments showed great promise. The company ramped up investment, customers were happy, things started to grow, and it seemed like a smash success. Then the rug got pulled out and the project was suddenly cancelled. The team was in shock.

Why did this happen? Answer: the company was going to get sold. The new business was growing quickly but had much weaker gross margins than the parent company. The bigger it got, the more it risked making the company worth less, not more. The project got nixed. Customers were disappointed. The team involved was crushed to see their hard work and passion wiped away in an instant, all because not all revenue is equally valuable.

I commonly hear aspiring product leaders say they need to increase financial savvy. That’s a very broad term. If we break it down, there are really three big buckets of “financial savvy” one needs to understand:

  1. Accounting terms like EBITDA (defined below), capex/opex, gross margin; which ones matter most for your business; what drives them (a statement which feeds into the next two).
  2. Key business metrics, often more specific to your business than generic accounting measures; the interrelationship between the different metrics; how leading product indicators translate into lagging financial results.
  3. Company valuation — in other words, what your company is worth

For this post, I want to dive into #3, but before I do, a few tips on the first two:

For #1 (accounting terms), get some basics down with online research. If you need to bolster your confidence first (yes, you too can get fluent this stuff), read Tommi Forsstrom’s intro piece. Tommi also recommends this book and I’ve heard good things about this class from Harrison Metal. After that, go talk to your CFO or, if they’re not accessible, someone else knowledgeable and reasonably senior in your finance department. They will know the financial levers for the business and can explain which ones are particularly important and why. Don’t be intimidated! They will be pleased that someone outside of finance is taking an interest in the money-side of the business.

For #2 (key business metrics), there are a ton of useful resources out there, especially for SaaS businesses (here is VC David Skok’s). This world is awash with acronyms (LTV/CAC, MRR, NDR, etc) but don’t let that put you off, nor the fact that there aren’t universally agreed upon calculations for these items. Once again, you’ll want to understand the interplay of key metrics and financials that are specific to your business, and for that, someone in your finance (or data/analytics) department is a great place to start. By understanding these dynamics, you’ll supercharge your ability to model the impact of your ideas. This is an essential skill to rise to leadership, because corporate boards prefer to communicate in spreadsheets more than screenshots.

The rest of this post focuses on company valuation, since I’ve seen fewer resources out there for product people.

Why is Valuation Important to Understand?

Certainly in tech, the value of a business determines the financial rewards to its owners. This is because most companies don’t make their shareholders wealthy through profit distributions but rather through selling some or all of the business. If you go public, the stock market sets the worth of a company. For everyone else, it’s a bit murky.

For this reason, the equity/asset value of your business will constantly be in the minds of your CEO and board. Your decisions can and will affect this. If you want to be a strategic decision maker, you need to know how.

How does product connect to valuation?

How the product is designed, delivered and priced makes or breaks a company. Your prioritization decisions can help or hurt revenue cyclicality, predictability, and concentration. They can help or hurt margins. Thus you have a direct influence on the valuation of the business.

How do you figure out how much a company is worth?

Academic theory says that you derive the current value of an asset by discounting future cash flows to the present. The reality is that most businesses aren’t bought and sold this way.

In truth, there is no intrinsic value to a company. As an investment banker many years ago, I learned that we could justify just about any valuation for a business. Like anything, it’s worth the amount someone else will pay for it. Value is in the eye of the beholder and it’s very influenced by both competition for a deal, the macro state of the economy, and how badly a seller needs to sell. It comes down to supply and demand and negotiating power. That said, there are fundamentals that create likely zones for where a business will be valued.

Because value is in the eye of the beholder, it’s also worth understanding the different buyers and what they generally care about (for those interested, I’ll touch on that further down).

I’m going to simplify things, but there are two ways businesses are usually valued:

  1. a multiple of the revenue of the business
  2. a multiple of the EBITDA of the business. EBITDA = earnings before interest, taxes, depreciation and amortization. EBITDA is considered a decent measure for the true operating profits of a business because you put aside the debt on the business, what the government takes, and non-cash accounting treatments.

Cautionary Tale #2

Company Y was a successful SaaS business. They had quickly grown to $75M ARR (annual recurring revenue) with 85% gross margins. They raised a few hundred million in VC along the way at a high valuation (30x their revenue). But then growth started to slow. In an attempt to boost revenue, they sold some large enterprise deals that each required a fair amount of custom work (this boosted revenue, but it was services revenue, not software). They also tried to grow inorganically with a few acquisitions that proved challenging. They were still growing but much slower and their gross margins had dropped from 85% into the low 70s. Buyers/investors decided this was now a business that should be valued on EBITDA, not revenue.

At $75M in revenue, if they had been able to maintain that 30x multiple, they would be worth $2.25B. Even if investors had decided to continue valuing them based on revenue, but brought them closer to earth with a 10x multiple, they would still be worth $750M. Instead, with EBITDA margins of 20%, at a (very friendly) EBITDA multiple of 20x, they were now worth $300M.

Their valuation had dropped by over half.

On Revenue-Based Valuations

High-growth tech businesses are often valued on revenue, not least because they are often intentionally unprofitable in order to fuel growth. In my time as an i-banker at Broadview/Jefferies, I saw deals with multiples that ranged from 1x revenue to infinity (selling pre-revenue companies with really hot intellectual property).

If a company is valued on revenue, the multiple is decided upon by a few factors: (a) the multiples that other, similar businesses (called “comparables” or “comps” for short) were purchased at; (b) the growth rate and attractiveness of the specific business (potential future margins, intellectual property, etc); and (c) the amount of competition for the deal. Bankers will often also look at how similar public companies are trading, but the disappearance of middle-market public companies has made this a weaker approach (treating a multi-billion dollar company as a comparable to a mid-sized company is a real stretch). Still, it can be useful for you to go look at how some public companies in your general space are trading. See footnote #1.

To be valued based on revenue, you need certain characteristics. The two big ones are high growth and high gross margins (at or above 75%). Another historical attribute of software companies is their costs are operating expenses (mostly expensive labor) rather than capital expenses (think expensive manufacturing equipment or buildings).
This has gotten confusing and blurry in this age of hybrid “tech” companies which have a lot of hard assets. We’ve seen a lot of drama where high profile startups have been treated as revenue-multiple businesses by private investors, only to have the public markets say, “not so fast.”

Here’s some things that make revenue more valuable (worth a higher multiple):

  • recurring / predictable nature
  • strong growth
  • high gross margins (think: more like software than services)

Here’s some things that make revenue less valuable:

  • volatility / cyclicality during the year
  • concentration on a few key customers
  • weak margins
  • high levels of churn
  • excessive customer acquisition costs

Cautionary Tale #3

Back in my banker days, I ran a transaction selling a business process outsourcing (BPO) company. They had built proprietary software that allowed them to use (and scale) much lower-cost labor to do a complex task. They had very little cyclicality (good!) and they had good distribution of revenue across many customers (good!). They were hoping to be valued as a software company in the 4x or 5x revenue range. Buyers weren’t having it. There was still labor involved in delivering the service (thus lower gross margins and in theory more complexity in scaling), so buyers were aiming more at 1x to 1.5x revenue. If I remember correctly, the company was about $30M in revenue, so that was the difference between a $30M valuation and a $150M valuation. It was only through a competitive process that we got the valuation above 2.5x. Thankfully, one buyer just wanted them really badly.

On EBITDA-based Valuations

Businesses outside of the software industry are typically valued as a multiple of EBITDA, but as you saw in Cautionary Tale #2, even software companies can fall into this approach. EBITDA multiple ranges usually spread from 4x EBITDA to 15x EBITDA. The smaller the company, the lower the multiple (smaller = more risk in many buyers’ minds), and of course the weaker the company or the less competition for the deal, the lower the multiple. PEs generally know what a business will “trade for” just based on a few simple financial metrics. Surprisingly (to me anyway), the industry a business is in often matters much less.

A SaaS-specific Point: rule of 40

If you’re in SaaS, there is another point to consider as you weight the kinds of initiatives you might take on. Within SaaS, there is a rule of thumb that a good business lives by the “rule of 40” — that growth rate and profit margin should add up to 40% (see Brad Feld for more color, or google “rule of 40”). The closer a business is to this, the more competition there will be to buy it, and the better the valuation.

Let’s Talk Buyers For a Sec

Since value is in the eye of the beholder, it’s worth touching upon typical buyers. There are two large buckets of buyers out there, so called “strategic” and “financial” buyers. Strategics are other companies who are buying your businesses for reasons above and beyond pure financial returns. For example if you look at Apple or Google’s acquisitions, they are trying to expand into a new market, buy a team or capability, and/or snag some intellectual property. Usually strategics buy entire companies. If they take a minority stake, it’s often a precursor to buying the whole thing.

Financial buyers are investors, and today this typically means private equity (PE – called “private” because they invest in companies that aren’t traded on a public stock exchange). PE comes in many shapes (see footnote #2), and while it can get blurry, they shouldn’t be confused with venture capital. PE funds invest later and expect lower returns but on more of their portfolio, while VCs needs huge returns on just one or two in their portfolio. Another key difference is PE’s use debt to boost returns (see footnote 2).

Several decades back, strategics usually outbid (paid more) financials, but that started to shift in the 2000s, and these days it is often the reverse.

These days, my guess is for most businesses that are going to get sold, more than half, if not 75%, of the potential buyer list will be PE. An exception is really hot, early-stage companies or hard-core R&D businesses.

Why is this relevant?

Because PEs make up such a high percentage of buyers these days, what they like/dislike has a strong impact on the ability to get a good valuation. If your company has unappealing elements (see the list above as to good/bad revenue), you’ll be under pressure to fix them. PEs will usually be more sensitive to gross and EBITDA margins than a strategic; strategics have a lot more options as to how to integrate or change the shape of your business (or simply, if they are much bigger, they can absorb your flaws without making a dent in their financial ratios). PEs also care more than strategics about other topics like: the ability to successfully absorb additional add-on acquisitions, having a defensive moat of some kind, and having a strong leadership team intact. The first two can be very influenced by a strategic product leader.

Unlike VCs, PEs also care a lot more about profitability and cash flows because they need the business to be able to support interest payments on debt (footnote 2).

In Conclusion

As a product leader, for example, your answer to these questions (and more) can have a significant effect on valuation:

  1. How does your product, pricing model, and target market(s) combine to stress (or balance) growth versus profit margin?
  2. How does product/pricing/market improve the predictability of revenue?
  3. Do you have the right portfolio balance of optimizing/maintaining your main revenue lines versus growing new income streams?
  4. How can technology be applied to improve gross margins?
  5. Do you have issues with cyclicality/seasonality and, if so, what can you do to diversify?

Don’t sit there wondering why your company seems to making decisions on the above. Don’t get caught out like the innovation team at the start of this post.

Don’t wonder which financial metrics matter most to your CEO and CFO. Go ask. They’ll be glad you care.

If you are aware of the desires and pressures the CEO and board is feeling, you will be able to pick up on those signals, understand them, and help solve them. That’s the only way to be a partner at the highest level.

This overview is far from perfect, and it might leave you with more questions than answers. That’s not a bad thing. If you want to improve your financial fluency, asking questions and doing your research is the name of the game.

Thanks to Tommi Forrstrom, Daniel Pardes, Melissa Perri and Simon Riker for comments on an early draft

Footnote 1: “Enterprise Value”

If you want to understand the kind of multiples tech companies trade at in the public markets, go to Yahoo Finance, type in a stock ticker, and click on the link for Statistics. You’ll see a list of metrics, including “Enterprise Value / Revenue” and “Enterprise Value / EBITDA”. What is enterprise value? It is the market capitalization of a company (which is, at simplest, shares outstanding * stock price), PLUS the debt on the business, minus the cash. This is a confusing concept.

The best analogy is one I was given as a young i-banker: you’re buying a used car. Let’s say the car itself is worth $10K. It so happens that this car still owes $2K to the bank. Also, in the trunk of the car, there is $1K in cash. Both of these items are coming with the car. So, if you were to pay the owner, you would lower the price of the car by the debt you’ll now be taking on, and you would raise the price by the extra cash in the car. Thus you would pay $9K (10 – 2 + 1).

When you look at a stock price, the stock market has already done this math and baked in consideration for the debt and cash. The market cap is equivalent to the $9K for the car. So to arrive at the truer value of the “enterprise” (just as if you wanted to know the true value of the car), you need to deal with the debt and cash on the business. You reverse that math: you ADD the debt and subtract the cash. 9 + 2 – 1 = 10.

You use EV when dealing with financial measures before balance sheet elements have been applied (i.e. interest payments on debt, depreciation and amortization), thus when working with revenue, gross profit, EBITDA. You use market cap when looking a multiples of net income or EPS.

Footnote 2: Private Equity

Private equity come in all shapes and sizes (there are thousands of players in PE). There are dedicated funds, family offices (where the wealth of a really wealthy family is professionally managed by a dedicated team), and so-called ”independent sponsors“ who raise the money for a transaction on a deal-by-deal basis. Some PEs only buy controlling (majority ownership) stakes in businesses, some only minority, and some will do both. Many buy companies across all industries, while others specialize. Some only like buying companies in healthy shape, while others love fixer-uppers. They often stick to a certain size of company.

PEs often use debt to improve their returns. To oversimplify in an attempt to illustrate: say you bought ACME Co for $10 and later sell it for $20. If you didn’t use debt, your return would be 200% (20/10). If you borrowed $5 for the initial purchase, with an additional $1 owed in interest, your return would be 280% (14/5)).

Top image from Sahand Hoseini on Unsplash