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Valuations: Why Revenues Matter...But Only Sometimes

Posted by Micah Tapman on Jul 30, 2018 2:46:19 PM
Micah Tapman
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One of the black box mysteries I am often asked about is valuation of a company during an investment. As I've been preparing for a presentation I’m giving at the MJBizInt’l conference in Toronto next month, I’ve been thinking about a common aspect of the debate - the importance of revenues.

Revenues come up often when debating the valuation of a prospective company. Undoubtedly, the conversation turns to a discussion of the company’s “multiples” as a way to compare investments to one another. 

Before we get too far, let’s take a second to review what we mean by multiples.

Multiples are simply ratios used as shorthand to better understand how one company’s valuation compares to another. We can’t simply use the numbers (i.e., the dollar figure) because different companies will vary widely in dollar figures while still costing the same.

For startups, the common ratios used include the revenue multiple (valuation/revenue) or profit multiple (valuation/profit). Also used, though less frequently, is a valuation/gross profit ratio, as well as other similar variations based on P&L line items. Whichever is used, all are intended to help the investor clearly see the price of the opportunity.

However, investing - particularly in startups - is an inherently uncertain business. The very companies we’re investing into are uncertain. They have virtually no historical data from which to draw, and by definition they are disrupting or inventing something new.

Projections are a fool’s errand, best used to evaluate the relative optimism of the person behind them.

And yet, that question, “What’s the revenue multiple?” will arise in every conversation as we search for certainty. Of course, it is human nature to look for certainty in the uncertain. Psychologists (and now behavioral economists) often point out that humans are constantly looking for patterns and stability even when there is none. These methods of valuation are just another example of trying to make sense of something uncertain; however, investors should be careful not to rely too heavily on multiples when determining valuations. 

I fully acknowledge that it’s fair to look at money when we’re talking about investing for profit. However, I think the very discussion of revenue when working with start-ups is a misunderstood issue that often leads to confusion and missed opportunities.

Simply put, startups don’t know what they are doing – or rather - don’t know what they’ll be doing tomorrow. Right now, what they are doing is figuring out their future. Would we ask a college student how much they currently make before determining if they are likely to succeed? Would we judge a baseball prospect by how many All-Star games he’s already been selected for? No, because we understand that both the student and the prospect are still learning and developing.

We look instead to other metrics to determine their probable success. In other words, we look to leading rather than trailing indicators.

Investors should do the same with investment opportunities. And while those leading indicators may include some consideration of revenues, there are many other factors of equal, if not greater, importance. Personally, I like to view revenue as one proof of product-market fit, simply demonstrating that someone wants to pay for that product or service. Combine that with churn, CAC, and determine LTV, etc.

So, what ARE the leading indicators investors can focus on instead?

First, investors ought to start with data on the team.

  1. How big is it?
  2. How many of the team members could easily find good employment elsewhere but choose to be here?
  3. How many unique skills are available across the team?
  4. How long have they been together?
  5. How many strategic connections does the team bring to the table?

Another easily measured variable is technical agility.

  1. How many iterations of the product has the team produced in the last few months?
  2. Have they completed a major upgrade?
  3. Have they successfully outsourced a project?
  4. Have they successfully completed a pilot with a strategic customer?

Each of these, along with many other similar variables, help the investor to compare the business with other opportunities and come up with an accurate and holistic valuation. In short, these variables will give a better indication of how the team is positioned to achieve success. And they’ll be more accurate in comparing deals than an analysis of a tertiary variable. Remember that the determination of a “good” price will only be complete when you cash out your shares, and that’s dependent not on a single line item like revenue but on a host of variables.

Of course, I’ll close by saying if revenues are strong it’s probably not a bad idea to pay attention...hell, someone else thinks this thing is worth paying for! 

Topics: Analysis, Investing, frontier markets, valuations, valuing investments, startups