Building a business that will be valued at high multiples

I’m going to talk with the board of one of our portfolio companies today about the characteristics of highly valued businesses and what they might do to get into that category, and my thoughts are below.  I only really started thinking about what I was going to say last night and this morning and I’m kicking myself for not publishing a blog post on the topic earlier in the week, allowing time for feedback and debate before I sit down with the company.  As it is my talk starts at noon and there will only be limited time for comments before then.  That doesn’t matter too much though as this is an interesting and enduring topic in its own right.

The first thing to say is that there is no magic short cut here.  Sure, some companies get lucky, but the only really reliable way to get someone to value your business on a high multiple is to be able to credibly argue that your business will soon generate significant and fast growing free cash flow.  Any business school text book will tell you that a business is worth the sum of its future cash flows discounted for the cost of money (Fred Wilson describes what that means in more detail here) and hence that is what public market investors look for when valuing companies and what execs at public companies think about when evaluating acquisitions.

In practice EBITDA is often used as a proxy for cash flow as it strips out the effects of any loans or other financing a company has which will most likely change when a company changes ownership.  Going forward in this post I will talk about EBITDA.

The two best ways to convince people that you will generate significant and growing EBITDA going forward are to be able to show in your financial statements that you have done so in the past, and by being an evidently well run company.  This last point bears repeating – new owners for a business will pay a premium for a business that is a well oiled execution machine.  The management of buy.at did a great job of always being very professional and of delivering great service, both to its customers and partners and to the ultimate acquirer AOL and I heard multiple times through the exit process that one of the things that made the company attractive was the perception that it was high quality.

Beyond these basics I think the trick is to build elements into your strategy which could underpin super growth for years to come.  Here are some examples:

  • be in a large market – ideally fast growing and/or undergoing a structural change that you are exploiting.  Our portfolio company Zeus Technology is on a roll at the moment because they are exploiting the shift from hardware in the $2bn internet traffic management market
  • fantastic product – any number of successful internet companies are good examples here – but I will pick out Playfish, they were able to command high multiples for their business from a very early stage because the product was demonstrably awesome, and were recently acquired by EA for up to $400m.  If your product is good enough that people tell their friends and marketing costs are low you will be in a particularly strong position.
  • high margins – an obvious one this, high margins equates to high profits and makes a business more resilient to shocks – I remember Credit Suisse telling me excitedly about how MoneySupermarket was valued very highly when they floated it in part because of its 32% EBITDA margin
  • strong and innovative brand – Zappos (acquired by Amazon for $900m) did a good job of this with their reputation for great customer service, and Apple is probably the best in class in this regard and partly as a result they yesterday passed Microsoft to become the largest tech business in the world by market cap despite being 25-50% smaller in profit terms over the last two quarters.
  • track record of successful acquisitions – many small(ish) companies bolster their growth timely acquisitions.  You’ve got to pay the right price though because the higher multiple you achieve will be on a smaller piece of the pie – our portfolio company Lovefilm is a good example of a business that has used M&A to good effect
  • build a massive customer base – even if many of them are not generating much in the way of revenue today if you can extrapolate from current trends to show that in the future conversion rates will improve and the profits will come then you will reap the rewards – Skype and Last.fm are probably the best example of companies to pull of this trick recently, and they were acquired for $1.5-2.6bn and $600m respectively, both with relatively modest revenues and extremely modest profits
  • focus on building the revenues first – history has shown that it is easier to improve margins than accelerate growth as a business scales, and hence fast growing revenues businesses showing minimal profits can attract good valuations – provided they can show that the margin improvement will come.  This was another thing that we did well at buy.at
  • make it difficult for others to compete with your company – for example:
    • track record of continued innovation
    • structural cost advantage
    • aggregation of large numbers of small business customers
    • aggregation of large number of small business suppliers
    • demonstrable network effects
    • significant know-how

Everything I’ve talked about so far focuses on a company’s own performance.  This post wouldn’t be compete if I didn’t mention one external factor – and that is fit with the strategy of a potential acquirer.  If they can see how plugging your company into their offering will either allow them to increase the sales of your product by pushing it to their customers, or sell more of their own products then they can pay high multiples of your stand alone business, sometimes extremely high multiples, because there are additional increases in profits to factor into the discounted cash flow analysis.

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  • Great post Nic. I would add having (significant) positive cash-flow… problem with EBITDA as measure is that the margin can mask negative cash-flow which can result in a significant working capital requirement for a “profitable” business particularly one that is growing rapidly. All else being equal a business that takes payment from debtors before paying creditors will always be more valuable than one where the reverse is true.

  • Another good one is for a business that has a very low fixed cost base with a very high proportion of its costs fully variable to sales.

    That way the business’s risk of not hitting sales forecasts can be somewhat mitigated and particularly so in the event of a down-turn.

    High fixed costs will kill cash if sales drop and usually a great deal of those costs will take a while to cut in the event of a prolonged downturn ie headcount / rent.

    This also makes the business a lot simpler to predict/model particularly across multiple scenarios.

  • And my last one… A balanced management team who are highly incentivised for the longer-term performance of the business i.e. are not going to leave as soon as the business is acquired. And that anyone that is going to leave (founder) is no longer critical to the performance of the business.

  • I would add – create/dominate a fast growing category. Twitter did that with micro messaging, Foursquare (still to be valued high, but definitely growing) with location, Apple with MP3s, Facebook with social networking, Microsoft with PCs (back in the days), Google with search, LastFM with personalised music streaming. Sometimes the domination starts just with focus, and drawing media attention all the time (look at Foursquare). To sum up – be a company that people talk about (in the new category) – not necessarily the one that is doing it best (in terms of product features etc).

  • FWIW, I would look at the combination of revenue growth and operating leverage.

    It's hard to deliver FCF growth off flat revenues (although it can happen in special cases). Crucially, these additional revenues should flow evermore easily down the P&L. This is were operating leverage comes in.

    An ideal investment would have a low correlation between variable costs and revenues. This is another way of saying the business model scales efficiently.

    All it means is that incremental revenues are translated evermore efficiently into FCF.

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  • Hi David – operational leverage is key to most startups, certainly most venture backed ones, otherwise they couldn't grow out of their losses!

  • Thanks for these Tom. Having a management team that want to stay with the acquirer is a good one. Taken to the next level some companies are very motivated to acquire by the individuals they will get. I remember that was the case with AOL's acquisition of behavioural targeting company Tacoda, which was a high multiple deal. Similarly Joanna Shields was part of the draw at Bebo.

  • Chris H

    Hi Marcin
    Really interesting comment about being the company that people talk about and not doing the product features best.

    I'm not so sure that works any more.

    One of the issues that I have with a number of “successful” companies of the last five years is that they were great at spinning a yarn and raising cash but at the end of the day they didn't execute well and so weren't adding value. Eventually you get found out!

    Its timely as I was looking at a company yesterday that is a B2B firm and they have just raised a big round and now have a full time comms manager. The CEO loves publicity and and I was surprised that for a twenty something person b2b firm there is room for someone just to “spin” full time.

    Chris H

  • Hi Chris – I agree with you. I tried to be very clear in the post that the first thing you need is profits and growth, after that a good story can add to your multiple, but you need the substance first.