Applying one multiple to varied revenue streams

I was advising a company on revenue strategy, and was surprised to see the exit target for which the exec team were aiming. It was… high. And they appeared to have convinced themselves it was plausible.

The valuation was based primarily on comparable transactions. I.e. they researched the acquisitions of other companies in the space, and noted down the prices paid as a multiple of those companies’ gross revenues. They calculated the mean multiple, and applied that to their own gross revenue.

There are plenty of ways to value a company. As a quick method, revenue multiples based on comparable transactions can be really useful. And in this specific example, the company’s Board and investors were encouraging them to think in terms of gross revenue multiples.

The problem was that the company had varied material revenue streams, but the exec team’s approach was to treat gross revenue as one number, and then multiply it. This had the merit of simplicity, but it was too simple. No serious prospective acquirer would fail to notice different revenue streams. And even superficial due diligence would expose significant variation in the volatility or risk profile of each revenue stream.

For businesses in which much or most of the revenue is annually recurring, a common approach is to calculate the ratio of annually recurring revenue to total revenue. For example, a SaaS business in which 80% of revenue is ARR, with the remaining 20% coming from one-off services. In that case, you might apply a different multiple to the ARR than to the services revenue.

However, in the case to which I’m referring here, there were more than two streams, and some of those streams had endured significant volatility through the preceding few years.

So, I broke out the four main streams, made some (stated) assumptions about each of them, and then applied a different multiple to each one.

One stream in particular stood out as at significant risk of decline, even, potentially to zero. I suggested the company apply a multiple of 1 to that stream, and consider the impact of a multiple of less than 1.

Of course, the whole exercise was a bit ‘finger in the air’, and it’s reasonable to assume a serious prospective acquirer would have used something more sophisticated in reaching a valuation.

Nevertheless, it was important because there was a huge difference in the valuations reached by the two methods. Of course companies want to present a bullish view of themselves to the outside world: it’s why vanity metrics exist. But, in this example, the ‘vanity valuation’ was bandied about internally.

This had consequences, not just in how, say, employees perceived the value of their own options, but also in how the product roadmap was structured, and which products were being prioritised. A set of mistaken assumptions about the company’s revenue strategy (and particularly its exit route) were impacting its product strategy.

There was a valuable lesson in this, and one which I always try to apply with my clients. Specifically, revenue strategy and product strategy are always connected. It’s inadequate to ask that product managers simply build ‘great products’, while insulating them from the commercial demands of what they’re creating. Where I see companies trying to dig themselves out of holes, it’s frequently because they lost sight of that intimate connection between revenue strategy and product strategy.