Throughout my tenure at Microsoft, I’ve spent much of my time engaging with partners discussing strategy and how to best maximize profitability. Often times, this leads to the topic of valuation and what to expect when the time comes to sell the business. Whether you’re nearing retirement, a serial entrepreneur, or just starting out, it’s good to understand what elements will shape the value of your company and how to prepare for when that moment comes.
We’ve all seen the headlines of sky-high valuations being offered for some of the well-known brands in the technology sector, but what does that mean for our channel and how do we translate that into our space? As part of our efforts around Cloud SureStep, we recently invested some time with a Canadian VC, Vanedge Capital, to help us make sense of it. Their perspective was incredibly interesting and I would like to share some of the high-level points here via a three-part blog.
Before we get into the details, however, it’s important to first center on the valuation multiple itself. While there have been transactions measured as a multiple of revenue, these are typically used to describe transactions for companies that investors consider to be market creators (Facebook or Concur, for example), rather than those who fall into the categories of early adopters or early majority. In these cases, revenue multiples are often leveraged due to the heavy early investments being made in branding, product development, marketing, and sales, causing operating margin to be low. The most common metric used outside of these pioneering companies is Earnings Before Interest, Taxes, and Depreciation (EBITDA). This is a better proxy as it provides a clearer line of sight into the health of the business and how profitable it is and is a more common and relevant measure for most members of the partner ecosystem.
From our research and the insights shared with us among the analyst and investment community, members of the channel with a strong cloud focus can expect to see these in the range of 5 to 8 times EBTIDA. This is compared to the historical ranges that pre-date the era of SaaS, PaaS, and IaaS of 1.5 to 3. The key point here is that companies tracking toward leading with the cloud and building ahead of the curve are being rewarded. The cloud now not only drives a greater profit margin, but a greater multiple. These figures serve only as a starting point and can vary depending on how your business is structured, the health of your balance sheet, and how you stand against some other key variables.
With that in mind, Vanedge outlined ten of these key areas of consideration for acquisitions or investing in a cloud-based entity. These aren’t necessarily the only pieces; rather, they are among the ones considered most commonly across many transactions. These ten can then be aligned to two areas: the increase levers or those pieces that help to drive up the valuation multiple, and the discount factors that drive it back down.
For our first installment of the series, I’m going to focus on the two variables that really start the conversation: revenue growth and gross profit. In the cloud, revenue growth is a completely different equation due to the way in which the annuity model builds revenue. In the past, the market would often consider 20-25% growth to be strong, but in this new era, the bar for what many investors consider to be “good” has accelerated to over 50%, and we’re now seeing a fair number of partners exceeding that.
The driver here is no secret, it’s the recurring revenue model. It’s what has made Office 365 the fastest growing business in the history of our company. For us, this has been attributable to product revenue while for highly successful members of the channel experiencing this type of growth, the drivers have come from what they attach to it – managed services and packaged IP.
When talking with partners about their future strategy, I’ll often ask questions such as the following:
How are you thinking about building your own annuity stream outside of the Microsoft Online Services?”
What pieces such as delegated administrative support, infrastructure helpdesk, proactive IT systems management, SharePoint templates, CRM Online vertical/workflow IP, etc. are you providing?
How can projects you’ve done in the past where you’ve built what could be considered a custom solution provide value to other clients, and can you package that up and resell it as an annuity? I like to call this “funded R&D” where one customer pays for your project services while the others consume it as an annuity.
Understanding how to develop these lines of revenue is where the aggressive growth rates really kick in. As more of this revenue moves toward the subscription model, the snowball effect begins to take over. For example, let’s say that half of your revenue comes from the subscription services I mentioned above. If you can effectively manage churn, it’s easy to run numbers showing how you can develop hyper-growth rates — $1 in revenue is $0.50 in booked revenue and so on.
With that said, it’s also important to focus on where this revenue is coming from. By this, I mean that not all revenue sources are created equal. Each of the four major lines (product, project services, managed services, and packaged IP) produces a varying level of gross margin, and for this reason, it’s critical to think beyond just the product resell. As you move up the value chain, project services can deliver higher returns – depending on what type of projects the partner is delivering, what products they’re building on, and the operational maturity of their consulting practice. Where things start to get really interesting are in the areas of managed services and packaged IP. Most partners with mature IT offerings today realize gross services margins twice that of resellers, and even better yet, those with strong productized IP offerings can see three times the gross margins.
These are often the two areas suitors will begin with – what is the current growth rate of the business, and what proportion of revenue is coming from the higher margin lines. These serve to help define the near-term potential of the company and its long-term ability to turn a profit.
So, how does this translate into your approach? Are you attaching value-added services and IP to generate subscription revenue of your own? If so, what proportion of your total income comes from these sources, and what are your plans to increase this over time?
As I mentioned above, this is the first installment of a three-part series. Next week, we’ll cover the topic of specialization and the importance of standing out. In the interim, if you’d like more information on this topic, I’d recommend spending time reviewing the Cloud SureStep site with particular focus on the section on Maximizing Shareholder Value.
As always, we welcome your comments and feedback.
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