NVTC is inviting members and industry leaders to serve as guest bloggers, sharing insights and information on trends or business issues relevant to other members. In his second post on the NVTC blog, Matt Rajput of CohnReznick shares his insights on new methods for valuing technology companies.

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As the IPO market continues to churn and with plenty of money on the sidelines, could it be that investors are changing their models for valuing a technology company?

In recent years, a company’s top line revenue and projected growth carried significant weight in attracting interest from investors as evidenced by valuation multiples of 5x, 10x, even 20x. However, we’ve recently seen that an increasing number of investors are taking a closer look at “marginal gross margins,” which is defined as a new dollar of revenue minus the cost of producing that revenue as the company grows.   Simply put, this measurement identifies the cost incurred in earning another dollar of revenue.

Calculating marginal gross margins has become a more popular method of calculating the value of a technology company because it is considered a cleaner look at operational efficiency, which is often challenging to measure in acquisitory companies that actively buy customers and market share to drive growth.  Some investors feel that buying customers and market share through acquisitions is not a favorable long term strategy for solid growth.  What happens when customers become more challenging to find and the next couple of deals fall through?

To me, it doesn’t make sense for investors to acquire a company that spends a dollar to earn a dollar in revenue, even if revenues increase by millions of dollars resulting in impressive top-line results.  A few months back, the $19B valuation of WhatsApp seemed outrageous to some, but when industry analysts began to dig deeper into the numbers, it came to light that WhatsApp had a very high operating gross margin. Coupled with its ability to grow as a cutting-edge technology, the sustaining membership revenue cash flow, and the sizable market cap, this valuation seems more reasonable.  WhatsApp passed the sticky test with flying colors!

Stickiness usually leads to higher gross margins.  The better that a technology company can become engaged with its current client base, the greater the opportunity for increasing gross margins and in turn the more positive an impact on the valuation of the company.  So, as an alternative strategy to building value, technology company decision-makers may want to think twice about buying that next customer or company and instead develop new and engaging products and services that contribute to the organic growth of their customer base.

If you’re a technology investor or a technology company decision maker, I’d be interested to hear your thoughts.

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Matt Rajput, CPA, is an Audit Manager with CohnReznick LLP and a member of the firm’s Technology Industry Practice. Working from the firm’s Tysons Corner office, Matt has eight+ years of experience servicing publicly-traded and closely-held companies in the technology sector and he routinely provides services to private equity and venture capital backed companies. Contact Matt at matt.rajput@cohnreznick.com.

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