July 6, 2016
A common question many startups have is what valuation multiple should they expect for their company. Multiples are commonly used to calculate the value of a company and are generally calculated as a ratio of enterprise value divided by earnings; a higher multiple would lead to a higher valuation. The chart below summarizes recent transactions of North American private tech companies and their wide variation of multiples.
In general, the variation in multiples observed is a result of the quality of the earnings in the company and the forecast of future earnings, which is dependent on a few key factors.
- Growth rates – Higher revenue growth rates serve to boost the future profitability of the company and can indicate the strength of the market being targeted.
- Gross margin levels – Gross margin levels impact the profitability of each revenue dollar generated by the company. Higher profitability will result in higher revenue multiples.
- Customer churn rate – High switching costs and customer lock-in boost predictability over future revenues.
- Marginal profitability calculation – Low incremental costs related to new customers will allow growth to have a significant impact on earnings.
- Customer concentration – Diverse customer base ensures less dependency risk versus reliance on one or two major customers.
- Sustainable competitive advantage – Ability for competitors to easily provide a comparable product.
- Presence of network effects – Network effects result in increasing customer value as the customer pool increases (e.g., Facebook).