The “Execution Risk” Angle to Valuation

3/24/24 Benchmarks for Operators

Bold claim (screw it, wish me luck!) - I’m pioneering a new category - Operator Equity Research.

My goal is to create the best valuation and performance benchmarks specifically for tech operators. If you are in Finance, Strategy, or Operations, this will help you translate what the outside world values to your target operating model.

The “Execution Risk” Angle to Valuation

I was speaking with a friend who’s a growth stage investor (Series A through C) this past week. Regarding valuation he told me:

“The big disconnect we often have with operators is understanding what the metrics mean for them. People often point at the public comps when they’re a $5M to $20M ARR business, which is nonsensical… you can’t expect people to give you the same credit as a business that’s 10x your size with the same metrics.”

What he was getting at is the inherent execution risk in betting you can achieve that scale… and also still have the same margins and growth rates. It’s really hard to get to that size. It takes time + timing + execution + luck. And all that needs to be priced in.

Is it a 3x multiple discount? 4x? IDK. But it’s not nothing.

Achieving a 130% net dollar retention rate at $250M in revenue with 50% annual revenue growth is MUCH harder than doing it at $25M.

Plus, the vast majority of businesses whiff on the forecasts they put in their pitch decks. Seriously - almost none actually do what they say they will do. So the investor perspective is that price needs to be adjusted for the level of perceived risk. It’s not a precise science, but that’s how investors think about it.

• Figures for each index are measured at the Median

• Average, Median, and Top 10 Median are measured across the entire data set, where n = 151

• All margins are non-gaap

• SMB is defined as average customer size below $100K in annual revenue

• Enterprise is defined as average customer size above $100K in annual revenue

• You can find the list of companies within each index here.

• All definitions and formulas can be found here.

• If you’d like the company level performance benchmarks used in these reports visit Virtua Research.

Revenue Multiples

Revenue multiples are a shortcut to compare valuations across the technology landscape, where companies may not yet be profitable. The most standard timeframe for revenue multiple comparison is on a “Next Twelve Months” (NTM Revenue) basis.

NTM is a generous cut, as it gives a company “credit” for a full “rolling” future year. It also puts all companies on equal footing, regardless of their fiscal year end and quarterly seasonality.

However, not all technology verticals or monetization strategies receive the same “credit” on their forward revenue, which operators should be aware of when they create comp sets for their own companies. That is why I break them out as separate “indexes”.

Reasons may include:

• Recurring mix of revenue

• Stickiness of revenue

• Average contract size

• Cost of revenue delivery

• Criticality of solution

• Total Addressable Market potential

From a macro perspective, multiples trend higher in low interest environments, and vice versa.

Multiples shown are calculated by taking the Enterprise Value / NTM revenue.

Enterprise Value is calculated as: Market Capitalization + Total Debt - Cash

Market Cap fluctuates with share price day to day, while Total Debt and Cash are taken from the most recent quarterly financial statements available. That’s why we share this report each week to keep up with changes in the stock market, and to update for quarterly earnings releases when it’s time.

Historically, 10x NTM Revenue has been viewed as a “premium” valuation reserved for the best of the best companies.

Efficiency Benchmarks

Companies who can do more with less tend to earn higher valuations.

Three of the most common, and consistently publicly available, metrics to measure efficiency include:

• CAC Payback Period: How many months does it take to recoup the cost of acquiring a customer?

CAC Ratio is calculated as: (∆TTM Sales * Gross Profit Margin) / TTM S&M

CAC Payback Period is calculated as: (1 / CAC ratio) *12

Note: Some may measure CAC Payback using the change in last quarter’s revenue x 4, but I believe this overstates a company’s progress if they are growing fast, and the output can be volatile due to quarterly sales seasonality. That’s why I look at it on a Trailing Twelve Month Basis.

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• Rule of 40: How does a company balance topline growth with bottom line efficiency? It’s the sum of the company’s revenue growth rate and free cash flow margin. Netting the two should get you above 40 to pass the test.

Rule of 40 is calculated as: Total Revenue Growth YoY% + Non Gaap Operating Profit Margin %

Non Gaap Free Cash Flow is calculated as: Net cash provided by operating activities, minus capital expenditures and minus capitalized software development costs.

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• Revenue per Employee: On a per head basis, how much in sales does the company generate each year? The rule of thumb is public companies should be doing north of $450k per employee at scale. This is simple division.

Revenue per Employee is calculated as: (TTM Revenue / Total Current Employees)

A few other notes of efficiency metrics:

• Net Dollar Retention is another great measure of efficiency, but many companies have stopped quoting it as an exact number, choosing instead to disclose if it’s above or below a threshold once a year. It’s also uncommon for marketplaces and fintechs to report it at all.

• Most public companies don’t report net new ARR, and not all revenue is “recurring”, so I’m using annual change in TTM revenue timeframes as a proxy in my calculations.

Operating Expenditures

Decreasing your OPEX relative to revenue demonstrates Operating Leverage, and leaves more dollars to drop to the bottom line, as companies strive to achieve +25% profitability at scale.

The three most common buckets companies put their operating costs into are:

• Sales & Marketing: Sales and Marketing employees, contractors, marketing programs to drive pipeline, conferences, tools

• Research & Development: Product and Engineering employees, development expenses, tools

• General & Administrative: Finance, HR, and IT employees… and everything else. Or as I like to call myself “Strategic Backoffice Overhead”

All of these are taken on a non Gaap basis and therefore exclude stock based comp, a non cash expense. SBC is still an important figure to track for total comp and dilution purposes, though.

All benchmarking data provided by Virtua Research.

For assistance with your own benchmarking and equity research needs, contact cventi@virtuaresearch.com.

Tell him CJ sent you; he'll hook you up!"