The Silent Valuation Killer - Stock Based Comp
The Silent Valuation Killer - Stock Based Comp
5/26/24 Benchmarks for Operators
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The Silent Valuation Killer
Stock based comp - what employees are paid through firm ownership - impacts company valuation. We just like to look the other way.
Quick refresher - Stock based comp is a non cash expense that shows up on a company’s profit and loss statement. A non cash expense means you record a charge on the P&L, but no cash actually leaves the building. It’s kind of like a theoretical hit you have to take when you report your financials. As a result, it increases your operating expenses and decreases your net income. And if you trace it all the way through, it makes your earnings and earnings per share go down.
The more stock based comp that’s rewarded, or the more shares that are given out, the more existing shareholder’s are diluted. Increasing the denominator means shareholders are entitled to a smaller chunk of whatever income is left over.
There’s been a recent shift where more and more public investors are thinking about share based comp as a real charge to run the biz. Call it a revelation of sorts!
If we were all being academically honest, we’d assume ~3% annual dilution and fully burden our valuation models for share based comp.
(BTW - here’s a primer on how dilution works.)
The impact of SBC dilution is significant over the long term. A company diluting its share count by 4% annually, compared to one diluting by 2%, could see a 20% lower valuation on a per-share basis over a 20-year period
I sampled 25 random companies for their SBC dilution in FY23:
Everyone chose to ignore SBC for a long time. It was like we were all in on the ruse. And it’s hard to put the toothpaste back in the tube.
“We’re at the point where if we started to include SBC we couldn’t invest in anything.”
-Hedge Fund friend I asked about SBC
You may counter that share based comp and free cash flow dynamics cancel out in the long term by way of share buy backs. That’s true.
In a perfect world, the company becomes MSFT or Oracle and can use all those fat stacks of cash to actually buy shares. Doing so reduces the denominator of shares outstanding, and entitles each shareholder to a bigger slice of the FCF pie. It’s kinda like reverse dilution.
But in my opinion, this is purely philosophical thinking. Not every company becomes MSFT or Oracle.
The lesson here: If you are an operator, you need to budget for equity grants just like you budget for expenses. While not a cash expense, it eventually becomes an expense that reduces your net income. And too much dilution makes you less attractive to prospective future investors. It’s like a silent valuation killer in the middle of the night.
And if you’re an employee, keep an eye on how many new execs your company is bringing on each year. Is there a lot of turnover in the C suite?
Perhaps the biggest impact caused by executive turnover is the brain damage it causes to the cap table. New CRO? While there’s only one in the building making decisions, you still have the impact of two on your cap table. So you better hope new execs improve the prospects of your company’s future revenue and profit generation, as they’re diluting your ownership.
TL;DR: Multiples are trending slightly DOWN week-over-week.
Top 10 Medians:
EV / NTM Revenue = 13.8x (-0.4x w/w)
CAC Payback = 23 months (flat w/w)
Rule of 40 = 54% (flat w/w)
Revenue per Employee = $379K (flat w/w)
Figures for each index are measured at the Median unless otherwise stated
Average, Median, and Top 10 Median are measured across the entire data set, where n = 116
All margins are non-gaap
You can find the list of companies within each sector here.
All definitions and formulas can be found here.
If you’d like the specific company level performance benchmarks used in these reports book a benchmarking consultation with 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 sectors 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 reports when they drop.
Historically, a 10x NTM Revenue multiple has been viewed as a “premium” valuation reserved for the best of the best companies.
Efficiency Benchmarks
Companies that 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.
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.
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. And I believe it cuts through all the noise - there’s nowhere to hide.
Revenue per Employee is calculated as: (TTM Revenue / Total Current Employees)
A few other notes on 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. I admit this is a “stricter” view, as it is measuring change in net revenue, rather than gross revenue additions pre-churn.
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, advertising, demand gen, events, 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.
Book a benchmarking consultation with them here.