A founder’s guide to understanding the five key areas considered during a valuation.
If you’re thinking about finding a new home for your business, understanding how buyers land on a valuation is pivotal. Valuation is rarely a figure plucked out of thin air. It is a structured assessment of your business across several key areas. Knowing how that final number is calculated will help you prepare the information needed and have more productive conversations about selling.
And, even if you don’t decide to sell, it’s hugely valuable for planning purposes and to understand how your business would be valued.
Let’s review the five key areas that you should consider:
1. Revenue quality and recurring revenue
Not all revenue is created equal. Your buyer will carefully analyse what types of revenue your business generates, not just the figures themselves. Recurring revenue, particularly annual recurring revenue (ARR) is considered more valuable than one-time lump sums or ad hoc project income. ARR proves predictability and therefore reduces the risk for your potential buyer.
Revenue retention will also be reviewed. Gross revenue retention (the percentage of existing revenue that you renew each year) and net revenue retention (accounting for the expansion of your customer base) are the two key metrics. A business retaining 80%+ of its ARR and growing its customer base is significantly more valuable than one reliant on new customer acquisition.
2. Growth rate and profitability
Your buyer wants a business that is going to continue making them money for years to come, so the efficiency of your historical growth, and opportunity to continue this, is very important.
Often the ‘Rule of 40’ will be applied here, whereby the sum of the revenue growth rate and profit margin should exceed 40% to predict strong future profitability. Achieving this signals to your potential buyer that the company has long-term potential in its current market. But if you come up slightly short – don’t lost hope! This is a general rule of thumb and a conceptual target that incorporates both growth and profitability, it does not entirely rule you out by any means.
3. Customer base and retention
The shape and quality of your customer base tells buyers a great deal about your position in the market and future risk. More often than not, a large number of customers of varying sizes forming your overall customer base is preferable as this means your revenue is better protected, rather than a significant percentage being attached to one customer.
Buyers will also consider the stickiness of your customer base, whether they are likely to remain long-term customers or move away from your product to a competitor. A sticky product reduces churn, so this is a highly considered factor during the acquisition process.
4. Market size and position
Alongside the customer base, buyers will review your market size and position. How well-known is your product in its target market? What is the win rate against competitors? How strong is your brand recognition? What percentage of your target market do you already work with?
These questions will give your buyer an indication of how strong the product and how it measures up against others like it. This should identify areas for improvement or expansion, giving your buyer more opportunity for growth as they invest in your product.
5. Team, product and scalability
Acquirers are not only buying into your revenue and customers, they’re considering your product, your people and your infrastructure too. The knowledge and experience of your team is very important, particularly if you’re planning to step back after acquisition. A business that has too much dependency on you as the founder – or any one specific person – will flag as a risk that should be addressed.
From a product perspective, your buyer will need a clear, well documented product roadmap and clear processes. They will want evidence that the product can be scaled operationally, and the ability to do this without having to strip too much back or rebuild. Scalability will be supported by the market size and customer base analysis, but the product itself is naturally crucial here too.
Ready for the next step?
If you’re comfortable with these five key areas then you massively reduce your risk when entering into a valuation process, and will likely speed up the due diligence process too.
The most successful software founders will build genuine clarity around each area, addressing any weaknesses before serious talks about acquisition begin and approaching a buyer with clear metrics and a credible path forward. At its core, it’s important to remember that valuation is a reflection of confidence, and confidence is earned through preparation.
If this sounds like you and you’re ready to start conversations about finding your business a new home, get in touch with our M&A team for more information.
