In business, it's important to always have an exit strategy. Many founders of early-stage firms have their eyes set on initial public offerings of their firms while others have a potential sale of their companies to a competitor or other company seeking inorganic growth (an acquisition). Another often overlooked exit strategy is the sale of a firm by its owners to its employees.
When considering exit strategies, the goal is to maximize the company's valuation at the time of exit. There are several choices to make in the process, and economic downturns can complicate these challenges even further. Traditional valuation methods have their place, but they may not account for every aspect of a business’s potential worth.
Traditional Valuation Methods
The most commonly used valuation methods can be mathematically heavy or surprisingly straightforward. The net present value of discounted cash flow, for instance, relies on intricate mathematical models to estimate a business’s current worth. This method is particularly suitable for businesses with substantial future earnings and is a popular method amongst investment bankers and corporate development staff at acquisitive firms.
A public company's valuation is easily determined through its market capitalization, which can be found in several publicly available sources on a real-time basis. Then, there's the simplistic approach where the valuation is just a multiple of a financial variable such as earnings before interest tax and depreciation or revenue. For this blog, we'll focus on the revenue multiple.
The Limitations of “Rational Valuation”
The term "rational valuation" refers to a value that is logically deduced and backed by financial data. However, it's important to remember that revenue, the basis of many valuation models, is at risk in several situations. There may be no product-market fit, poor market timing, competitive actions, or economic downturns. In addition, the valuation multiple can sometimes be rigidly set for certain industries or markets. So, what happens when your business can only attain a maximum "rational valuation"? It may be time to consider an alternative approach.
Enter Total Competitive Valuation
Total Competitive Valuation combines traditional valuation methods with competitive strategy to potentially increase a company's worth through an "irrational premium." This term may sound paradoxical, but it denotes the additional value that a company brings to the table beyond its rational valuation. This irrational premium could be driven by several factors and can help shape your competitive strategies.
Drivers of the Irrational Premium
The drivers of the irrational premium can be tangible or intangible and quantifiable or non-quantifiable. For example, the company's brand strength, intellectual property, net promoter score, and the founder's reputation can contribute to an irrational premium. Understanding these drivers and how they connect to competitive strategy can help businesses amplify their value.
For example, a professional services firm might choose the irrational premium drivers of eminence in domains of choice, for example, supply chain in the case of SGS Maine Pointe. Another case would be that of a consumer products firm, such as Proctor & Gamble, with its brand position as trustworthy. Emphasizing these drivers of irrational premium not only affects valuation but also provides effective areas of competitive advantage.
However, irrational premiums are not easy to maintain. Leadership necessarily needs to continually emphasize the strategically chosen drivers throughout their organizations. And communications to analysts, shareholders, owners, competitors, and customers are equally as important.
Public SaaS Company Examples
Consider top public Software-as-a-Service (SaaS) companies ranked by market capitalization. By applying a benchmark multiple of their trailing twelve-month (TTM) revenues, we can calculate a "rational valuation." The differences between rational valuations and their actual market capitalizations are the irrational premiums.
In the table below, you will see the calculated rational valuations based on a benchmark revenue multiple (12.7 times revenue), the market capitalizations, and the resultant irrational premiums.
Two things to note: (1) the extraordinary irrational premium of Snowflake at 85% of market capitalization and (2) the negative irrational premium of Salesforce.com at -6.4%. Rhetorically, in which position would you want your company to be?
More Than Just Rational Valuation
Whether or not the market explicitly recognizes Total Competitive Valuation, understanding the drivers of irrational premiums can help formulate effective competitive strategies. Knowing where to invest time and money in these drivers can greatly influence your plans of attack on competitors.
Begin with Your Wealth-Creation Goal
Setting a personal wealth goal at the time of exit is a crucial first step. This is generally projected 5 to 7 years out. Once this goal is set, you can determine what the business’s valuation needs to be at the time of exit to achieve your wealth-creation goal. This process, referred to by The Silicon Valley Laboratory as "reverse financial engineering," allows you to develop a roadmap with intermediate valuations by year and concurrently set your competitive roadmap.
Remember, among all wealth-creation vehicles (for example, equities, bonds, real estate, and precious objects), owning and operating your own business is the one you control the most. By leveraging the rational valuations and irrational premiums method, you can better position your business for a successful and lucrative exit.