Nuts? Bubblicious? A (very) simple explanation of super high startup acquisition pricesPosted: January 20, 2014
More often than not the reaction to a large company buying a comparatively small startup for a few hundred million or even a few billion is “nuts”, “bubblicious”, etc. In some cases this may be true and history sure is littered with poor acquisitions.
It is also full of great acquisitions that were called crazy at the time.
The problem is that we (e.g. wider public, journalists, the tech community and anyone not part of the deal) are largely working of a fraction of the information required to determine the “true value” of the startup company (let’s call it StartCo) to its acquirer (let’s call it LargeCo). The two key pieces missing to outsiders are usually the financial projections of StartCo for the next years and the synergies (both cost savings and additional revenues) LargeCo thinks it can achieve by acquiring StartCo.
Let’s say we know a lot more than the public usually would:
- StartCo’s 2014 revenues are expected to be $10m
- the discounted value of an independent StartCo’s future cash-flows is $100m
- StartCo’s stock-exchange traded peer group has an average 2014 revenue multiple of 5x (enterprise value divided by 2014 estimated revenues)
LargeCo just announced they are acquiring StartCo for $200m. You can add a few 0’s here and there for more fun – the same math applies.
Limited information usually leads to two mostly knee-jerk reactions that go something like this:
- “StartCo’s peer group is valued at 5x revenues and LargeCo bought StartCo for 20x! Nuts!”
- “Even if you factor in future cash-flows and the high growth of StartCo, StartCo is still only worth 10x revenues at most – and LargeCo bought them for 20x! Bubblicious!”
Yet 20x revenues could be just the right valuation of StartCo for LargeCo. In fact it could be a complete steal for LargeCo. Why?
1) Growth Premium
The first one is easy and independent of LargeCo acquiring the company: growth. It explains why startups can be acquired (or listed for that matter) at much higher multiples than a more established lower growth peer group of companies.
Having more growth means you should be valued at a higher multiple than your lower growth peers. The reason is that today’s valuation needs to – in relative terms – reflect a much higher cash flow going forward vs. the cash flow today.
So let’s look at how StartCo’s revenue profile compares to its more established, lower growth peers:
So you can easily see that StartCo is in a growth league of it’s own (145% compounded annual growth rate – “CAGR” – from 2014 to 2016) compared to it’s more established peers (17% average CAGR over the same time). I am assuming here that cash flows are growing at an equal rate because they ultimately determine value. In fact StartCos cash flow growth is likely to be even higher, coming from negative, to low % positive to (better than) industry standard. But to keep it very simple I’ll stick with revenue multiples.
Ok so now let’s look at how StartCo’s peers are valued on the stock exchange and what their implied EV (Enterprise Value) / revenue multiple is. I have also added the acquisition price LargeCo is paying for StartCo so we can get its implied EV / revenue multiples too.
So StartCo’s peer group trades at 3.3x – 9.0x 2014 revenues with an average of 6.2x. So looking at 2014 revenue multiples the acquisition price LargeCo paid for StartCo sure looks a bit crazy (20x vs. an average of 6.2x). But it doesn’t look so crazy when you look at 2015 (6.7x vs. 5.2x) and based on 2016 multiples the acquisition is a complete steal (3.3x vs. 4.7x)!
Remember – the 2014 revenue multiple of StartCo is very high because it reflects extraordinary growth; the revenue (and cash flows) will ‘catch-up’ with the valuation and it is not unusual that the implied 2016 revenue multiple is even lower than the peer group, probably due to the relative higher risk, still lower profitability, etc.
The picture becomes even clearer if you map the revenue multiples and growth rates on to a chart.
You can see that revenue multiple and growth rates are correlated within the listed peer group:
… and if you add in StartCo’s data points (top right) you can pretty much see it’s actually below the likely correlation line.
Key takeaway: extraordinarily higher growth warrants extraordinarily higher revenue multiples.
But wait – didn’t we say that all future cash flows of StartCo are worth $100m; so clearly $200m is still way overpaid – even if growth warrants a higher multiple to StartCo’s peers?
No – because we haven’t factored in…
2) Synergies LargeCo can achieve
This is harder and relies heavily on assumptions made by LargeCo – i.e. on how beneficial LargeCo thinks the acquisition of StartCo will be, beyond the actual value of StartCo’s future stand-alone cash flows.
LargeCo isn’t just buying StartCo and planning to keep it as it is. It plans to aggressively push StartCo’s products through its own sales channels, it plans to bundle StartCo’s products with its own improving conversion and churn, it wants StartCo to be the nucleus for an entire new product strategy, etc.
Let’s say LargeCo’s management team has carefully analysed the potential synergies and presents the following to the board (list of synergies with corresponding value of future cash-flows of these synergies for LargeCo):
So StartCo is actually worth $300m to LargeCo. Now of course if LargeCo paid $300m it would not create any value for its own shareholders.
But the management team and it’s board decide that it’s worth paying $200m for StartCo. This will create $100m in value for LargeCo’s shareholders – while paying 2x the value of StartCo’s future stand alone cash-flows and over 3x the peer group’s average revenue multiple.
Nuts? Bubblicious? Maybe, maybe not – time will tell for LargeCo. That’s why I’m careful with knee-jerk reactions to startup acquisition prices.