In a recent post, we took a look at how digital signage software companies are valued, with a focus on early stage companies since they currently dominate (in numbers) today’s marketplace. For the most part, seed and early stage valuations are based largely upon a combination of the investors’ knowledge of and faith in the management team; an establishment of ownership position; and a clear sense of how far each round will take the company. Those who come in early understand the risk of their investment, but they can generally protect their ownership position as the company evolves if they choose to do so. Investors who come in after a track record of some sort is established tend to base value upon the clarity of the path toward next phases of the company’s life cycle and important business milestones.
As start-ups mature and gain defensible market positions, growth and profitability, and ultimately achieve significant market share milestones, the factors that go into valuation become more measurable and the art of early stage investing gives way to the science of enterprise valuation. The three stages that follow start-up can be captured with alliteration: viability, visibility and validation. When a software company is able to drop the anything-for-money strategy and carve out a market space for itself, it crosses the chasm from start up to viable entity. That market space may be based upon a particular feature, function or technical capability, or it may be based on a market segment or vertical that offers great growth prospects. In both cases, if the niche can be both exploited and defended, then an important foundation for future growth has been laid. Valuation at that point might be based on a multiple of reasonably forecastable revenue numbers for the current year and one to two years out. What that multiple would be would largely depend upon an assessment of the size of the niche that has been established, the level of competition, and its attractiveness to both potential competitors (risk) and suitors (reward). Certainly the universal intangibles of management and team skill sets come in to play, but at this stage there are actual numbers and real performance that can enter into a discussion of value.
As a company enters a stage where growth accelerates and profits are realized, it becomes not just viable, but visible. By dint of achieving sustained and substantial growth, a company moves up the important ladder of perception to become a factor to be reckoned with in attracting new deals, new partners, new people and new investors. This visibility adds value as it serves to mitigate some competitive risk while creating exit options that drive valuation higher. An emerging and visible company has options that include organic growth fueled by internally-generated cash flow; hyper growth, typified by infusion of institutional capital; and M&A activity from either side of the table, depending upon the deal. Valuation at this stage may depend upon which glide path the company appears to be on. If it is playing the organic growth, self-funded game, then value would tend to be based on a multiple of EBITDA, factored for the growth rate of same. In the hyper growth model, where valuation is obtained for the purpose of a large infusion of new capital, discussions may begin around the post-money value of previous rounds, EBITDA and revenue growth, the amount of money being raised, and the ownership objectives (and sometimes limitations) of the investors. It is at this stage where prospective values, those determined upon an exit or liquidity event, come in to play. Set a pre-money value too high, and targeted exit values start to get unrealistically high, which tends to scare off institutional investors.
The digital signage software industry faces two challenges right at this stage. First, because there have very relatively few transactions in which terms were made public, benchmark multiples or the “market rate” if you will, are not well established in this sector, which creates some uncertainty. Second, no pure play digital signage software company has scaled to the size where an exit valuation, whether by acquisition or IPO, would be high enough to meet IRR goals of institutional investors who invest at the growth stage. This might lead to a conclusion that smart capital invested at this stage would be earmarked for consolidation activities to achieve scale, or for diversification efforts to become less reliant upon pure digital signage growth. In fact, it may be difficult to get to the fourth stage, validation, without one or the other.
Validation entails the achievement of significant financial and market share metrics. As an example, the $10 million revenue metric (and not one that is artificially pumped up by low/no margin hardware sales) is generally considered an important milestone. A profitable company at that level of sales has started to mature, and has the need and the ability to add and deploy resources to open new markets, develop and market new products and consider new business segments. While share metrics will be more difficult to determine in a fragmented market, it will be apparent to most objective observers when a company becomes a market leader and a go-to option for customers. This type of validation opens the door to growth, innovation and ongoing profitability. It also creates more options for an exit from private ownership. Valuation at this stage becomes a financial exercise. Investors can go through complicated calculations of discounted cash flows, price to earnings ratios, and revenue and earnings multiples based upon values of other (non-digital signage) software companies at a similar stage.
Without doubt, this is where valuations will be most generous, and the temptation to go the IPO route will be high. While there is a publicly traded company from the sector, its market capitalization (net of cash) is probably lower than many private competitors would value themselves today, yet higher than the private firms could realistically expect to achieve in a transaction. To achieve maximum valuation, whether in a capital raise, a transaction or an IPO, a digital signage company would have to find a way to achieve the milestones of validation. Failing that, market realities will keep a lid on value. Don’t be surprised if there are dramatic attempts to force the issue as 2011 unfolds.
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