Is ARR a Golden Ratio to value an IT business, or just an easy way to run a financial model?
According to a Wall Street Journal recent article, Brad Gerstner, CEO of Altimeter Capital, has recently forbidden the usage of the ARR (Annual Recurring Revenue) word to all his investors when they are talking about AI firms’ valuation. Main argument being that historical model and current business intensity are not right to give some medium-term perspective for an uncertain yet potentially explosive business.
This triggers some thoughts about the currently common practice of evaluating a software business from a multiplier of its current ARR (thus assessing both the existing asset and the acquired growth rate).
The ARR-based valuation method is indeed comfortable for financial people (they like easy and standards models) but it intrinsically assumes that many markets forever stay untapped and therefore offer an unlimited potential for growth of performing players.
On top of this, the use of this valuation approach does raise two key questions:
- Is it relevant to a market which is globally turning very fast to business models where SaaS delivery models are getting the lion’s share?
- Is it consistent with the current development pattern of many software companies: first, an initial phase of exponential growth based on intensive acquisition of new customers with a breakthrough portfolio, then a stabilization phase implying new cash injection in order to find a second wind of solid growth?
Old-timers will recall telco mobile businesses that started boosting some 25 years ago and have been valued for many years on the basis of ARR dynamics (ARR as a consolidation of average revenues per individual users). There, this valuation model has long proven to be right, but:
- market potential for growth was unlimited (more than 7 billion potential mobile phone users),
- access to market was extremely costly (cost of license and cost of infrastructure to initially deploy) and therefore very selective,
- technical constraints and friendly regulations inhibited any churn for many years,
- oligopolistic vendors have secured long technological market steps that allowed them to finance new generation R&D (2G, then 3G then…) with the revenues from currently deployed generation.
None of those 4 points stands for the current IT software industry.
Our opinion is that valuation of an already established business that would only be based on ARR is highly challengeable as it does ignore some critical points such as:
SaaS models generate fierce competition with immediate impact
Very low entry barriers and easier churn create necessary reactions such as immediate price lowering and accelerated innovation to keep or go on increasing market share.
SaaS models enforce a very intensive cash “grow or die” model
New customer acquisition is more and more costly (direct selling costs as well as costs of channels depending on your go-to-market approach)
Cross selling and upselling to existing customers as well as acquisition of new customers rely on ongoing investments in R&D.
In addition, they generate additional selling costs (direct selling costs as well as channel costs) as well as additional infrastructure costs to secure delivery.
SAAS models lead to consolidation
Growth being based on significant cash burn, only consolidation will trigger a significant profitability bounce.
Also, due to the ongoing digital transformation, the IT software market is boiling and the situation of a vendor can hence change very fast.
Our experience therefore leads us to recommend going through a more elaborate 3-step process to craft an adequately balanced business valuation. Let us now describe these 3 steps.
3 steps to achieve a balanced business valuation
- Evaluate on ARR and MRR basis combined with an assessment on “where does the business stand vs IT software cycle: first wind, plateau or second wind?”, based on revenues and gross margin percentage trends.
- Evaluate on business plan basis (one basic scenario and variations)
The first elements to assess are the evolutions of the top line and the R&D (and product support) costs to enable it. Then turn to the evolution of the selling and delivery costs.
Targeted top line (and variations) for each year can be defined after consideration of the following questions.
What is known as market trends especially from a geographical standpoint?
Based on current geographic mix, what should have been nominal growth so far?
How does it compare with ARR historical and future trends?
Defined target must then be split between customer base and new customers.
Targeted costs (and variations) for each year can be defined after consideration of the following questions:
R&D and support
Are there extra costs to plan (on top of current roadmap estimates) in order to deliver targeted upselling at existing customers and to support different options for price evolution (keeping current prices or suffering various lowering pressures)?
Are there extra costs to plan (on top of current roadmap estimates) in order to penetrate new markets or geographies for delivering targeted revenues to new customers?
Selling and Delivery
What are the go-to-market and extra selling costs to support that growth (on top of current estimates)?
What infrastructure costs to support the delivery of planned business (on top of current estimates)?
- Assess vs potential future consolidation
Best here is to systematically establish a SWOT that will allow to assess the chances of “consolidating” vs the risk of “being consolidated”. Main parameters are the strengths of differentiators such as “customer base”, “robustness and acknowledgment of the offer” , “employees skills” etc.
This approach will lead to valuations that include the cost of risks vs what you would get from the ARR valuation model and will therefore be lower from a strict calculation standpoint.
At the same time, it will also open several options to control those risks and generate additional opportunities; opportunities will allow to fine tune the valuation to the type of transaction that could be at stake and the type of professional you are dealing with (strategic investor/industry player, financial investor, specialized financial investor focused on software companies aggregation…).
Why CDI Global
At CDI Global, our team of senior bankers and IT industry experts utilize decades of experience to implement and execute upon cross-border M&A, debt and equity transactions vital to maintaining competitive positioning. Our proven transaction execution capabilities, combined with niche market and channel expertise, position CDI Global as a leading cross-border advisor for IT mergers and acquisitions.
By Eric Pradier, CDI Global Member and IT Industry Expert
