Access to capital has changed over the last few quarters, which, of course, is impacting the real estate technology mergers-and-acquisitions space. There are a lot of things happening on a macro level causing this shift, including rising mortgage rates, inflation and the ongoing war in Ukraine.
The grow-at-all-costs tech approach and reliance on the ability to continually raise subsequent rounds of funding, regardless of profitability that predominated in the 2010s, has changed noticeably, especially over the last few months.
To get a sense for just how much the tech M&A market is changing, it is useful to evaluate the BVP Nasdaq Emerging Cloud Index from the venture capital firm Bessemer Venture Partners. The index tracks the stock performance of a mix of emerging cloud-based technology companies including Salesforce, HubSpot, Zoom, Okta and Zendesk and serves as a fairly decent proxy for the performance of the real estate tech company investment market.
In 2022, through August 18, the index dropped by over a third (36.4 percent). In other words, the average revenue multiple of the index companies’ valuation dropped from 14.2X to 9.0X over that period.
This cooling tracks with a broader shift in investor focus to solid operating fundamentals for their targets, Thus, property technology companies, especially those looking to participate in the M&A market as acquirees, face increasing pressure to run solid businesses.
Company valuations are always a bit of an art. However, some solid fundamentals remain core to the way investors evaluate M&A targets. Some of the most prominent metrics include:
- Annual recurring revenue, which shows just how big the company’s business is in dollar terms.
- Growth rate, which reveals how fast the company is growing and its longer-term trajectory and potential as an investment.
- Net customer retention rates, which reveals how well the product or service serves its customers.
- Gross margin, which reveals the amount of money a company has left after subtracting all direct costs of producing or purchasing the goods or services it sells.
- The ratio of long-term customer value to customer acquisition cost. This number indicates the overall efficiency of the business. A ratio of three and above is solid in the software-as-a-service world.
Other important metrics exist, of course, but to get a sense for how well a business is run, how it is growing (if it is) and serving its customers, these stand as solid, market-independent evaluation metrics. Companies who perform well in these areas command higher valuations, especially now. Other more qualitative factors like brand and management team expertise play additive roles to these core measurements.
In this more disciplined M&A environment, a classic investment rubric will likely gain importance: the Rule of 40. This rule looks at just two of the core valuation measurements – growth rate and profit margin – and reveals the attractiveness of an acquisition target. The idea is that a target is generally considered attractive If the sum of these two measurements is above a 40 percent threshold.
A business, for example, could be growing fast, at 100 percent year over year, but losing money with a negative 30 percent profit margin, and that business comes in north of the Rule of 40. Or, a business is growing at a slower rate, say 25 percent, but it has a 15 percent profit margin, and that also satisfies the rule.
The Rule of 40 is not the only metric or sole focus for investors (and targets), but it presents a short-hand way to quickly estimate the health and attractiveness of an investment target.
If you are looking to acquire or be acquired, reach out to the T3 Sixty for a knowledgeable review of options and how to best prepare for the event. You can reach out to me, Mike Feller, vice president of technology corporate development at T3 Sixty, at firstname.lastname@example.org.