Can you grow the value of your business by being less involved in it? Under some conditions, you can. You read that right. This of course is a very controversial stance. Even those in favor of it will agree it is highly counter-intuitive. According to conventional wisdom, small businesses run better with greater owner involvement, right?
Yes, and no. For the purpose of this article let us restrict ourselves to tech startups. Let us further sharpen our focus on Software-as-a-Service (SaaS) businesses. Most SaaS entrepreneurs will tell you that greater founder involvement will lead to stronger IP and a better product. So, the idea of higher valuation with lower involvement is totally counter-intuitive to most tech founders. They go – What? If I am less involved, I get paid more? The answer is yes, and this article will tell you why.
But before we go there, let us get some basics out of the way.
SaaS Business Valuation
The value of a growing SaaS startup is usually estimated in one of the three ways: the EBITDA multiple, the seller discretionary earnings (SDE) multiple, and the Revenue multiple. Let us focus on the EBITDA multiple to illustrate valuation. You can use a similar analysis for other methods.
The EBITDA multiple is appropriate for companies that have a positive earnings margin before interest, taxes, depreciation, and amortization. Okay, so you say here is my EBITDA. What multiplier do I use now to find out the value of my startup? The answer is a bit lengthy. First, you find comparable companies (same industry, similar size) that were traded in the recent past, study the multiple of EBITDA at which they were traded, and arrive at a baseline multiplier. Then you apply a premium or a discount based on a variety of factors: revenue growth rate, SaaS gross margin, the ratio of customer lifetime value to customer acquisition cost, and so on. Thus, you modify the baseline multiplier and arrive at a new number. Finally, EBITDA times that number is an estimate of your startup’s value.
The Early Days of SaaS Firms
The key activities of a SaaS startup revolve primarily around product development and marketing. Product development tends to involve technical work. Often, founders tend to be technical experts with innovative ideas. They bake their competitive advantage into patents, products, and processes around their inventions. This makes them deeply involved in technical work not only before the product is rolled out into the market, but long after.
Fast forward a few quarters, or a few years, and the startup has built some market momentum. It has growing revenue, adequate gross margin, even a decent EBITDA. Now the founder is ready to sell the business. This is when the search for a buyer begins.
And that is when your involvement in products starts showing unintended consequences. What does founder involvement have to do with valuation? That is what we explore next.
Passivity Premium and Non-technical Premium
If you play out the acquisition game from a buyer’s perspective, one of the key issues is how to transition the acquired business. If the founder is highly technical and deeply involved in technical work, the transition requires that the acquirer have the capability to handle that work. Owner’s lower technical involvement changes that equation: It becomes easier to transition the business to a nontechnical owner. That in turn means that you can choose from a greater pool of potential investors. Otherwise, your buyer pool is limited only to technical owners.
In short, owner passivity expands the market for your SaaS business, and therefore adds a premium.
Another way to look at the owner’s involvement in technical work is the replacement cost it necessitates when the business is sold. The buyer must invest in a technically competent and motivated person who would probably cost a bunch of salaries, benefits, and stock. When the buyer factors in this cost, the real EBITDA appears lower than what your P&L shows, and therefore lowers the valuation of the business to be acquired.
In other words, you earn a ‘non-technical premium’ for your SaaS business if you can show that your replacement cost is not a factor.
How Can You Benefit from This?
You read all this and say, fine, that sounds intriguing. But what can I do so that I benefit from knowing this? I cannot help being an engineer who loves to get into the trenches. Even if I delegate technical work to my team, they fall back on me for most decisions that require me to look under the hood anyway. So, what can I do differently?
One idea is to selectively outsource pieces of your product development work to a reliable and competent provider of product engineering services. Most companies favor outsourcing because it avoids a bloated payroll, converts fixed costs into variable costs, and saves money due to labor arbitrage. All those are good reasons but as a SaaS founder, you must remember there is a strategic financial reason for outsourcing.
If you can demonstrate to your potential buyer that you have a well-oiled outsourcing engine for technical work, you have discovered one of the greatest levers of exit value of your SaaS business.
Why is that? By making a timely decision to outsource pieces of your development work, you have shifted the burden of development work to a stable and competent outside company. When a buyer sees that your development work is reliably outsourced to a company that has been there long before you started up and will continue to be there for years to come, it immediately means an easier transfer of ownership. The buyer goes, Ah-ha! I have been spared the headache of knowledge transfer.
As a tech founder myself, I will be the last person to ask you to be less involved, much less ignore the technology aspect of your business. That is not what this article is about. I have merely built a case for not making yourself indispensable to a point of making the business unattractive. I have explained why it makes sense for the buyer to pay more for a SaaS startup if the founder is less involved technically, whether through using an outsourcing partner or by other means. Agree? Disagree? I would love to hear your views.
The author acknowledges prior work by Thomas Smale that has been immensely useful in framing this issue. Smale’s writing confirms what we have seen at Harbinger Systems time and again over three decades of helping tech startups in their product development and business growth.