There are plenty of reasons why you might want to value a tech company. First and foremost, an accurate business valuation is a critical piece of information for would-be investors and shareholders – if you’re looking to attract investment or sell more shares in your business, establishing its value is a vital step. Alternatively, you could be preparing to sell. Business owners typically start looking for a valuation two to four years ahead of a sale.
Ultimately, you may need to seek an objective valuation from an independent advisory firm. Before you shell out on a third-party appraisal, however, it’s worth conducting an internal valuation to give you an initial idea of the figure and determine whether you should proceed. This guide offers an introduction on how to value a tech company, exploring the relevant factors to consider and some of the valuation methods you could use.
Valuing a tech company is a complex process. On top of the challenges you would usually face as part of any business valuation, technology businesses in particular are notoriously tricky to value for a number of reasons.
Firstly, these organisations typically experience periods of rapid growth, making it tricky to project profits with any certainty. The business models used by technology companies can also make it difficult to establish how revenue might shift in the future, with software-as-a-service (SaaS) and subscription-based models presenting their own unique valuation challenges.
In certain cases, firms can be valued by comparing them with other similar businesses that have recently been sold – however, if the tech company sells an entirely novel product or service, there could be no point of comparison to work from. Operating in a new or developing market also means that there’s little data on which to base projections of business growth.
Despite the added complexities, it is still possible to arrive at a valuation that potential investors and buyers can rely on. Below, we’ve outlined some of the most important considerations to take into account as part of the tech company valuation process.
This factor has traditionally played an important role in the valuation process but is particularly relevant in the tech sector. Tech startups often go through sudden periods of growth as awareness takes off, but this type of firm is also highly likely to fold at short notice – the high degree of uncertainty and risk attached to young tech firms makes it hard to establish a reliable valuation.
As a result of this, the value of tech startups is liable to change by a significant amount in a short space of time. In 1999, Larry Page and Sergey Brin offered to sell Google to a rival search engine for $750,000 – just a few years later when the firm went public, it was valued at $23 billion.
Whilst the potential for volatility makes the valuation process difficult, it is not uncommon for new tech companies to receive sky-high valuations (often, this is based on comparisons with similar startup businesses that experienced equivalent growth levels in recent years). What’s more, with greater potential rewards on the table, the risk doesn’t necessarily put investors off: more than £288 billion was invested in new ventures worldwide in the first half of 2021, an all-time high.
That said, a well-established hardware or software business with a demonstrable record of profitability is a much safer bet. In such cases, the valuation can be calculated based on previous earnings, providing potential buyers and investors with a much more accurate figure to rely on.
When valuing a tech company, your approach should be tailored to the market in which it operates. Market maturity is a major factor to consider here. An advisory firm might increase its valuation if the business has a sizable share of a young up-and-coming market, particularly if the overall market data points to significant growth in the near-future.
In cases where the market is still in its introductory or growth stage, the key is to establish the firm’s current market penetration and then estimate the potential size of the market a number of years from now (considering how long it might be before growth slows down and the market stabilises). You can use this information to estimate how much revenue the company could be bringing in if it retains its existing market share and factor this into your valuation.
Does the company sell software or hardware? And how does it monetise its products? These are two key questions that you need to ask as part of a tech company valuation.
With higher margins and lower investment required, software firms have a greater propensity for rapid growth than their hardware counterparts – analysing the North American tech sector’s fastest-growing companies, Deloitte’s 2020 Tech Fast 500 found that 71% of them were software-based. As such, you’ll often hear about software startups receiving higher valuations. Hardware companies with extensive facilities and resources are an exception to this because their assets are accounted for in the valuation process (more on this below).
When valuing an established tech company with a decent amount of historical financial data, revenue-based methods such as multiple of earnings are typically used. This is the case for most business models, whether the business sells directly or through intermediaries, online or offline. SaaS and subscription-based tech firms are also valued based on previous and expected earnings where possible, but the valuation process might additionally focus on metrics such as customer lifetime value (CLV) and customer acquisition cost (CAC).
The worth of a company’s tangible assets is usually considered as part of the valuation process. Here, we’re talking about physical assets such as inventory, buildings, vehicles, equipment, investments, and money.
Consider these two tech companies:
Based on tangible assets alone, the first business would receive a significantly higher valuation than the software company. In reality, physical assets are just one of the many factors that are considered as part of a tech company valuation.
Intangible assets such as intellectual property, brand reputation, and customer loyalty can be equally important when it comes to determining the value of a technology business. Returning to the example above, it might be the case that the cybersecurity company’s trademarks and software patents are valued more highly than all of the physical assets owned by the semiconductor manufacturer.
As with any type of business, the context in which the company valuation occurs is vital. The same technology firm could receive completely different valuations depending on its current position – for example, a high-growth business seeking additional investment is likely to be looked upon more favourably in valuation terms than if it were being bought out by its main competitor.
Now that we’ve explored some of the main factors to consider, this section introduces you to some of the calculations and methods you could use as part of a tech company valuation. Unfortunately, there’s no one-size-fits-all approach to this process – you need to tailor your technique to the specific circumstances of the business in question, and often this means combining several different methods.
Tech company valuation methods that focus on earnings are often considered the most accurate and reliable by would-be investors. The multiple of earnings calculation is commonly used in cases where sufficient financial data is available. The general idea is simple: you take the company’s yearly earnings and multiply it by a given number (a ‘multiple’) to calculate its value.
In practice, this method is much more complicated. The process looks something like this:
1. Step one is to calculate earnings. There are different ways of determining earnings – often, this is considered to be earnings before interest and tax (EBIT) but sometimes earnings are calculated using EBITDA (earnings before interest, taxes, depreciation, and amortization).
2. With earnings calculated, the next step is to work out the multiple in the equation. Multiples are ratios used to compare an aspect of the financial status of one company with another. Price/earnings (P/E) ratios are often used in valuation – this is a company’s share price divided by its yearly earnings.
3. Once you’ve calculated this ratio, compare it to other similar businesses in the same industry to ensure you’re in the right region (P/E ratios of 10-25 are common in the tech sector, but you should look up the figures that relate to your specific niche).
4. Finally, take the ratio and multiply it by yearly earnings to work out the company’s value.
When using the multiple of earnings method, you should also adjust your final figure based on the factors discussed above (for example, taking any assets and the maturity of the market/company into account).
This is another conventional method of valuing a company based on its expected future cash flows. Discounted cash flow (DCF) is quite a traditional calculation to use in the company valuation process. Whilst it might seem outdated to use it in the technology sector, McKinsey recently argued that DCF is the most reliable method for valuing a high-tech business.
To calculate DCF, you need to forecast cash flows over an agreed period and determine a discount rate based on the potential risk of investing in or purchasing the company. If it’s possible to forecast cash flows for your company accurately, see Investopedia’s guide to DCF for more information on using this valuation approach.
The entry valuation method can be useful when there’s not enough data to support calculations based on historical financial data. Deceptively simple, this technique asks you to work out how much it would cost to start a similar business and develop it to the same point as the one you’re trying to value.
Of course, entry valuation is not without its challenges. Every single aspect of building a business must be considered in the cost calculation, including:
Whilst it might not be too hard to work out the value of a company’s assets, the people-related costs can be tricky to determine. Putting an exact figure on the price associated with re-creating an organisation’s products or services can also be almost impossible in the case of some software firms.
Whichever valuation method you use to value a tech company, it’s important to take a look at the bigger picture when arriving at your final figure.
An independent advisory firm won’t just stick to one simple calculation when deciding how much a business is worth. Several different methods will often be used in order to compare the figures. The final valuation will then be adjusted to take into account factors such as market conditions and the company’s age and assets.
This guide has introduced you to the tech company valuation process. Whilst this is an immensely complicated task in reality, hopefully this blog has provided you with some initial insights into how it works and the calculations you might go on to use.
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