Revenue quality is an area of focus for buyers and venture capital/private equity investors. High revenue quality companies are valued higher than low quality revenue companies. But what does this really mean and why is this?

It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues? Primarily it is about revenue continuity (i.e the expectation that today’s revenues will still be here tomorrow) but it is also about revenue diversity and margins/profitability.

Revenue Continuity

Long term customer contracts provide future revenue predictability. In many cases capital projects will not get financed without long term customer contracts. But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have? What percentage of revenues can be counted on to recur every year? Is the product/solution mission critical? Is it embedded in your customers’ businesses? Are switching costs high?

As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis. In some cases upfront customization is required and in all cases customers have to learn how to use the new software. Once customers have adopted such a solution, they will not switch very quickly. The solution becomes embedded in another business’ processes which results in high switching costs. As a result, its recurring revenues are usually quite stable.

There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.

Revenue Diversity

The greater the customer concentration the greater the risk. The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a small company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration. While the growth that it drives will increase value, the associated risk of these revenues will reduce value.

Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base. Ideally no customer generates more than 10% of revenues.

Profitability

If you operate in a low barrier to entry, fragmented market, then it will be hard to increase prices and produce sustainably strong margins. Of course different business models generate different margins. For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%. Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.

Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what. But stuff happens. Maybe this belief is based on personal relationships which cannot be sold with the business. There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin. Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.

Real World Implications for Revenue Quality

In the private M&A market, we are seeing buyers looking for third party quality of earnings reports as a requirement to closing a transaction. Especially when third party financing is required to fund the deal. Companies that don’t produce audited statements should expect the closing process to take an extra three to five weeks to accommodate an earnings quality review.

Raising Capital? Prepare for Your Needs Well in Advance

Nov 20, 2019 by dvp605

Raising capital can be time consuming and expensive. Capital may be in the form of a loan or an investment. The lender/investor will seek a return on the capital in the form of interest, royalties, dividends, and/or capital gain. Different forms of capital require different degrees of investment in time, due diligence, and closing costs. The spectrum, as measured by ease and timeliness of closing, ranges from a bank secured term loan, being relatively quick and easy to a minority or majority equity investment which can be complex and arduous to complete. Simply put, low risk capital is cheap and fast, and high risk capital is expensive and time consuming.

A secured loan can close about as quickly as the proper documentation and legal searches can be completed. This usually takes several weeks. An unsecured financing requires an assessment of equity risk which, if the issuer is not properly prepared, can take many months and, in a worst case scenario, unforeseen issues can derail the process entirely.

Preparation

An unsecured, or equity based financing is best approached in a prepared manner. Even if only 10% of the equity is being sold, the steps in the process are similar to those of selling the entire business. This includes writing a comprehensive business plan with a detailed use funds. Amount sought and use of funds are critical and, if the capital is for an acquisition then the investor may want to do due diligence on both companies and time the transactions to close at the same time. The amount should be enough to fund the plan plus a cushion to reduce risk.

Owner-entrepreneurs tend to under-estimate the difficulty of raising capital. Not being properly prepared can result in anticipated interest fading, a more expensive deal or, worst case, no deal at all.

Time-frame

If the required information is readily available, the preparation phase can be completed in about one month. Securing investor interest will take another month, investor presentations another month, negotiating an LOI and closing another 60-90 days. So six months, best case scenario. While technically the process can move faster, practically speaking, taking busy schedules into account, this is realistic. If the financial statements are not audited, then a quality of earnings review can add another 6 weeks to the process.

Cost

For a secured loan pricing factors include credit quality of the borrower, the bank’s cost of funds and the level of competition in the marketplace. As an example, if the bank cost of funds is 3% and the credit quality warrants a 300 basis point premium, the bank would charge an interest rate of 6%. On the equity side, the cost of funds is much higher and to meet target returns, investors have to compensate for the fact that not all investments will turn out as planned. Equity investors target returns of 2-3 times their original investment at the end of a 5 to 7 year holding period. A “triple” in six years is the equivalent of 20% return per annum.

Hiring an Advisor

Raising capital is generally not normal course business. Therefore, hiring external resources to manage the process can be an ideal solution to these ad-hoc circumstances. While the cost of an advisor typically represents a few points of the equity raised, it may well be that this would otherwise have been given up by going it alone anyway. The intangible benefits of finding the right partner that is a cultural fit and has sector relationships to help grow the business are immeasurable. The benefits of outsourcing management of the capital raising process to an advisor include:

I Experienced strategic positioning and the preparation of a comprehensive CIM

II Identification and engagement of the most suitable potential investors

III Professional assistance in the preparation for presentations and due diligence

IV Timely management of the process and securing the best price

V The strongest chance of closing

If raising capital is critical to your business’s success, then don’t take any chances. Start six to nine months in advance, assemble the best team and follow a process for success.

For more blog posts, please see Private Company Mergers and Acquisitions.

DVP Capital Inc.

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