How to see the wood for the trees in company valuations

It’s a law of physics that no tree can ever grow into the stratosphere. At some point, they hit a ceiling, and then the trees all start to look like a forest.

Only when you climb down into the branches and bark is it possible to see which trees are healthy, which have the best trunks, the hardness of the wood and whether there’s any delicious fruit hanging from the twigs.

Looking at a company’s intangible assets is a bit like learning to see the wood for the trees, so to speak.

Each day, a company’s intangible assets, such as data, brand, expertise, relationships, confidential information, software, design, approvals and certifications, content and invention all help to build up its revenue base, add new customers and come up with fresh ways of doing business.

These intangible assets add real dynamism and energy to a company, driving it upwards until it, hopefully, bursts out from the forest canopy.

Accountants are often flying high above the forest of businesses, judging the value of a company by measuring its revenue growth, cash on hand and the hard assets it owns. They whip out a tape measure to calculate a tree’s height, the quality of its wood or if there’s a clear demand for its lumber in the housing market.

That’s usually what a “fair” valuation looks like. But there’s so much more to a business than its dimensions. Just as the intangible aspects of a tree make it valuable, so too for businesses.

For example, is the tree growing in the middle of the forest or on the outskirts? That’s important because wind toughens a tree’s wood. So, if wood strength is important to a buyer then a tree on the edge of a forest will be more valuable than a tree taken from the centre, all other things being equal.

Likewise, does the tree grow fast or take 500 years to reach a mature height? A Redwood pine grows tall and straight, but it’s not economical because a builder can’t wait a century for it to reach 40m. They have a house to build today. Yet a Monterey pine (pinus radiata) that grows quickly will be much more valuable to a builder with a deadline, even if the wood isn’t the best quality.

And sometimes if a tree attracts animals, that might be its most valuable feature. A buyer may not want to chop such a tree down for firewood or wall frames. For that buyer, the value of the tree is in the environment it creates or that it was planted right in the centre of a playground.

In the same way, valuations that fly briefly over the top of a business are sure to miss what makes it so different – especially if that company sits inside a big forest.

When the forest of software-as-a-service (SaaS) companies was reaching maturity in 2015, it consisted of hundreds of different firms with annual revenues north of $100 million. Their revenues had grown steadily for years.

But by the time a US-based private equity firm went shopping for SaaS businesses that it could roll up into a larger corporate vehicle, the revenue growth trends in the SaaS sector had already begun to decelerate and may have hit a ceiling.

The PE firm had a price in mind for buying a SaaS company: a 2-3x multiple. That seemed reasonable given the sector’s revenue growth stagnation. So, when it approached the real-estate CRM company Agentbox with a proposal, the leadership of Agentbox wanted to prove it was worth much more.

By analysing its intangible assets, it quickly became clear that Agentbox was at the tipping point of controlling the entire real-estate CRM sector in its native Australia. It boasted a >60% market share and was the preferred option for all the “who’s who” in the country’s real-estate world. The closest rival could only show a measly 14% market share.

Agentbox’s dominance was creating a network effect, in which the cost of adding new customers got cheaper and cheaper as word-of-mouth did all the heavy lifting of marketing. The company’s brand was also well-known, its software easy to use and it had plenty of high-quality data on all kinds of customer profiles. It was brimming with intangible assets.

Tabulating these assets into the valuation, Agentbox came up with a 7.3x multiple. The broker on the other side of the deal immediately dismissed the valuation as crazy and the CEO of Agentbox was nervous that the price might blow up the deal.

He didn’t need to worry because when all the parties looked at the rationale, line by line, to understand these intangible assets, Agentbox’s valuation made sense. There was simply no other SaaS company in that space that had such a constellation of excellent intangible assets.

The deal closed and both parties went away under the full impression that they got a good deal. That’s the best outcome in any transaction.

But if the Agentbox valuation had stayed at the level of the treetops, looking down on the forest of SaaS companies, the final price might have been the middling 3x multiple expected at the outset.

It was only by digging into what truly made Agentbox a valuable – and different – company that it could reflect a price that considered all its hard-won intangible assets.