The Exit Conundrum
As summer winds down, the positive macroeconomic picture has renewed optimism that exits and deal-making will improve in the coming months. With inflation falling and the potential for rate cuts looming, we have already seen signs of this recovery in 2024.
Pitchbook reports that the number of M&A deals in the first half of 2024 is 10% above the same period for 2023, while deal value is up 15%. This is being driven by corporate acquisitions and PE-related deals. That said, M&A is still probably being held back for a couple of reasons.
First, while PE-backed exits present a range of scenarios that create liquidity for long-time investors, they present founders with difficult choices about giving up control. Second, investors are still spooked by regulatory issues after intense scrutiny led to the cancellation of several mega deals, including the $20 billion Figma-Adobe acquisition abandoned in late 2023 and Amazon’s decision to drop its $1.4 billion bid for iRobot.
Meanwhile, the IPO window seems to finally be cracking open, though the bar for an IPO remains high.
There is also a surge in secondary deals, attractive options because they release some of the pressure to push for a total exit by creating liquidity for early shareholders, especially employees.
With several routes to liquidity, trying to determine which may be the most optimal is complicated because the investment frenzy of 2020–21 left many companies — even very successful ones — with distorted valuations. In addition, investors have changed their emphasis on growth versus profitability since those peak investment years. While growth still matters, it can’t come at all costs. Companies must demonstrate the durability of their business model.
As exits move into reach, investors and founders are increasingly trying to get better insight into their present valuations before they go into the market to see what price they can command.
In recent months, our firm has been getting more calls from companies that want to understand their intrinsic valuation, one that is not determined by an investment or liquidity event. Having clear visibility into valuation is critical for optimizing the chances for a successful exit — not matter which form that takes.
I want to share some high-level thoughts about why this is important, how to think about value, and how to properly assess valuations.
Part I: Price vs Value
Companies should start by understanding the distinction between price and valuation. These are often considered to be synonymous. They are not.
Price is driven by external factors. This is the amount someone is willing to pay at a given moment. However, the factors that will drive a hypothetical buyer’s calculations are hard to know in advance. In an M&A bid, the price consideration could be driven by a strategic or competitive need. In an IPO, the market could be driven by changing macroeconomic conditions, or the failure or success of another company in the same vertical.
Founders and investors can’t control these external forces. Trying to map out the various possibilities and then optimize a company for those scenarios is futile — and possibly destructive.
Value is about taking a clear, honest look internally. Valuation is based on levers that founders can move and influence. This enables the creation of a playbook based on the things that can be controlled right now. Companies can use that to correct any fundamental weaknesses and create a more resilient business model. Maybe your margins are cracking. Maybe you’re under-investing in certain departments, especially R&D. These are fixable.
Such insight is especially important when it comes to GenAI. No matter the exit, GenAI is raising the expectations for performance. At the same time, GenAI presents new challenges in terms of operational and capital expenses and uncertainty about revenue impact. The ability to sufficiently invest in GenAI can become a point of failure if the tradeoffs in terms of spending and margins are not well understood. Being able to track this at a granular level and course correct is vital for making a convincing case about valuation.
Part 2: Inside the numbers
Determining that intrinsic value is a complex process that requires digging deeply into every aspect of the business. One of the best tools for getting a read on value is Discounted Cash Flow.
However, for DCF to be effective, the company must be making defensible assumptions about the future of its business. Many are not.
We were recently engaged by a client who wanted our firm to conduct an independent analysis to validate their view of the valuations. To do this, we used our Advanced Growth Intelligence (AGI) analytical framework that was specifically developed to analyze disruptive companies by rigorously testing the quality of revenue, growth, and margins.
In this case, the client was profitable, and management had made a cash-flow projection for the next 10 years when it would finish its hyper-growth period. At the moment, growth remains robust, and the assumptions made about revenues were reasonable based on peer benchmarks and our analysis of the different levers — like user growth and usage — driving those elements.
However, the cost analysis was another story. First S&M were restated to reflect the level of spend needed to reach the company’s ambitious growth targets. Then the company had effectively projected that its overhead for things like G&A, and R&D, would remain unchanged over the next decade even as it massively scaled. This was inflating margins in our view. Using AGI, we revised those numbers to create a more defensible projection. As a result, the projected net income was cut by about 40%.
To be clear: This is still a fantastic business, and its future is extremely bright. But now management has a more candid view of how their different decisions will impact margins and that path to demonstrating resiliency.
An example of how this looks to external investors can be seen with Rubrik, the data management and security company that went public in late April. In the weeks before the IPO, I published a detailed breakdown of Rubrik’s S-1 breakdown based on our AGI methodology.
Overall, I came away extremely bullish. Rubrik had demonstrated strong performance across many of AGI’s key pillars that that made the company a solid IPO candidate. However, I did highlight one red flag: Rubrik’s weakest area was its Quality of Margins. The company is navigating a complex business model transition toward becoming a SaaS platform, and its spending across a number of categories to fuel its growth was potentially troubling.
“In our view, the company is still burning a lot of cash though margins have improved: losses are growing as the company appears to be spending heavily to acquire customers and manage its product transition,” I wrote in April just after the IPO.
Rubrik reported its first earnings as a public company in late June and, in general, the company beat analysts’ expectations with higher revenue than expected and strong customer growth. With one notable exception: cash flow from operations. For FY 2025, executives told analysts that the company expects free cash flow of negative $115 million to negative $95 million. While that includes about $23 million in one-time expenses related to the IPO, it’s still an indication of the big spending the company needs to make its transition.
The question that I raised by Rubrik’s IPO in April is still paramount today: Do investors put a premium on (high) growth vs profitability?
Investors are giving us some clues. Despite those strong earnings, Rubrik’s stock is trading slightly below the first-day close. Of course, 4 months is hardly enough time to make sweeping judgments about Rubrik’s performance. Still, the stock price suggests public markets remain hard to please and need more convincing on the underlying durability of the business model.
It’s also worth considering the example of Samsara, the software and analytics IoT company that went public in late 2021. Samsara had a rough first year amid the broader tech stock meltdown in 2022, losing more than half of its value. But since then, the stock has climbed gradually and now trades at about 1.5 times its opening price. Why? The company continues to deliver growth above 30% YoY. Even better, analysts are projecting a positive EPS will grow to 13 cents by the end of this FY, up from 3 cents. That combination of high growth and a strong bottom line is being rewarded by investors with a strong enterprise valuation to revenue ratio of 21.7 — one that some analysts believe still undervalues the company’s intrinsic valuation.
Likewise, Toast is delivering high growth at scale and is being rewarded with a valuation that is 10x its ARR.
For companies still weighing their potential exit options, this does not mean they have to be profitable today to achieve a successful exit. But a company does need to be able to clearly articulate its path to getting there within the next two years, a challenge that will be complicated by the impact of GenAI.
Databricks, a hotly anticipated IPO, has been laying the groundwork for going by public by disclosing its detailed audited financials for several quarters. In June, the company reported 60% annualized revenue growth. Just as important, as I noted last year, Databricks has been aggressive about investing in key GenAI infrastructure tools through deals such its billion-dollar acquisition of MosaicML, an MLOps open-source startup with neural networks expertise that has built a platform for organizations to train large language models and deploy GenAI tools based on those models. Just a few weeks ago, Databricks announced it had acquired data optimization startup Tabular for $1 billion to further reinforce its GenAI infrastructure offerings. It remains to be seen how investors will reward that should Databricks finally go public.
Overall, the advent of the AI era is leading to a resurgence in values of cloud-related companies, especially those of the cloud giants, according to Bessemer Venture Partners’ most recent State of the Cloud report. Among several interesting trends highlighted: the fierce competition among the biggest cloud companies is heating up the market to relevant acquisitions that can bring some kind of advantage.
Again, these signals — good and bad — can tempt investors and founders to use these valuations to benchmark their own valuation. But gaining genuine insight into the intrinsic valuation is the starting point. Improving the things that can be controlled is fundamental to making a convincing case that the company has developed the resiliency that makes it attractive no matter which player is trying to set an external price.
